Crowdfunded REITs: Big Savings for Investors or a Recipe for Disaster?
When lawmakers and regulators first cracked open the door to crowdfunding in the JOBS Act by approving private placement advertising to accredited investors, real estate platforms were the most prolific adopters of the internet-driven investment model. They have arguably been the most successful, too, providing debt and equity to residential and commercial properties in markets around the country.
With proven deal-flow platforms, over the last several months at least two crowdfund sponsors – Realty Mogul and Fundrise – have launched REITs amid the expansion of Regulation A under the JOBS Act, which opened crowdfunding to retail investors subject to suitability standards. Meanwhile, Rich Uncles, which was originally established as a platform to crowdfund REITs, also formed a new REIT last year.
To gain an edge over traditional publicly registered non-traded REITs, the crowdfunded REITs are promoting the lack of up-front sales commissions and fees as a key cost-savings piece of their Internet direct investment model. It’s a feature that could lead to many more crowdfunded REITs as sponsors choose a less regulated and costly route to funding, said Markley Roderick, a partner with the Flaster Greenberg law firm in Cherry Hill, New Jersey.
“Crowdfunded REITs will have better yields, not only because of no upfront costs, but because internal fee structures are also going to be much lower,” said Roderick, a capital formation and securities attorney who is spearheading the firm’s crowdfunding practice. “I believe that REITs will be the most significant piece of crowdfunding in the future.”
Yet retail investors that invest in traditional non-traded REITs typically work with financial advisors who explain the investment’s risks and associated costs and enjoy the protection of due diligence performed by their advisor’s broker-dealer and often by third-party diligence reports that assist broker-dealers and their advisors. Investors in crowdfunded platforms are responsible for their own due diligence, and those that conduct a cursory reading of a crowdfunded REIT prospectus may not fully grasp the pitfalls. It’s a distinction that the Securities and Exchange Commission has recognized, according to its correspondence with Rich Uncles.
The sponsor in July 2016 began a $1 billion offering for its Rich Uncles NNN REIT, which as of March 31 had raised $44.8 million. The Rich Uncles website prominently touts no middleman, which enables it to “deliver a real estate product to the market that has roughly 10 percent more of the investment amount actually being invested in real estate.” Rich Uncles also advertises across a broad number of talk shows.
Yet the Rich Uncles NNN REIT prospectus reveals that it charges several fees, in particular an annual 40 percent participation fee on distributions – or a cash flow interest fee – subordinated to a 6.5 percent preferred shareholder return. Similarly, it also is charging a 40 percent incentive fee in the liquidation phase, also subordinated to a 6.5 percent preferred return. (Rich Uncles NNN REIT considers itself a perpetual life investment vehicle, however, and has no set liquidation date.) Those are well above similar fees non-traded REITs charge: In the few cases where a cash flow interest fee exits, it totaled 10 percent to 15 percent, according to a review of prospectuses. Typically a liquidation incentive fee is 15 percent. In each situation, the fees are above a 6 percent preferred return.
In addition to the 40 percent cash flow interest and liquidation fees, other Rich Uncles NNN REIT costs include acquisition and disposition fees and expenses of between 3 and 6 percent, an asset management fee of 1.2 percent, and organizational and offering expenses of 3 percent. It owns 12 properties that it has paid $65.5 million for before expenses.
When asked if Rich Uncles is a better deal for investors – even with higher back-end fee structure, the company said that it “trades off low front-end fees for higher back-end fees,” noting that “the investor is better off with [their] fee structure vs. NASAA guidelines,” which they claim most other non-listed REITs utilize. The company provided a side-by-side comparison of the maximum non-traded REIT fees allowed by NASAA – such as 15 percent O&O costs, and Rich Uncles came out on top. However, none of the non-traded REITs currently raising equity charge more than 2 percent in O&O fees – all except for Rich Uncles.
Ray Wirta, chairman of CBRE, launched the Newport Beach, California-based firm in 2012 to provide “real estate investing for everyone,” and the platform allows participants to invest as little as $500. The platform launched Rich Uncles REIT I in 2012, which is limited to California residents and primarily invests in properties in the state. Rich Uncles terminated the offering in July 2016 after raising $83.6 million, but Rich Uncles NNN REIT has acquired nearly 4.5 percent of REIT I’s shares for some $3.6 million.
