It was a hot real estate trade. Now investors are worried

Given the opportunity to park money with the world’s largest private equity firms, ordinary investors rushed in. Getting out might not be so easy.

The private equity firms began to seek out smaller investors almost a decade ago. It was a major shift for firms such as Blackstone, Starwood Capital Group and KKR that had previously been funded by enormous pensions, endowments and sovereign wealth funds. But it was also a way for the big fund managers to grow their assets and rake in ever larger fees.

For the individual investors, who were directed to the new private funds by their wealth managers, the chance to invest with Wall Street’s elite was too good to pass up — even if it came with rules, such as limits on withdrawals that would mean that getting money back in tough times might be a challenge.

The private equity firms had an allure, created by stellar track records, including during the 2008 financial crisis, and the fact that they had been off-limits to ordinary (although wealthy) investors. One offering, in particular, captured people’s attention: private real estate investment trusts, known as REITs, which own commercial or industrial properties and pay big dividends off the rental income they generate.

From 2017, when Blackstone introduced one of the first REITs backed by a private equity firm, through June, the two dozen or so of these private REITs raised more than $110 billion from investors, making them one of the hottest so-called alternative investments. The REITs were particularly appealing when interest rates were near zero, because they paid dividends of roughly 4% of assets or more.

But some of their allure was lost starting in 2022 when the Federal Reserve began to quickly raise interest rates. Even the least risky bond investments now pay out close to 4%, and rising interest rates have hammered the commercial property market that many REITs are invested in.

The private REITs are also being scrutinized because of some of their claims. How have they managed to show investors high returns when publicly traded competitors have suffered losses? How can they continue paying out lucrative dividends when they’re not generating as much cash flow each quarter as they’re giving back to investors? What’s their rationale for saying the properties they own are holding their value, when in public markets commercial real estate prices are tumbling?

There are more than 100 REITs that trade on public stock exchanges. Exiting an investment in one of those is as easy as selling shares of any stock.

But when it comes to a REIT that’s controlled by a private equity firm, the fund itself must buy back an investor’s shares. To make sure their investments remain stable and keep from being forced to sell properties in shaky markets to repay investors, most limit how much investors can withdraw in any given month or quarter.

Private equity firms do the same sort of thing to their big investors, typically preventing withdrawals for at least five years. For the smaller investors, withdrawals from private REITs are typically restricted to about 5% of the firm’s assets in any single quarter. Ordinarily, that might be fine, but if a large number of investors start running for the exits, it means some might face a long wait to get out.

And the REITs can put even more restrictive limits in place.

One of the bigger private REITs with about $10 billion in assets, managed by Starwood — the real estate and infrastructure investment firm run by billionaire Barry Sternlicht — added to limits in May on how much investors could redeem. Starwood said it would only buy back 1% of the value of the fund’s assets every quarter, down from 5%.

The REIT said at the time it didn’t have enough cash to fund all the withdrawals and didn’t want to be a forced seller of properties in a weak real estate market. It wasn’t the first time this had happened: In late 2022 and early 2023, Starwood, Blackstone and KKR each tightened the existing limits on redemptions, but after a few quarters, the firms eventually gave investors back all the money they asked for.

Even so, Starwood’s recent decision spooked investors, and since May, redemption requests have spiked at Starwood’s competitors too, according to public filings and an analysis by Robert A. Stanger & Co., an investment bank that follows alternative investments.

New filings due out later this month should shed more light on the situation, but the increase in investors asking for money back raised questions about the future of non-traded REITs. Even if the fund managers have slowed down the exodus, they can’t stop it entirely. Kevin Gannon, CEO of Robert A. Stanger, predicts that half of the money raised from non-traded REITs will be redeemed in the next year.

Some investor exits are because of concerns that the REITs may have to knock down the value of their investments.

One key metric for REIT investors is net asset value, which is the value of the real estate in a portfolio after deducting the debt used to pay for the properties.

For publicly traded REITs, the net asset value dropped roughly 14% from the end of 2021 to June 30, according to Robert A. Stanger. During the same period, the net value of real estate in REITs backed by private equity firms fell by just 4%.

