There is no question that the effectiveness of FINRA Notice-to-Members 15-02 and the looming implementation of the Department of Labor (DOL) Fiduciary Rule for registered representatives has, and continues to, impact the fee structures of public, non-traded REITs. The question is whether these changes are material or cosmetic and whether they provide interim, or long-term solutions.
Cosmetic changes to REIT fee structures typically involve timing delays in the payment of fees
Deferred payment of selling commissions. The most common cosmetic change to REIT fee structures is the advent of common shares that pay a sales commission over time, rather than up-front. Many argue that this is a material change to the fee structure since it reduces fees by the time value of money (i.e., $1 paid tomorrow is worth less than $1 paid today).
However, such shares, often called class T or class C shares, often pay higher sales commissions in the aggregate than shares that pay the full sales commission up-front (commonly known as class A shares). For example, a class A share may pay 7% up-front, while a class T share pays 7.5% over time. The additional 0.50% is often paid out of a reduced dealer manager fee, which begs the question as to why a dealer manager can charge a lower fee on T shares than on A shares.
Many broker dealers have decided to sell only class T shares, unless a volume discount would apply for a class A purchase. However, recent offerings have included even lower up-front commissions to equalize commission payments among classes. Each deal is different. Neither fee structure is consistently better for an individual investor. The key is that, until recently, the changes resulting for multiple share classes were primarily cosmetic and did not result in significant reductions in fees.
Advances of offering expenses. A few sponsors address the implementation of 15-02 by paying a portion of offering expenses. This lowers the front-end load and thereby decreases the impact of offering expenses on a client’s account statement. For example, the advisor would pay half of the selling commissions and/or the dealer manager fee, then recoup these fees though increased acquisition and/or management fees. In these cases, the higher net share value on the clients’ account statements are largely cosmetic.
As a side note, a few sponsors who advanced offering expenses subordinate the return of such advance to specified investor returns. In this case, the advancing of fees could have a material impact on the performance of the REIT, especially if overall returns are close to the performance hurdle.
Material changes to REIT fee structures typically involve reductions or eliminations of fees
Material changes to REIT fee structures have occurred gradually over time and include the following.
Expense support agreements. The first significant change was the formalization of the waiver of fees to the extent that distributions exceeded modified funds from operations (MFFO). These support agreements are prevalent in business development companies (BDCs), and have gradually become a familiar feature in REITs. Under these agreements, the advisor typically agrees to waive fees (which benefits investors the most) or purchase common stock (which is helpful but dilutive) to the extent distributions exceeded MFFO, so that the REIT does not otherwise “dig itself into a hole” through distributions.
Lowering of offering expenses. Certain REITs are offering class A shares at a 6%, rather than a more historically customary 7%, selling commission. This reduces fees to the investor, but at the expense of the broker dealer rather than the sponsor. However, certain sponsors are also lowering, or agreeing to pay, portions of the dealer manager fee, which represents a reduction in fees payable to the sponsor or its affiliates.
Elimination of acquisition fees. A more recent trend is the elimination of the property acquisition fee. This has a material impact on the potential performance of the REIT as long as the sponsor does not increase other fees.
Another Share Class. The pending DOL Fiduciary Rule has encouraged registered representatives to adapt a fee-based, rather than commission-based model. To address this trend, many sponsors are offering a third share class, typically called class I or class R shares. These shares are similar to the class A shares that have waived sales commissions; however, they often also include reduced or waived dealer manager fees. Once again, this brings into question the higher dealer manager fees paid on other share classes.
A Possible Fly in the Ointment. A prominent sponsor has recently announced the distribution of class A shares online, at a 9.5% discount to the fully loaded price. This discount brings to light the question of the value of the advice being provided by registered representatives, which is the only thing that distinguishes the class A shares they may be selling from the class A shares available to investors online.
Elimination would affect almost every industry
Industry pressure is encouraging the fee structure on public, non-traded REITs to converge with that of lower-fee products. The Fiduciary Rule, if imposed, would require registered representatives, and by extension, broker dealers, to justify any additional fees charged for alternative products. Sponsors are addressing these issues gradually over time.
Once again, we are seeing a divergence in fee structures as sponsors attempt to design the most viable fees structures for public, non-traded REITs. In the meantime, there is no best fee structure for commission-based registered representatives. Broker dealers must evaluate the aggregate fee structure, rather than individual components, then apply their findings to individual investor situations to maximize potential investment returns. Ultimately, broker dealers must be able to justify the fee structures of the programs they sell. 