Healthcare: Talking Non-Traded REITs With Nick Schorsch of American Realty Capital
By Randyl Drummer for CoStar
Real estate investment trusts (REITs) of all types — publicly traded, publicly registered but not traded, and so-called private REITS — have been fairly aggressive in raising and deploying capital in the current market.
But few have been as aggressive as Nicholas S. Schorsch, chairman and chief executive officer of real estate advisory firm American Realty Capital. Schorsch recently sponsored his fifth non-traded REIT, American Realty Capital – Retail Centers of America Inc., which targets power and lifestyle centers, grocery-anchored shopping centers and other necessity-based U.S. centers for acquisition.
Schorsch has experience serving on both the traded and non-traded sides of the REIT universe, first as founder, president, CEO and vice-chairman of American Financial Realty Trust from its inception as a publicly traded REIT in September 2002 through August 2006. AFRT invested in offices, operations centers, bank branches and other critical net-leased assets.
In 2007, Schorsch along with William M. Kahane, Michael Weil, Peter Budko and Brian Block, founded American Realty Capital (ARC) as a sponsor of non-traded REITs. The following year, ARC launched the non-traded American Realty Capital Trust (ARCT), focused on net-leased retail, office and industrial. Also in 2008, Schorsch, Kahane and Weil formed Realty Capital Securities, LLC (RCS), a broker-dealer that sells investments in a variety of non-traded REITs, including ARCT, Healthcare Trust of America, Inc., and United Development Funding IV (UDF).
In late 2009, ARC registered to raise funds for American Realty Capital New York Recovery REIT Inc., targeting assets in New York, and organized Phillips Edison – ARC Shopping Center REIT, Inc. In August 2010, ARC filed to raise up to $1.5 billion for American Realty Capital Healthcare Trust Inc., a REIT targeting medical-office buildings and other health-care facilities, and filed to raise funds for American Realty Capital – Retail Centers of America Inc. in September.
Realty Capital, which also serves as distributor for the American Realty Capital New York Recovery REIT, Inc., Phillips Edison-ARC Shopping Center REIT, Inc., and the most recent retail REIT, has now raised over $1 billion dollars in equity.
CoStar caught up with Schorsch to discuss how non-traded REITs have performed in 2010, how they differ from the traded universe, and what changes his company and others in the industry are making to further bolster investor confidence in the non-traded sector.
CoStar: Operating five REITs and a broker-dealer, Realty Capital Securities, LLC, makes you somewhat unique in the space. Tell us about your strategy in the non-public space and how it’s working out.
Nicholas Schorsch: Our strategy in the non-traded alternative space is indeed unique, and our broker-dealer RCS is having tremendous success. We recently announced that we raised our first $1 billion in the past 20 months, a time during which equity raising was challenging. The non-traded industry itself is on pace to reach about $8 billion in fund raising for 2010. RCS is running at around $140 million to $150 million a month in fund raising. In the current month, we account for about 18% of the total non-traded equity market. One reason is the broker-dealers are seeing a lot of money moving out of the stock and bond markets. We benefit from that volatility and flight to non-correlated yield. Investors want to own real estate, but they’re moving away from that which correlates with the traded market.
Also, we’re seeing all-time record spreads between Treasuries and real estate yields: almost 470 basis points between 10-Year Treasuries and the unlevered average cap rate on commercial real estate of around 7.23%. It’s kind of staggering. Investors are looking for yield. The traded REIT sector is seeing yields of 3.0% to 6%, but investors buying assets are valuing publicly traded REITs at premiums of between 20% and 30% to NAV. So people are scratching their heads and asking, ‘Why would I pay a premium to buy a publicly traded REIT with mostly legacy assets? There’s volatility in the public market. I have capital risk, and I don’t get the depreciation I normally get for new assets. It seems like a high price to pay for liquidity.
Several REIT IPOs, a lot of them blind pools, have been withdrawn this year. Why are they pulling back while you’re moving ahead?
There are no blind pools being issued on the New York Stock Exchange. The most recent one, by Callahan Capital Properties, Inc., was just pulled off the market. The stock exchange doesn’t want to support blind pools. To the contrary, with non-traded REITs, specified or partially specified pools are frowned on. You’re typically constituting your portfolio by buying new assets at today’s market prices; you’re not paying a premium. In the U.S., 85% to 90% of all the CRE owned is not owned by publicly traded REITs. There’s about $14 trillion of commercial real estate in the U.S, and there’s about $400 billion of market capital in the entire NYSE REIT index. With leverage, that’s about $1 trillion. So only about 15% of the entire market is owned by traded REITs.
You’ve operated both publicly traded and public non-traded REITs. What’s the difference, or is that missing the point?
As a former public company CEO from the NYSE, I find while real estate assets are clearly the common denominator to both traded and non-traded, the dynamics are quite different.
If you make a daily market in a stock with buyers and sellers, it’s always going to be bouncing around more like an EKG than valued like a piece of real estate. Real estate over 12 months is basically supposed to do nothing. Income producing real estate is not supposed to be vacant; it’s supposed to earn income, no surprises. It’s supposed to be boring. A bad piece of real estate is very volatile. The fact is, someone who buys a traded REIT may be buying it because he wants public traded equity exposure to real estate. Well, he can’t get that in a non-traded REIT. It doesn’t have daily liquidity, and it isn’t supposed to. You can’t leverage it or take a margin position.
