PRIVATE EQUITY FOR THE COMMON MAN

Transcription

1 PRIVATE EQUITY FOR THE COMMON MAN Timothy J. Riddiough Department of Real Estate & Urban Land Economics School of Business University of Wisconsin Madison 5262D Grainger Hall Madison, WI Jonathan A. Wiley Department of Real Estate J. Mack Robinson College of Business Georgia State University 35 Broad St., Suite 1408 Atlanta, GA June

2 PRIVATE EQUITY FOR THE COMMON MAN Abstract We describe and analyze supply and demand characteristics of a private equity investment vehicle called the Unlisted REIT. Equity shares are offered through registered investment advisors to retail investors whose net worth and income level requirements are low relative to those seen with other private equity and hedge fund investment alternatives. Fee structures, including front-end loads, are shown to exceed (often far exceed) fee structures on mutual funds, private equity funds, venture capital funds, and hedge funds Unlisted REITs offer high dividend yields and post share prices that do not vary over time, and as such are promoted as high-yielding fixed-income substitutes even though they remain a residual claim on time varying cash flows produced by commercial real estate assets. We show that investment flows into the Unlisted REIT vehicle vary directly with fee percentages paid to the investment advisor, and inversely with interest rates and dividend yields on close and more liquid investment substitutes. Realized holding period returns are calculated and compared to direct liquid share substitutes that offer lower dividend yields and that experience standard share price volatility. Return differentials are shown to exceed 9 percent per year on average, in favor of the liquid share substitute, illustrating the deleterious effects of high fees and a conflicted management structure on realized investment outcomes. Alternative explanations are considered for the anomalous investment behavior (why would informed investors accept such low returns), where we conclude that macroeconomic conditions and monetary policy are at least in part responsible for the proliferation of the Ponzi-like Unlisted REIT investment vehicle. I. Introduction In this study we undertake a detailed analysis of the capital raising process for Unlisted Real Estate Investment Trusts (REITs). These firms have rather interesting and controversial business models, raising capital primarily from retail investors with only moderate levels of wealth and who are often retired. The Unlisted REIT promises high dividend yields (6-7 percent typically on initial investment, gross of fees), issuing common equity shares that are generally 2

3 illiquid and have little apparent volatility. As such, the investment offers the appearance of highyield bond-like returns made available to yield-hungry investors in a low interest rate environment. We refer to this modified cash flow delivery scheme as an equity-for-debt transformation process. At the same time, front-end fee loads for Unlisted REIT investment approach 14 percent, with ongoing operating fees further eroding cash available for investment and capital gains available for distribution upon the realization of a (highly uncertain) liquidity event. The relative success of Unlisted REITs is somewhat puzzling, however, given the high cost of investment and the close liquid alternative of Listed REITs. 1 More specifically, the combined Listed and Unlisted equity REIT industry has now surpassed the $1 trillion mark for assets under management, where proceeds from new equity offerings by Unlisted REITs have outpaced those by Listed REITs every year over the 2006 to 2013 time frame. While the Listed REIT raises new equity through an initial public offering (IPO) an event that occurs on a single date the Unlisted REIT offers share subscriptions through independent broker-dealer networks in a continuous blind pool offering process. This equity raise channel is remarkably effective, with the average Unlisted REIT raising $150 million per quarter by Q Fees paid to the investment advisor, which do vary but are generally in the range of 6 to 7 percent, essentially make Unlisted REITs the highest commission product available to offer their clients. The Unlisted REIT sector provides a unique setting to examine issues associated with private equity investment available to low-to-moderately wealthy retail investors what we call private equity for the common man. While a large degree of heterogeneity exists among the assets and income sources for most private equity funds, REITs largely invest in income- 1 For both Listed and Unlisted REITs, we are referring specifically to public firms which register their securities and submit periodic filings to the Securities and Exchange Commission (SEC), as opposed to private REITs. 3

4 producing commercial real estate. The lengthy economic life and functioning secondary market for the underlying assets generates consistent patterns among fund cycles. The minimum investment in Unlisted REITs is $2,500. High net worth investors are qualified by either minimum net worth of $250,000 or minimum annual gross income of at least $70,000 plus a minimum net worth of $70,000. These investor suitability standards constitute strikingly low minimum thresholds when compared to restrictive criteria applied by most private equity and hedge funds. There are two main contributions of this study toward the understanding of private equity for retail investors. First, we collect detailed management compensation fee data along with key macroeconomic measures, and provide estimations for the determinants of common equity subscription flow at the fund level. Second, we introduce a novel methodology for calculating investor returns to date (as of Q4 2013) based on an Imputed share price if the security were liquid and valued as a going-concern. The Imputed share price is based on a ratio of total capitalization to book value of assets for comparable Listed REITs selected in a propensity-score matching. Holding period returns calculated as an IRR for the Unlisted REITs are then compared to returns over consistent horizons for Listed REITs. We show that investment flows into the Unlisted REIT vehicle vary directly with fee percentages paid to the investment advisor, and inversely with interest rates and dividend yields on close and more liquid investment substitutes. Realized holding period returns are calculated, where return differentials are shown to exceed 9 percent per year on average in favor of the Listed REIT. In comparison to the Unlisted REIT, the Listed REIT provides superior liquidity in its share price, greater transparency, and a lower risk asset investment structure, but with greater observable (but not actual) share price volatility. In short the Listed REIT dominates the Unlisted 4

