Real estate private equity: the case of US unlisted REITs
| Pages | 132-150 |
| DOI | https://doi.org/10.1108/14635780810857881 |
| Published date | 07 March 2008 |
| Date | 07 March 2008 |
| Author | John Corgel,Scott Gibson |
| Subject Matter | Property management & built environment |
Real estate private equity:
the case of US unlisted REITs
John Corgel
School of Hotel Administration, Cornell University, Ithaca, New York, USA, and
Scott Gibson
Mason School of Business, The College of William and Mary,
Williamsburg, Virginia, USA
Abstract
Purpose – The purpose of this paper is to demonstrate how fixed-share prices, as a structural flaw in
private equity funds targeted to small-unit investors, economically disadvantages those investors in
favor of sponsors.
Design/methodology/approach – The theoretical model incorporates fixed share prices with
continuous investment opportunity and evaluates the wealth transfer from long-term investors to
marketing affiliates and soliciting dealers in the form of fees paid on the sale of shares to follow-on
investors.
Findings – This result holds in the presence of high-payout dividend policy that attempts to
compensate for wealth transfer.
Research limitations/implications – Should share prices be marked-to-market using real estate
appraisals or another method, the unlisted REIT and related offerings, such as tenant-in-common
funds, will be profitable for sponsors without economically disadvantaging long-term investors.
Practical implications – The findings from this research are useful to fund sponsors who design
real estate investment products for small-unit investors. These products may retain the advantageous
characteristics of existing products while eliminating the disadvantageous features.
Originality/value – This is the first academic research on private equity capital raised from
small-unit investors.
Keywords Real estate, Equitycapital, Property finance
Paper type Research paper
1. Introduction
Private equity funding of institutional-grade commercial real estate in the US has
historically come from wealthy individuals and pension funds. These sources remain
dominate today as evidenced by the recent wave of real estate public-to-private
transactions. Small-unit investors were provided the opportunity to purchase shares in
publicly-traded portfolios of commercial real estate in 1960 in the US when the first
REIT law was enacted and now in many countries throughout the world as the REIT
concept proliferates.
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
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
The authors wish to acknowledge the assistance provided by Deborah Froling of Hirschler
Fleischer and Glen Fuller of Mackenzie Patterson Fuller, Inc., who provided critical input about
how the Unlisted REIT business operates.
JPIF
26,2
132
Received July 2005
Accepted July 2007
Journal of Property Investment &
Finance
Vol. 26 No. 2, 2008
pp. 132-150
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780810857881
networks established by mutual fund groups, sponsors offer real estate investment
programs to the population of mostly small-unit investors who rely on the services of
financial planners. Sponsors using broker-dealer networks to raise equity capital begin
as private companies. While sometimes referred to as “private REITs”, a select group
of these companies and the mini-industry that now surrounds them, prefer the title
“unlisted REIT” because sponsors follow the SEC’s rules for publicly-traded REITs,
but do not list shares on exchanges[1]. The success of the unlisted REIT approach is
evidenced by the relatively high volume of equity flows to these companies, sometimes
resulting in near-parity with inflows to publicly-traded REITs. During 2003, for
example, the unlisted REIT group, raised $7 billion through broker-dealer channels
while all publicly-traded REITs raised $8.1 billion through public stock offerings[2].
Similar broker-dealer networks are now used in the in US to facilitate tax-free
exchanges through tenant-in-common (TIC) funds[3].
1.1 Unintended consequences for unlisted REIT investors
The emergence of unlisted REITs as highly visible participants in the commercial real
estate markets may be the result of small-unit investors rationally responding to the
attractive investment opportunities offered by these firms. Yet, some members of the
financial press and executives of publicly-traded REITs question the methods used by
unlisted REITs (Smith, 2003a, b; Fitch, 2003; Ostrowski, 2004; Farrell, 2006). Criticisms
center on the adverse effects of aggressive fees (i.e. often 10 percent to 15 percent)
deducted from investor contributions and paid to financial planners and sponsors. To a
lesser extent, criticisms focus on structural characteristics of the ongoing contractual
relation between investors and sponsors.
Unlisted REITs sell shares at a price (i.e. typically $10) that either remains fixed or
may be modestly adjusted throughout investors’ holding periods[4]. This feature
differentiates unlisted REITs from publicly-traded REITs and is frequently cited by
sponsors and broker-dealers as an advantage of the unlisted REIT structure.
Small-unit investors, as the argument goes, find the volatility of public REIT prices
undesirable, and therefore feel more secure with a relatively high dividend paying
investment in which the share price remains constant. As Fitch (2003) notes, the
apparent advantage of a fixed-price structure may instead represent a disadvantage to
investors because they cannot share in appreciation without asset liquidation or
company sale.
In this paper, we argue that the fixed price feature of unlisted REITs potentially has
more serious negative financial consequences for investors who contribute capital
early in the funding cycle. After controlling for dividend payout, we demonstrate that
fixed share prices with continuous investment opportunity adversely affects long-term
investors by transferring wealth to unlisted REIT affiliates and soliciting dealers in the
form of fees paid on the sale of shares to follow-on investors. This contractual feature
represents a flaw in the unlisted REIT structure with several detrimental
consequences. These consequences, as we argue, place in jeopardy the long-term
viability of unlisted REITs that rely on fixed share price structures. Higher div idend
payout moderates the wealth transfer from initial investors, but also exacerbates the
financial stress experienced by unlisted REITs that distribute more money than
current cash flow, as we show later in the paper. Should unlisted REITs elect to
periodically mark share prices to market using either real estate appraisals (following
Real estate
private equity
133
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