DOL rule delay is a relief for nontraded REITs, but some change is here to stay

The nontraded REIT industry breathed a sigh of relief after President Donald Trump signaled he would delay the Department of Labor's planned fiduciary-duty rule, but broader trends shaping the way financial advisers sell illiquid investments to retail clients will be hard to resist and could squeeze some sponsors' balance sheets, industry figures said.

The proposed rule, announced in 2015, would require financial advisers to act in their clients' best interests when recommending investments for pretax accounts and aims to prevent brokers from pushing one investment product over another based on sales commissions.

Sponsors of some commission-generating products, including nontraded REITs and business development companies, feared that advisers would stop selling their products under the rule because of high compliance costs and the potential for class-action lawsuits. A comment period on the proposed delay ends March 17, and the Trump administration is expected to push implementation back at least 60 days for further study. The rule was initially slated to go into effect April 10.

Yet even as nontraded-REIT industry figures welcome the delay — part of Trump's broader push to reduce government regulation — they say their business model has already been changed in recent years by market forces and the rollout of other rules. Specifically, following implementation of a different rule in 2016 by FINRA, the financial industry's self-regulatory organization, most nontraded REIT shares sold now spread out fees charged to investors over a longer period. As a result, they feature smaller up-front commissions than the fees that raised critics' eyebrows in the first place.

Moreover, the work that some large broker/dealers and sponsors have done to prepare for the Department of Labor rule, and to adjust to investors' desire for lower fees, is unlikely to be undone, Kevin Shields, chairman and CEO of nontraded REIT sponsor Griffin Capital Corporation, said in an interview.

"The concept of putting the client's best interest ahead of the financial adviser is the right concept, and it's kind of been baked into the mindset," said Shields, a former chairman of the Investment Program Association, an industry group. "A lot of the stuff that the firms have prepared for, in anticipation of the rule going into effect in April, is going to go forward regardless of whether the rule is implemented or not."

Existential threat

Unlike publicly traded REITs, nontraded REITs are largely illquid: There is little secondary market for their shares, which are marketed directly to investors by financial advisers. As a result, most investors are locked into their positions, regardless of the performance, until the REIT liquidates generally through a sale to another company, a piecemeal liquidation of its assets or an IPO. Share sales have fallen sharply in recent years following a confluence of unrelated events affecting the sector, including the implosion of the top nontraded REIT sponsor, American Realty Capital, in an accounting scandal. Separately, companies scrambled to adjust to a new FINRA rule, Regulatory Notice 15-02, that required them to disclose fees more clearly.

When the Labor Department rule first surfaced, it seemed like the greatest threat to nontraded REITs yet, in part because, as it was then worded, it prohibited advisers from earning commissions by selling REIT shares to pretax retirement accounts, which account for nearly half of industry sales. That language was later dropped in favor of the "best interest" rule, which would be enforced, practically speaking, through civil courts: Investors who believe their advisers have represented them badly on specific investments can sue, either individually or as part of a class.

Vagueness in the rule about the exact definition of the client's best interest, and the way that brokers can prove they acted in it if a particular investment goes wrong, has made some broker/dealers who sell nontraded REIT shares worry about their potential legal liability: "Can we take on that risk, because are we putting ourselves at the mercy of an activist plaintiff's bar?" Alice Connaughton, co-head of Greenberg Traurig LLP's nontraded REIT practice, said in an interview.

Different brokerage firms have responded in different ways. Merrill Lynch, a unit of Bank of America Corp., and Commonwealth Financial Network said in late 2016 that they would stop offering commission-based investment products such as nontraded REITs in individual retirement accounts and pretax retirement accounts — though since the fiduciary rule's delay, Merrill Lynch has suggested it could relax its ban.

Meanwhile, LPL Financial LLC, the largest independent broker/dealer, moved to standardize commissions for various types of products, so that all investment vehicles within a given category — mutual funds, variable annuities, nontraded REITs and the like — will pay brokers the same commission.

Competition from other corners

For REIT sponsors, such an approach has forced many to begin tailoring their own offerings to meet the different broker/dealers' specifications. The process, which can result in different share classes for different distributors to sell, can be extensive and complex. Besides requiring SEC approval for new share classes, the variations raise questions of consistency, Shields said: "Aren't we creating more fodder for the plaintiff's cannon if Ameriprise thinks that 3.5% is the appropriate fee, but LPL thinks it's 3%?"

The good news for REITs, however, is that all the work allowed broker/dealer firms like LPL to continue selling their shares. Shields criticized the Department of Labor rule, arguing that the SEC is in a better position to regulate investment products because the Labor Department has purview over only a portion of existing retirement accounts. Still, he said, changes that have arisen from the industry's efforts to comply with the fiduciary rule are likely to go into effect whether the rule itself survives or not.

"I think it's going to cause more fee compression," Shields said, "which ultimately is going to translate into a better experience for the investors."

Peter Fass, co-head of the real estate capital markets group at Proskauer Rose, said nontraded REIT sponsors have been moving toward lower fees on their own in recent years, especially as large firms like Blackstone Group LP and Cantor Fitzgerald & Co. have entered the space and moved to cover costs that would have been passed on to investors.

Fass suggested that it is competition from such well-capitalized firms, rather than any single regulatory development, that will squeeze many smaller and weaker REIT sponsors' business models. Lowering fees to compete with the big new players is a dangerous game, Fass said. If sponsors aren't raising a lot of money, he added, "It's going to bleed them."