5 REIT alternative along just about every dimension of preferred investment characteristic, where inferior Unlisted REIT investment performance differences illustrate the deleterious effects of high fees and a conflicted management structure on realized investment return outcomes. We wonder why informed investors would accept such low returns for a superficial equity-for-debt cash flow transformation, which could in fact be replicated at home by the investor. We consider an ignorance is bliss / tree in the forest / head in the sand rationale to explain this behavior in a world with high volatility-risk averse investors. But with greater than a 9 percent return difference it is hard to believe that a superficial reduction in share price volatility could be worth that much. The more likely explanation is effective marketing and promotion by the Listed REITs and their investment advisors, who, with the prospect of harvesting outrageously high fees, likely mislead or otherwise fail to properly disclose significant investment risks and fee structure. It is not a stretch to conclude that Unlisted REITs are a Ponzi structure that will eventually collapse under the weight of its high fee and conflicted management structure. Importantly, this investment vehicle has thrived in a low interest rate economy in which many volatility-risk averse investors exist that are desperate for yield. We conclude that the Unlisted REIT investment vehicle private equity for the common man is a Ponzi-like investment scheme that exists within the confines of the regulated financial investment environment. This is in contrast to the usual characterization of Ponzi schemes as idiosyncratic creations of narcissistic anti-social amoral individuals working alone or almost alone outside the reach of the regulatory community. The remainder of this study is organized as follows. Section II provides background information for the Unlisted REIT business model. Section III covers data, methods and results 5

6 for the equity issuance analysis. In Section IV, the propensity-score matching and Imputed share price methodology are explained, along with a comparison between firm characteristics in the Listed and Unlisted REIT sample. The IRR calculations are presented and discussed. Section V summarizes the behavioral and policy implications that can be drawn from this study. 6

7 II. Background and the Basic Business Model A primary contribution of this paper is our analysis of dual investment vehicles for a particular type of asset: commercial real estate. The vehicles are the listed or public equity REIT (L-REIT) and the unlisted or private REIT (UL-REIT), where the UL-REIT vehicle can be characterized as private equity. Both vehicles must follow a specified set of rules laid out by regulation in order to avoid taxation at the entity level, including minimum requirements on assets invested in real estate, income sources, investor holdings and dividend payouts. The L-REIT has been studied extensively, so we will not focus on the details in this section. 2 The UL-REIT has been studied much less extensively, so we will provide additional background and a description of the basic business model. Other than the exchange-listed versus non-listed nature of equity share liquidity, the most important differences between investment vehicles are that L-REITs are internally-managed going concerns at the time of investment with standard fee structures, management costs and corporate governance that are typical of a public company, whereas the UL-REIT is an externally-managed blind-pool private offering with an offering period can remain open for several years. As we will discuss in some detail shortly, fees associated with investment in the UL-REIT are substantially higher than those associated with the L-REITS. External management and the high fee structure, along with weak corporate governance, produce firms that are rife with conflicts of interest between outside equity investors and managers. At the time of organization, both L-REITs and UL-REITs will submit an S-11 filing with the SEC. During the period from January 1994 to May 2014, there were 981 such S-11 filings 2 For surveys of the literature on L-REITs see Corgel, McIntosh and Ott (1995) and Chan, Erickson, and Wang (2002). 7

8 submitted to the SEC. Not all these filings mention an intent to qualify as a REIT, however. Among the subset are 699 S-11 filings that state an intention to qualify as a REIT. Of this subset, 429 described the intent to have shares listed on an organized stock exchange immediately following the IPO, while 270 of the REIT filings explicitly state that they do not intend to apply for exchange listing and they will utilize a continuous offering process. The former describes the L-REIT sample, while the latter identifies the UL-REIT sample. Both groups are subject SEC, NASD and NASAA reporting requirements, as well as compliance with all tax-related REIT restrictions as noted earlier. Rather than issuing shares through an IPO on a single-day exchange event, new equity shares for UL-REITs are sold through traditional broker-dealer/investment advisor channels using a continuous offering process. As Corgel and Gibson (2008) describe: During the early 1990s, real estate fund sponsors in the US began raising equity for commercial real estate investment using broker-dealer channels. Replicating dividend networks established by mutual fund groups, sponsors offer real estate investment programs to the population of mostly smallunit investors who rely on the services of financial planners (p ). A nominal share price (typically set at $10 or $11) is held constant during the offering process. Corgel and Gibson (2008) present a model to demonstrate that the fixed share price and continuous offering provide an opportunity for follow-on investors to observe performance before investing. Under a more traditional IPO, strong demand for shares following the IPO would benefit early investors by the bidding up of share prices, creating capital gains. In the UL- REIT space these benefits, at least in the short and medium term, are unrealized due to the lack of share liquidity and price discovery, as well as the steep up-front loads paid to the brokerdealers and sponsors. 8