Stock prices also show a large drop in value in the public market. One REIT index— the FTSE Nareit Index — has fallen roughly 22% from the end of 2021 through early August. Shares of the largest REIT exchange-traded funds, including funds managed by Vanguard and iShares, are down 15% or more in that period.

Blackstone, meanwhile, has returned 4.1% on an annualized basis since the end of 2021, the fund said.

Since private REITs don’t trade on an exchange, their performance is determined by appraisals of the value of their real estate. The Securities and Exchange Commission has warned in bulletins meant to educate investors about REITs that these appraisals “may not be accurate or timely.”

“Up until a year and a half ago, it looked like a magical asset class,” said Phil Bak, CEO of Armada ETF Advisors, referring to the non-traded REIT market.

Bak runs a firm that invests in public exchange-traded funds and REITs on behalf of investors. He has been a critic of private REITs at the current valuations, because of what he sees as their lack of disclosures. “In any scenario, the returns for non-traded REITs will be diminished because they’ve borrowed from future returns by not marking them down when the asset class declined,” he said.

The fund managers have some rebuttals: On a recent earnings call, the CEO of Blackstone, which runs the largest of the private REITs, said it was the fund’s portfolio of warehouses, rental housing and data centers, rather than malls and office space, that explained the performance. Blackstone also says that since the beginning of 2022, its fund, Blackstone Real Estate Income Trust, has sold $26 billion of its $125 billion property portfolio at prices that were higher than where they were marked.

But the market for commercial properties isn’t transparent. So it’s difficult for investors to know how prices are changing — unlike, say, in the housing market where there are more ways to measure changes in property values.

“The fundamental problem is how do you value properties when there aren’t comparable sales,” said Eva Steiner, a professor of real estate at the Penn State Smeal College of Business, who has studied REITs.

For now, Blackstone says it is honoring redemption requests even if they’re higher than the fund’s standard withdrawal limits, and says the demand for redemptions has fallen since May. The firm said July redemption requests were the lowest since April 2022.

One reason Blackstone has managed to do that is a unique deal it struck with the University of California’s investment arm, UC Investments. In January 2023, UC Investments said it had invested roughly $4.5 billion in the fund, with a promise to stay in it for six years. In exchange, Blackstone gave UC Investments preferential terms, $1 billion of the fund’s REIT shares and the promise of a return of 11.25%, Blackstone said at the time.But investors have found another source of concern within Blackstone’s REIT. A big driver of the value to investors is the dividend it pays each quarter, which is nearly 5% of assets.

Those quarterly payouts have drawn scrutiny from a wide variety of analysts and investors, including those who would profit if Blackstone ran into trouble. In interviews with a half-dozen of these analysts and investors, many questioned how Blackstone can pay out more in dividends than it generates by certain measures of its cash flow.

“How sustainable is it to keep paying that amount of dividends if the underlying cash flows are so low relative to the amount they’re paying?” Steiner asked.

Jeffrey Kauth, a Blackstone spokesperson, said in an email that about half of the fund’s REIT investors choose to take their dividends in shares, not cash, so the REIT generates positive cash flow in excess of the cash dividends. He added that if the REIT wasn’t able to cover all the cash dividends, it would alter how it reports its monthly real estate net asset values. It would have no impact on the investor returns, he wrote.

In June, KKR announced a plan to support its net asset value per share at or above $27, approximately $1.50 above the current share price. If the price remains below that level in June 2027, KKR said that it would cancel its own shares in the fund to increase the value for all shareholders in the fund. “This is a good time to be investing in the real estate market,” the firm said in a release at the time.

Despite all the current headwinds, the real estate market and the REITs could be helped by one move — a cut in interest rates by the Federal Reserve, something it’s widely expected to begin as soon as September. Lower rates could push valuations on REITs higher.

On a recent investor call, Sternlicht of Starwood said that if the Fed cuts rates in September, the firm will start selling real estate this year in “an orderly manner” and increase redemptions “meaningfully” going into the new year.

Craig Siegenthaler, an analyst at Bank of America, said the withdrawal limits could help the REITs get through the months or quarters until the Fed’s rate cuts take hold and boost the real estate market. To him, that’s the point of the withdrawal restrictions.

“These products have worked as intended,” Siegenthaler said.