Some people say they don’t buy non-traded REITs because they’re not liquid. If they’re looking for liquidity, they shouldn’t. The problem with the wholesalers and the whole sales process is a lot of people are trying to make one better than the other. They’re different, aimed at different investors with different goals and investment profiles, and very different yield profiles and risk-reward characteristics.
So there’s a trade off for investors who prefer the comfort of that dividend?
Yes, they trade a more predictable, typically fuller yield for no daily liquidity. Traded REITs have been completely correlated to the S&P over the last five years. Investors aren’t getting a different asset class because they’re really buying an equity security, and it trades like an equity, highly correlated to the financial stocks. The advantage to publicly traded REITs for some investors is they’re highly liquid. However, liquidity has proved to be a two-edged sword of late. But the problem is you’re paying a big premium for that liquidity, buying assets at a premium to NAV. If you bought the assets at par, your dividends would be higher. But the fact is most of the bigger institutional investors need scale and flexibility. They buy the hard assets because they want the appreciation and they want to sell the assets at the end of the day.
We’re an alternative investment, and we don’t necessarily want to be like a traded REIT. The advantage is our money is it is patient and looking to own real estate. The money we raise is not the same dollars as go into non-traded REITs. Sometimes, people want to leave the public volatility behind. Other times, people are looking to invest in a very specific theme that resonates: net lease, retail, office, industrial. Non-traded REITs can provide this exposure to hard assets without the daily trading correlation to the financial sector.
Which of the product types targeted by your REITs is garnering the most interest among investors?
I can’t talk about the actual offerings’ specifics, but our offerings that are doing the most volume now are American Realty Capital Trust, our net-lease REIT that has no vacancy and long-duration net leases. It’s doing very well. It’s raising in the ballpark of $40 million to $50 million a month, and deploying that money every month into net lease assets leased to FedEx, Walgreens, CVS, JPMorgan. We’re also seeing a lot of growth in our Healthcare Trust of America (HTA), the medical office building REIT, which is raising about $75 million a month. Those are very income-based, very stable and predictable investment vehicles. We’re also seeing velocity now in our New York Recovery REIT as well as Phillips Edison, our grocery-anchored retail REIT. Those are the next wave, a little more opportunistic at present, but people are starting to feel a little better about the economy. UDF, which is our mortgage REIT, is more of a yield play that’s very stable.
What’s the concept behind your broker-dealer, Realty Capital Securities, and how is the market responding?
The beauty of what we’re doing at RCS, of having multiple products with different sponsors and management teams, is we’re not trying to be the best at everything. We’re trying to field the best management teams in each sector. In our case, for example, we manage American Realty Capital Trust because net lease real estate is our expertise. We buy freestanding single-tenant net leases. We also sell HTA, the medical office REIT with close to $2 billion of assets already. We also distribute the Phillips Edison REIT, which is grocery-anchored shopping centers, a very focused theme no different than Kimco or DDR or Federal Realty.
The non-traded space provides the same transparency, REIT structure and tax advantages of the traded markets, but we’re buying assets in today’s market at today’s prices. A lot of investors want to buy like the institutions do; they want new assets, not legacy assets. They want the pass-through tax benefits, the diversity afforded by the large pools of assets, the transparency, but they don’t want the volatility. They don’t mind holding properties in a relatively illiquid stock because it’s based on purchase price, not some market number.
What’s needed to quell some of the concerns among investors about fees and other issues with non-traded REITs?
There are at least four things. One, the internalization fees need to go. We’ve eliminated them on every one of our platform companies. All five of our REITs have no internalization fee due to the advisor on the occasion of a listing. That’s a fee we believe is part of a bygone era. In the way these deals are structured, you’re paid to buy assets, so we believe it’s not appropriate to be paid again when you roll up the company. A lot of investors have sued other companies in class-action lawsuits over that.
Number two, we must standardize transparency in reporting so that everyone is on an even playing field.
Dividend coverage must be a mandate. That’s a discipline that has come into play lately — the advisors are waiving fees to cover the dividend. That’s what they should be doing in deference to their shareholders.
Three, they must actually lower the fees – reduce acquisition fees, reduce financing fees, reduce asset management fees — to make them more ‘institutional’ in their cost structure. We’re seeing it in our own platform – all of our fees have been lowered. All of our fees look more institutional – for example, 1% acquisition fees instead of 2-3%.
The fourth and biggest issue is that as a multi-discipline platform, we also sell independent products. Many of our deals are not run by our sponsor. As the leading multi-disciplined platform in the industry, we’re seeing tremendous growth among our products because advisors are saying, ‘I like to have a choice.’ They may want health care, or office, or hospitality, or net lease, or retail. Our five specialties do not compete with each other and they do not have the same management teams. The retail investor, too, wants a strong, skilled management team, an investment theme and clarity of what he’s buying. In the non-traded REIT industry we believe we’re cutting-edge because we’re focused on what the investor wants, not on what we want to sell.
Have other companies followed suit in dropping or cutting fees?
Yes, a number of companies have followed suit and reduced advisory fees or eliminated internalization fees. We hear that there are many others looking at it. Also, there are a number of other companies that have started to waive asset management fees until they can cover their distributions from Modified Funds from Operations. And it’s on the tip of everyone’s tongue because people want to see these companies performing currently, not in the future. It’s also not important to be the biggest money raiser, it’s more important to be the most profitable, the most proficient investor. At the end of the day, nobody cares how much money you’ve raised. Your investors care how much money you make.