9 A blind pool offering is the industry standard, meaning that there are no assets under management at the time of the initial offering. Lacking assets, the fund is externally managed by the Advisor at inception. It is generally disclosed that significant conflicts of interest exist due to the Advisor s role as a fiduciary for other real estate funds. More specifically, the unobservable non-traded market share price, blind pool offering and external management intensify agency problems for UL-REITs relative to their exchange-listed counterparts. Anti-takeover provisions are commonplace, and include staggered board of director elections, expansive boards, poison pills and high fees to the external advisor should management be internalized. Exacerbating agency issues is the general void of participation by institutional investors in UL-REIT offerings, which limits monitoring, analyst coverage and shareholder influence. Corgel and Gibson (2008) outline the marketing approach to retail investors: The chain that connects REITs to investors begins with the establishment of an in-house broker-dealer affiliate that develops contractual relationships with national and regional managing dealers (e.g., A.G. Edwards, UBS Warburg, and Paine Weber). Local financial planners acting as soliciting dealers with or without affiliations to these national and regional broker-dealers then sell investment programs of unlisted REITs to the public (p.134). UL-REITs organize with finite-life and mention in their offering documents target liquidation dates (typically within 6-8 years). Targeted liquidation dates are non-binding and loosely worded. Illiquidity risk is an important issue in this environment, and UL-REITs almost uniformly attempt to address investor concerns through inclusion of a share redemption plan. The most common UL-REIT offering price is at $10 per share, and the most common share redemption plan allows investors to return their shares to the firm for $9.50 per share. However, the fine print of these share redemption plans reveals that they may not open the program until 9

10 such time that there is adequate subscription to the dividend reinvestment plan (which allows investors to elect for stock dividends at $9.50 per share in lieu of cash dividends). In addition, once the redemption program has opened, it may be suspended or cancelled at any point subject to managerial discretion. The finite-life structure implies that the continuous offering process will ultimately end at some point in time. Wiley (2013) provides evidence that roughly one-third of UL-REITs had never opened their share redemption program to investors by the end of Of those that did open, half of the open redemption programs ultimately became suspended, cancelled, recast at a lower price or constrained due to excessive redemption request volume. Wiley (2013) further notes that these adverse changes are often closely timed with the end of the equity offering. When the UL-REIT closes the gate on the share redemption program, investors are effectively locked-in and must wait until management can accomplish a comprehensive liquidity event. 3 Wiley (2013) shows that the most common form of liquidity event is acquisition by another UL-REIT (typically from the same Sponsor). Other options include exchange-listing, individual asset sales in the private real estate market and bankruptcy. Marketing of equity interests occurs as follows. Brokers/investment advisors/financial planners counsel potential retail investors that commercial real estate generates stable cash flows over time which generally move with inflation. This implies stable and gradually-increasing asset values that offer something of an inflation hedge. As a result of the bond-like structure of fundamental cash flows, share prices are suggested to experience little volatility in the short run. At the same time, the investment offers a high dividend yield, typically 6 to 7 percent based on 3 There are two exceptions to the investor lock-in: (1) online auctions for UL-REIT shares, and (2) tender offers that appear (not coincidentally) immediately after the share redemption program is suspended. In both cases, the share prices are deeply discounted (relative to the initial investment price) due to the thinness of buyers who participate in the online auctions, and the reality that those tender offers are made by vulture capital funds seeking high investor returns. 10

11 the constant posted share price (gross of up-front fees). 4 Given little or no observed volatility in asset values and share prices combined with high and stable dividend payouts, investment takes on the character of a high-yielding medium-duration bond. Retail investors with only moderate wealth and income requirements are the primary if not exclusive investor clientele, where it is thought that retirees on fixed incomes are the largest sub-investor clientele. Promotional materials and verbal promises of dividend payouts of 6 to 7 percent with stable and increasing share prices that provide inflation protection is clearly an attractive product in a low interest rate environment. These returns noted above are quoted prior to inclusion of transaction costs and fees. Front-end loads on these investments are remarkably high (typically 14 percent), with an initial booked share price that is net of the up-front fees (say $8.60 per share based on a posted share price of $10 per share). It is not clear whether the transaction costs and the net booked investment amount are verbally disclosed by the marketing agent, where the posted $10 per share price creates the illusion of the true or fundamental value of investment. The $10 per share price thus creates a mental anchor for the investor, who mentally sets $10 per share as a lower bound on value that is expected to be realized at the time of fund liquidation (analogous to the full repayment of the principal investment amount on a bond). From the time of initial investment to liquidation, investors are further comforted by the stated redemption policy in which they are told they can simply sell their shares back (typically at $9.50 per share) if there is any unanticipated demand for liquidity by the investor. As noted earlier, however, liquidity realized through the share redemption programs is largely illusory. 4 See Seguin (2012). 11

12 In reality early dividends paid out to incumbent shareholders are usually funded through new capital raised analogous to a Ponzi scheme. Those early dividends are at elevated levels and prove highly effective at attracting additional new equity from investors (see Wiley, 2014), but these elevated dividends also widen the gap on the firm s ability to return the initial equity investment by the point of liquidation. Fund behavior changes abruptly following the close of the offering period. Dividend cuts become more common and dividend volatility increases drastically (Wiley, 2014). Share redemption programs are significantly more likely to become suspended or cancelled (Wiley, 2013). Investors are then often left at the mercy of management to accomplish a meaningful liquidity event. III. Net Equity Proceeds III.a. Data and Mechanics This study focuses on the capital raise process for UL-REITs. As noted previously, equity offerings are predominantly blind pool offerings, meaning that the fund has no assets under management at conception. This is different from most other comparable investment vehicles, which generally attract capital as seasoned enterprises (e.g., mutual funds, hedge funds, SEOs by L-REITs) or disclose a list of existing assets in place at the time of the initial offering (e.g., many types of private equity, IPO by L-REIT). Venture capital and some private equity funds are, in contrast, blind pool investments (Gompers and Lerner, 1999). As a blind pool, and thus in lieu of observing any existing performance, the only public information at the beginning of the offering can be obtained from the S-11 filing the securities registration form for real estate companies submitted to the SEC. Of interest, the S-11 form includes content for management compensation structures and associated fees, among other 12