Rich Uncles NNN REIT originally filed to sell shares on Form S-11 in July 2015. But in a nearly yearlong review, the SEC issued a series of letters asking for more clarity on a number of items. In particular, the SEC requested that Rich Uncles provide more details in the registration statement related to the 40 percent cash flow interest fee and its calculation, its fees in general to balance claims that it would invest a higher portion of offering proceeds, and the fact that investors in Rich Uncles NNN REIT would not receive a third-party due diligence review of the sponsor and how that differed from the selling procedures in traditional non-traded REITs.
Among others, Rich Uncles commercials have caught the attention of Michael Stubben, president of Gilbert, Arizona-based Summit Investment Research, which provides financial advisers with research on non-listed investments. Brian Fricke, founder of Financial Management Concepts, a retirement planning and investment management firm based in Winter Springs, Florida., also has taken note of them.
Both cited the fact the Rich Uncles NNN REIT’s funds from operations were not yet covering its roughly 7 percent dividend – not uncommon for a REIT ramping up – and that the 40 percent cash flow interest and liquidation fees were unusually high. Fricke also posted a cautionary critique regarding Rich Uncles NNN REIT on YouTube after looking into the trust, a practice he undertakes whenever investment opportunities advertise in his market, he said.
“At the end of the day there is no free lunch,” Fricke told The DI Wire. “People putting together non-traded REITs are making money upfront or making money on the backend. And the less they make on the frontend, the more they’re going to take on the backend.”
Summit Investment Research’s most recent comparison of fees charged by the 21 open core non-traded REITs indicated that, over five years, the average real estate fee burden is about 14.6 percent and that the total fee burden is some 25.2 percent. Similar fees charged by Rich Uncles NNN REIT, absent the cash flow interest fee, would yield a real estate fee burden of 19 percent and a total fee burden of 22 percent over the same period. It is important to note that the total fee burden does not take into account the 40 percent preferred incentive fee that Rich Uncles would receive should they meet or exceed a 6.5 percent shareholder return.
Disclosures made by other crowdfunded REITs generally reveal lower fees associated with their offerings, which under Regulation A’s Tier 2 rules – or “Reg A+” – are subject to a $50 million cap in a 12-month period.
Washington, D.C.-based Fundrise, for example, has launched five REITs that make debt and equity investments. Fundrise’s REITs typically charge organization and offering fees of 2 percent, an asset management fee of 1 percent, a disposition fee of 0.5 percent, and loan servicing fees that could potentially total about 2 percent, according to its offering circulars, which follow the Form S-11 disclosure format. Instead of charging shareholders an acquisition fee, Fundrise collects up to 3 percent from sponsors of deals that the REIT funds.
Fundrise’s website also includes photos of the REIT properties with graphic breakdowns of the type of investment made, the REIT’s position in the capital stack, and the how it compares with other Fundrise investments on a risk-adjusted basis.
“Making sure that we have all our information out in the open is crucial,” said Kendall Davis, director of investments for Fundrise.
MogulREIT I, which was launched in January by Los Angeles-based crowdfund platform Realty Mogul, charges organization and offering fees of up to 3 percent, an asset management fee of 1 percent, and potential loan servicing and recovery fees that could total 2.5 percent, according to its offering circular, which also follows the Form S-11 disclosure format. Similar to Fundrise, Realty Mogul levies a 1 percent to 4 percent fee on sponsors of deals that the REIT funds, depending on whether it is debt or equity.
In an emailed response to questions, Realty Mogul CEO Jilliene Helman acknowledged that size limitations imposed by Reg A+ resulted in a greater concentration of proceeds and a reduced ability to lessen the impact of a bad deal. But she predicted continued growth in the young Reg A+ REIT space as more individuals invest via the Internet.
“There’s a tremendous opportunity for A+ REITs to evolve through asset types, geographic focus, and a range of underlying debt and equity products,” Helman said.
Crowdfunding REITs seem to be gaining in popularity. Earlier this month, Commencement Capital launched NY Residential REIT to invest in Manhattan residential real estate. The company is led by entrepreneur Jesse Stein and Georgetown professor Jonathan Morris, while television personality and real estate broker Ryan Serhant serves as an advisory board member. The company may engage independent broker-dealers to sell its shares in the future.
Of course, the true test will be in return to investors – does giving up the supposed protection of professional financial advice and due diligence pay-off in the long-term, or is it a recipe for disaster? Stay tuned, as only time will tell.