13 information. To define the sample, we use the SNL Financial database under Real Estate, REIT & Property Company, selecting all Non-Listed companies in United States and Canada. In April 2014, at the time of data collection, the query yields 173 UL-REITs, of which 57 are deleted because there is no financial information available for these firms in SNL. Panel A of Table 1 provides summary statistics for the fee structures of UL-REITs. Taking modes, the most common front-end loads include a 7 percent commission to the investment adviser who sells their client UL-REIT shares, 3 percent to the dealer-manager to cover administrative and marketing costs associated with distributing the shares, 2 percent acquisition fees for all properties acquired (paid up-front), percent reimbursement for acquisition expenses, and 1.5 percent reimbursement for organization and offering expenses. Thus, these numbers imply front-end loads of 14 percent. This in turn means that, for every $1 of shareholder equity contributed, the typical UL-REIT has about $0.86 available to invest. By comparison, of funds that have front-end loads, the average front-end load in the mutual fund industry is 3 percent (Gil-Bazo and Ruiz-Verdú, 2009). But many mutual funds have no frontend load whatsoever. Taking averages across all mutual funds, the dealer-manager fee is 9 basis points and the total front-end load is 52 basis points (Adams, Mansi and Nishikawa, 2012). In private equity, the typical front-end load is 2 percent, after a 1 to 2 percent transaction fee is levied for acquisitions (Metrick and Yasuda, 2010). Hedge funds typically do not have front-end loads and use promotes and hurdles instead to incentivize management. Once the Unlisted REIT brings in sufficient funds to begin to acquire assets, it moves into the operational stage (while still marketing shares during its offering period). During this stage, assets will have been acquired with management collecting fees on at least an annual basis. The 5 For exchange-listed REITs in Singapore, acquisition fees are almost always 1% (Ooi, 2009). 13

14 most common operational fees include 1 percent asset management fee, 4.5 percent property management fee, and 1 percent financing coordination fee. Comparing to mutual fund expense ratios, the asset management fee line averages 0.24 percent (Adams, Mansi and Nishikawa, 2012), although real estate mutual funds generally levy higher management fees, averaging 0.8 percent (Philpot and Peterson, 2006). Average asset management fees for hedge funds are 1.52 percent (Cassar and Gerakos, 2010). In private equity, asset management fees are typically 2 percent (Metrick and Yasuda, 2010). Other Unlisted REIT operational fees provide for construction and development fees (typically 5 percent of costs) or oversight fees for third-party property management (typically 1 percent of gross property revenues). These fees are somewhat less consistent in the sample, however. By comparison, private equity funds typically assess 2 percent monitoring fees for externally managed investments where applicable (Metrick and Yasuda, 2010). In a few cases, UL-REIT management participates in all distributions made to shareholders, with fees that range from 0.7 to 10 percent. In other cases, management earns incentive compensation ranging between 0.5 and 35 percent when shareholder returns have exceeded a specified return hurdle. At the liquidation stage there are incentives for management to exceed return hurdles once a comprehensive liquidity event is achieved. The liquidity event can take the form of an exchange listing (or an IPO if new shares are also issued), a merger with an existing firm, or asset liquidation in the private market (including bankruptcy, when administered by the court). The most common structure for liquidation incentives is subordinate participation after shareholders realize a stated return hurdle. For example, the mode return hurdle is an 8 percent shareholder return per year, with managers receiving 15 percent of all cash available for distribution in excess of the amount required to meet the return hurdle. These incentives compare 14

15 to an average percent participation with zero return hurdle for hedge funds (Cassar and Gerakos, 2010), or to the typical 20 percent participation rate after an 8 percent hurdle in private equity (Metrick and Yasuda, 2010). In the few cases where subordinate participation is not used on UL-REITs, the Sponsor holds preferred shares that are convertible to common equity based on a sliding scale which is linked to shareholder performance. Management is also entitled to a disposition fee, which is typically 3 percent of the contract sales price for every asset sold. Hartzell, Kim, Kimbrell and Sprow (2013) provide IRR calculations for Unlisted REITs that achieved full-cycle events. Merging their calculations with our data on initial hurdle rates, we find that less than one-half of UL-REITs are able to achieve liquidation values that exceed the stated return hurdle. Thus, performance incentives appear less relevant than they would be for hedge fund and private equity (as shown in Phalippou and Gottschalg, 2009). Instead, it would appear the dominant incentive with UL-REITs is to maximize equity subscription to produce high dealer and acquisition fees on the front-end. Those front-end fees are then replaced by operating fees, including high asset management and property management fees thereby generating annual income streams for management, which becomes a major disincentive for liquidation. Panel B of Table 1 describes offering outcomes. The average UL-REIT raises over $76 million per quarter during a continuous offering process that runs nearly four years (11.7 quarters). There are a number of Repeat Sponsors of UL-REIT funds which produce multiple offerings over time. More specifically, Repeat Sponsors typically generate one highly similar offering following another with the closure its immediate predecessor. These Repeat Sponsors are dominant in equity fundraising, averaging over $91 million per quarter, as compared to $20 15

16 million per quarter for One-off Sponsors (defined as completing an equity offering only once in the SNL sample). Figure 1 illustrates the historic development of the Unlisted REIT equity formation process. The gray portion of each bar represents net equity proceeds from Repeat Sponsors, while the black portion represents the same for One-off Sponsors. In cumulative amounts, Oneoff Sponsors have raised $3.4 billion of the total $69 billion raised by the sector thus far less than 5 percent of the total equity capital raised. Also shown in Figure 1 are the Fed Funds rate and the NAREIT dividend yield (a weighted-average dividend yield of Listed REITs). Equity proceeds for the UL-REIT sector appear much higher in recent years, corresponding with historic lows in both the Fed Funds rate and NAREIT dividend yield. Figure 2 shows equity fundraising for the Unlisted REIT sector in context of equity raised by Listed REITs, including through IPOs and SEOs. UL-REITs are represented by the black line and appear to have exceeded the aggregate capital raised in L-REIT IPOs for nearly every quarter since However, SEOs by L-REITs have become much more frequent in recent years and represent the largest channel for equity fundraising by L-REITs. We note that a handful of L-REITs began as UL-REITs and later succeeded in executing an exchange-listing. 6 Any IPO or SEO net proceeds that occur for these firms are counted for L-REITs upon the date of their exchange-listing. Figure 3 illustrates that with success comes competition. While the UL-REIT sector as a whole has experienced mounting success at equity fundraising, net proceeds for the average fund appear heavily influenced by the number of competing firms that have open capital offerings during the same quarter. Prior to 2007, there were seldom more than 10 UL-REITs competing 6 Examples include American Realty Capital Trust, CatchMark Timber Trust, Cole Real Estate Investments, Columbia Property Trust, DCT Industrial Trust, Healthcare Trust of America, Piedmont Office Realty Trust, Retail Properties of America, and Whitestone REIT. 16

17 for new equity in a given quarter. Since 2008, however, the number of UL-REITs with open equity offerings in a given quarter has fluctuated in the range of 15 to 35. Post-2008, the average net equity proceeds per fund appear inversely related to the number of competing offerings. The red line in Figure 3 depicts net flows into commercial mortgages from the Fed Flow of Funds Accounts. Commercial mortgage flows are correlated with commercial property price indices, but not highly correlated with L-REIT equity flows. In the REIT industry, underlying asset valuations in respective property markets can become somewhat disconnected from valuations in the stock market (e.g., see the series on premiums/discounts to NAV by GreenStreet Advisors). Thus, commercial mortgage flows provide a measure of the attractiveness of yield-based investments that are backed by commercial real estate, and are not necessarily closely dependent of stock market valuations of property. Panel C of Table 1 presents a selection of macroeconomic measures that will be evaluated for their impact on UL-REIT equity proceeds. The number of competing UL-REITs with open equity offerings is determined by examining the Net equity proceeds measure for each firm to distinguish periods of equity access from closed offerings. The Fed Funds rate, 3-Year Treasury, 10-Year Treasury and credit spreads are each extracted from the Selected Interest Rates (H.15) series from the Federal Reserve. Core inflation is from the Bureau of Labor Statistics (BLS), and includes the Consumer Price Index (CPI) for all items, less food and energy. Non-core inflation is the difference between CPI and Core inflation. Commercial mortgage flows and L-REIT equity flows are from the Fed s Flow of Funds (Z.1) series. NAREIT total returns to L-REITs and NAREIT dividend yields are from the FTSE NAREIT US Real Estate Index series. 17

18 III.b. Estimation To model the Unlisted REIT equity raise process, net equity proceeds per firm-quarter are estimated for all periods when the respective firm has an open offering i.e., one that it currently accepting new equity subscriptions. The estimation for net equity proceeds includes a set of RHS variables for firm characteristics and a set of variables for macroeconomic conditions during the offering period. Firm characteristics are drawn from the S-11 filing based on information observable at the time of initial offering and before the firm has any assets under management or performance record. ln(net equity proceeds) = β 0 + β 1 Broker commission + β 2 Dealer-manager fee + β 3 Acquisition fee + β 4 Asset management fee + β 5 Subordinate participation + β 6 One-off Sponsor + β 7 CEO age + β 8 Number of UL-REITs + β 9 Fed Funds rate + β 10 3-Year Treasury spread + β Year Treasury spread + β 12 Baa-Aaa spread + β 13 Core inflation + β 14 Non-core inflation + β 15 Commercial mortgage flows + β 16 L-REIT equity flows + β 17 NAREIT total returns + β 18 NAREIT dividend yield + + Σβ k Offering maturity k + ɛ. (1) Variables for Unlisted REIT characteristics include the Broker commission rate, Dealer-manager fees, Acquisition fees, Asset management fees, Subordinate participation, One-off Sponsor indicator, and CEO age at the time of offering. Aggregate-level measures include the Number of UL-REITs with active equity offerings, the Fed Fuds rate, the 3-Year Treasury spread (net of the Fed Funds rate), the 10-Year Treasury spread (net of the 3-Year Treasury rate), the Baa-Aaa credit spread, Core and Non-core inflation, Commercial mortgage flows, L-REIT equity flows, NAREIT total returns and dividend yields. Fixed effects for the number of quarters since offering inception are also included (as indicators variables over a maximum of 27 quarters). 18

19 Results from the estimation of Equation (1) are presented in Table 2. Broker commission rates and Dealer-manager fees have positive and significant impacts on equity subscription. Increasing the broker commission by 1 percent (e.g., from 6 to 7 percent) increases the quarterly offering proceeds by an estimated 57.3%. 7 Increasing dealer-manager fees, which are largely spent on marketing and promotion for the offering, by 1 percent increases the quarterly equity raise by 55.3 percent. 8 When average quarterly proceeds per offering are in the ballpark of $150 million at year-end 2013, the potential consequences from these fee adjustments are obviously quite significant. Mutual funds with front-end loads have been found to underperform no-load mutual funds (Carhart, 1997). In Barber, Odean and Zheng (2005), mutual fund investors are found to be sensitive to high front-end expenses, including brokerage commissions and acquisition fees, resulting in significant less funds flow. For UL-REITs, the opposite is true. Investor subscriptions are highest at funds with the highest front-end loads. As Golec (2003) points out, if equity flows fail to respond negatively to high front-end fees, it is likely due to the limited ability of investors to distinguish marketing efforts from performance. In any case, we are able to directly link front-end marketing fees to investor subscriptions. We are not aware of any other work that establishes this type of strong positive relationship between front-end load and funds flow. This in turn presents something of a new puzzle that is difficult to reconcile with existing rational or behavior-based investor theory. Investors are observed to display some sensitivity to ongoing Asset management fees. These fees are disclosed in the offering documents, and are likely highlighted by the investment advisor to investors prior to investment. Increasing asset management fees by 25 basis points 7 exp{45.31/100} 1 = 57.3% 8 exp{44/100} 1 = 55.3% 19

20 (0.25 percent) reduces quarterly equity proceeds by 16.5 percent. 9 One-off Sponsors indicate relatively unknown managers, and as such lack reputation in the UL-REIT space. Their success in raising new equity is reduced by 75 percent as a result, as compared to Repeat Sponsors. 10 Competition from other UL-REITs reduces an individual firm s equity proceeds in a given quarter. Adding one additional UL-REIT reduces net equity proceeds for incumbent funds by an estimated 2.8 percent. 11 This number approximates an equal market share when there are 35 funds competing (1/35 = 2.86 percent). Success in equity offerings for Unlisted REITs is strongly enhanced by low interest rates. A one percent reduction in the Fed Funds rate increases net equity proceeds for the average UL- REIT by 32 percent per quarter. 12 A related result obtains for dividend yields on Listed REITs. The coefficient for NAREIT dividend yield is negative and significant, where a one percent reduction in the NAREIT dividend yield increases equity proceeds by 18 percent. 13 We do not find any relationship between funds flow and realized inflation, but this may be the result of persistently low rates of inflation realized during the sample period. In summary, our main findings are that the rate of funds flow into the Unlisted REIT investment vehicle is sensitive to broker-dealer/investment manager load fees (positive relation), the level of interest rates as measured by the Fed Funds rate (negative relation), and commercial property fundamentals as proxied by debt flows into commercial property markets (positive relation). Recall the UL-REIT business model, which is presented to potential investors as a high-yield fixed-income alternative with underlying commercial real estate assets that promise to 9 exp{-72.14/400} 1 = -16.6% 10 exp{-1.38} 1 = -74.9% 11 exp{-0.03} 1 = -2.8% 12 exp{-38.57/100} 1 = -32.0% 13 exp{-19.92/100} 1 = -18.1% 20

21 generate stable cash flows that move with inflation, a 7 percent dividend yield, posted share prices that remain stable over time, a promise of a liquidity event in the next five years or so, and the stated option to liquidate early if necessary through a share redemption program. This investment as characterized is clearly attractive to certain retail investors in a low interest rate environment in which most fixed-income investment alternatives generate significantly lower promised returns over similar investment horizons. The extremely high fee structure for Unlisted REITs, together with the positive relation between investor advisor fees and the rate of offering funds flow, raises some concerns that retail investors may be overpaying for this high dividend yielding fixed-income substitute (that is, they apparently cannot distinguish between marketing effort and fund performance). Yet the Listed REIT exists as a direct equity investment substitute, with a much lower investment fee structure. The UL-REIT in comparison provides the illusion of reduced or even non-existent stock price volatility (at least until a liquidation event occurs) together with higher dividend yields (about 7 percent for UL-REITs versus 4 percent on average for L-REITs) that are also more stable over time. But at what price does this increased stability come (even though stability in the investment value is illusory)? And are the promises made to investors realized, in that they earn returns on average and after fees that compensate them for the risk of investment? This is the topic of the next section of the paper. IV. Unlisted REIT Holding Period Returns In this section we analyze the comparative investment performance of Listed and Unlisted REITs. In doing so we quantify the implied benefit to UL-REIT investors of financial claim transformation, in which a standard equity claim is superficially turned into a high 21

22 yielding debt claim. After quantifying this return differential, in the subsequent section we then ask whether the compensation appears reasonable or not. To the extent that the differential seems unreasonably high, we consider alternative explanations for the finding. To set the stage for analysis, consider first the standard equity claim as exemplified by the exchange-traded REIT share. The listed firm targets dividend payouts as a percentage of its share price and experiences stock price volatility that goes with being listed on an exchange. Shareholders can sell their stakes at any time into a (typically) liquid secondary market. The (pre-tax) holding period return realized for a representative L-REIT share depends on the price paid for the share, dividends received during the holding period, and the price at which the share is sold at the end of the holding period. In contrast, the Unlisted REIT posts a price for its shares that does not vary over time. This posted price is analogous to the par value of a bond. Up-front fees are subtracted from the posted price paid, where the remaining amount is available for investment. Dividend payout percentages are fixed as a percentage of the non-varying posted share price that is gross of fees, at least during the offering period (Wiley, 2014). After the offering period closes, dividends are often cut in recognition of the unsustainably high rate. The dividend payments promised at the time of the offering are analogous to interest payments that reference the bond s par value, and are high relative to interest payments on standard debt claims. The high dividend yield seems to acknowledge that there are equity risks contained in the UL-REIT share claim that exceed those of a standard debt claim. At the same time the high payouts dissipate capital that could have been retained within the firm to put to productive use. Unlike the L-REIT, there is little true liquidity in the UL-REIT share claim prior to a liquidation event. And like a bond, a maturity date is stated in offering documents (typically five to eight years). But unlike a bond the maturity date is 22

23 a non-binding liquidity event that is left completely to the discretion of management. Investors are led to believe at the time of investment that they will receive a liquidation payoff that equals or exceeds the par value or posted share price of UL-REIT investment. In sum, this equity-to-debt claim transformation process takes cash flows and prices from a given set of assets and reconfigures them by increasing dividend payouts and replacing markto-market share pricing with a constant posted price that net of fees in most cases and for most of the time overstates true share value. The posted price thus creates a mental anchor for the UL-REIT investor, much like the par value of a bond, say at $10 per share, where a liquidity event presumably results in the realization of a $10 price per share or more. 14 A holding period return for the UL-REIT can be calculated as with the L-REIT, where the terminal value of the UL-REIT share must be estimated if a liquidation event has not occurred prior to the end of the specified holding period It is relevant to note that the apparent transformation of an equity claim into a debt claim does not involve increasing the priority of the claim in the event of financial distress. The shareholder remains the residual claimant in the UL-REIT investment structure. 15 The list of UL-REITs [quarter of first dividend] are American Realty Capital - Retail Centers of America, Inc. [2012Q2], American Realty Capital Daily Net Asset Value Trust, Inc. [2012Q1], American Realty Capital Global Trust, Inc. [2012Q4], American Realty Capital Healthcare Trust II, Inc. [2013Q2], American Realty Capital Healthcare Trust, Inc. [2011Q2], American Realty Capital New York Recovery REIT, Inc. [2010Q3], American Realty Capital Trust V, Inc. [2013Q2]. Apple Hospitality REIT, Inc. [2008Q3], Apple REIT Ten, Inc. [2011Q1], Behringer Harvard Multifamily REIT I, Inc. [2009Q3], Behringer Harvard Opportunity REIT I, Inc. [2006Q4], Behringer Harvard Opportunity REIT II, Inc. [2008Q4], Bluerock Residential Growth REIT, Inc. [2009Q4], Carey Watermark Investors Incorporated [2011Q2], Carter Validus Mission Critical REIT, Inc. [2011Q3], CNL Growth Properties, Inc. [2011Q4], CNL Healthcare Properties, Inc. [2012Q1], CNL Lifestyle Properties, Inc. [2005Q1], Cole Corporate Income Trust, Inc. [2011Q2], Cole Credit Property Trust IV, Inc. [2012Q2], Cole Real Estate Income Strategy (Daily NAV), Inc. [2011Q4], Corporate Property Associates 17 Global Inc [2008Q2], Dividend Capital Diversified Property Fund Inc. [2006Q1], Global Income Trust, Inc. [2011Q2], Griffin Capital Essential Asset REIT, Inc. [2010Q1], Griffin-American Healthcare REIT II, Inc. [2010Q1], Hartman Short Term Income Properties XX, Inc. [2011Q1], Hines Global REIT, Inc. [2010Q2], Hines Real Estate Investment Trust, Inc. [2004Q4], Industrial Income Trust Inc. [2010Q3], Inland American Real Estate Trust, Inc. [2006Q1], Inland Diversified Real Estate Trust, Inc. [2009Q4], Inland Real Estate Income Trust, Inc. [2012Q4], Jones Lang LaSalle Income Property Trust, Inc. [2008Q1], KBS Legacy Partners Apartment REIT, Inc. [2011Q1], KBS Real Estate Investment Trust II, Inc. [2008Q3], KBS Real Estate Investment Trust III, Inc. [2011Q3], KBS Real Estate Investment Trust, Inc. [2008Q1], KBS Strategic Opportunity REIT, Inc. [2010Q4], Landmark Apartment Trust of America, Inc. [2007Q4], Lightstone Value Plus Real Estate Investment Trust [2010Q2], Lightstone Value Plus Real Estate Investment Trust [2006Q1], Moody National REIT I, Inc. [2010Q2], MVP REIT, Inc. [2012Q4], Phillips Edison ARC Shopping Center REIT Inc. [2011Q1], Resource Real Estate Opportunity REIT, Inc. [2010Q3], 23

24 With this background we will now compare investment performance of our sample of Unlisted REITs that have not experienced a liquidity event as of Q with the alternative investment of holding an index of Listed REIT stocks over an identical holding period. To do this comparison we calculate holding period returns as follows. Assume there are T+1 cash flows to analyze, Cash flow 0 is the initial investment on a per share basis (an outflow) that occurs one quarter prior to the first dividend payment made by the UL-REIT. 16 For the UL-REIT, the initial share offering price (typically $10) is obtained from the S-11 filing. In contrast, at time 0 an investment is made into a basket of L-REIT stocks that serve as a comparable substitute investment for the UL-REIT, as proxied by the NAREIT index. Cash flows 1 through T-1 are dividend payments per share (inflows) actually made to investors. The dividend history is collected from the SNL database for each UL-REIT. Dividends are automatically reinvested into the index in the case of investment into the NAREIT index. Cash flow T is the last dividend payment plus the share liquidation or sales price. Since liquidation has not yet occurred by Q4 2013, we approximate the share price of the UL-REIT by applying the Market-to-Book ratio as of Q from a comparable L-REIT. With respect to the basket of liquid L-REIT stocks, the NAREIT index is simply sold at its end-of-quarter market value at that time. Liquidation values of non-liquidated Unlisted REITs must be estimated because only asset book values are available in the data (the shares are non-traded and there is no other independent valuation of the firms asset values). To establish an appropriate match with the UL- REIT to estimate its liquidation value, we first identify 246 Listed REITs in the SNL database with available information in Q A simple linear regression of market value of total assets Sentio Healthcare Properties, Inc. [2009Q1], Signature Office REIT Inc. [2010Q4], Steadfast Income REIT, Inc. [2010Q3], Strategic Realty Trust, Inc. [2010Q1], Strategic Storage Trust, Inc. [2008Q3], Summit Healthcare REIT, Inc. [2006Q4], and TIER REIT, Inc. [2004Q1]. 16 This conservative assumption increases the holding period return to the UL-REIT investor, as early-stage investors will not realize a dividend payment for more than one quarter relative to the time of investment. 24

25 against book value of total assets for L-REITs yields an intercept of zero, slope of 1.32, and adjusted R 2 of 84.7 percent. In these data the Market-to-Book ratios for L-REITs tend to fluctuate within a relatively narrow band 50 percent of observations are in the range of 1.0 and 1.4 over the sample period. As a basis of comparison, among the UL-REITs that have subsequently exchange-listed, Market-to-Book ratios range from to at the earliest point of available capitalization data from SNL. 17 To establish a best match for the Unlisted REIT in question, we apply a propensity score matching approach, implemented as follows. First, a probit model is estimated for the combined sample of L-REITs and UL-REITs (the UL-REIT is indicated with a 1), where matching is based four firm characteristics as of Q4 2013: firm age, total assets, leverage ratio, type of assets held by property type. In particular, the model to be estimated is: Pr{UL-REIT = 1} = β 0 + β 1 Firm age + β 2 Total assets + β 3 Leverage ratio + Σβ j %Property type j + ɛ. (2) The property type percentage establishes the primary uses of commercial property held by a particular REIT, where the calculation method comes from Geltner and Kluger (1998) and Riddiough, Moriarty and Yeatman (2005). The probit estimation generates a propensity score for each REIT in the sample. Based on its propensity score, each UL-REIT is then one-to-one matched with the nearest-neighbor propensity score of a L-REIT. Then the corresponding Market-to-Book ratio of the L-REIT is collected, where Market value equals the market value of 17 Those Market-to-Book ratios are American Realty Capital Trust = (Q2 2012), CatchMark Timber Trust = (Q4 2013), Cole Real Estate Investments = (Q2 2013), Columbia Property Trust = 1.03 (Q4 2013), DCT Industrial Trust = (Q4 2006), Healthcare Trust of America = (Q2 2012), Piedmont Office Realty Trust = (Q1 2010), Retail Properties of America = (Q2 2012), and Whitestone REIT = (Q3 2010). 25

26 all equity shares (inclusive of UPREIT ownership units) as well as the book value of all other reported financial claims. Book value is calculated net of depreciation and amortization. Table 3 compares summary statistics of the matching characteristics for the sample of Unlisted REITs, the full sample of Listed REITs prior to matching (Pre-Match), and for the matched sample of Listed REITs (Post-Match). UL-REITs have very similar property type configurations to L-REITs overall, even though individual firms in both categories often elect to focus investment on a single property type. UL-REITs tend to be younger than the full sample of L-REITs (average age: 4.1 years versus 10.8 years), where the age gap in large part can be attributed to the finite life structure of an UL-REIT that is under pressure to accomplish a liquidity event (which in turn causes the firm to exit the sample as a liquidated firm). No similar pressure exists for L-REITs. UL-REITs are considerably smaller (at just under $1.3 billion in assets under management on average) than the typical L-REIT in the full sample (at over $4.3 billion on average). There are not large differences between UL-REITs and L-REITs based on average leverage. Finally, and not surprisingly, the Post-Match sample of L-REITs possess matching characteristics that are on average much closer to comparable UL-REIT averages than the full sample of L-REITs. Table 4 presents estimation results from the probit model of Unlisted REITs versus Listed REITs. The estimation confirms discrepancies noted from the summary statistics. UL- REITs are significantly younger, smaller and use somewhat less leverage. Following the outcome of the propensity-score matching, the sample of L-REITs have similar firm age, size and leverage ratios to the UL-REITs. The average Market-to-Book ratio of the matched Listed REIT is 1.1 somewhat lower than those of the full sample average. This outcome is not unexpected, since book values are 26