Real Estate Capital Channels: REITs in focus

Since REITs are required to distribute at least 90% of their taxable income to shareholders, raising capital is a fundamental function of a REIT's operations and its strategic and tactical roadmap for real estate acquisitions, development, and management.

In addition to raising capital through traditional real estate debt and equity markets at the single-asset and portfolio levels - such as senior mortgages, mezzanine financing, preferred equity, and seller carry backs - a REIT can also raise capital through various other mediums at the operating partnership and joint venture levels, or the REIT level.

Primary Markets: Initial Public Offering (IPO)

For many Real Estate Investment Trusts (REITs), their journey begins with an IPO. During an IPO, a REIT engages an underwriter, files a registration statement with the SEC, and sells shares to the public on a stock exchange for the first time.

Before proceeding with an IPO, companies must make significant legal and operational changes - such as implementing corporate governance standards and complying with federal securities law requirements, and securities exchange requirements. For instance, a company must review the governance requirements of each exchange and its respective financial listing requirements before deciding which exchange to choose. Other corporate governance matters such as board structure, committees, member criteria, related party transactions, and director and officer liability insurance must also be addressed.

Please note that filing to go public as a REIT is not the same as filing to go public; the process described in this paragraph (plus that described for filing a prospectus further below) is slightly more nuanced for REITs because of its unique value proposition and business structure, and the unique tax code, regulations, and disclosure requirements that govern REITs.

The IPO itself may consist of the sale of newly issued shares by the company (a primary offering), a sale of already issued shares owned by shareholders (a secondary offering), or a combination of these. Choosing the right one depends on various reasons, including stakeholder alignment, for example, directors and underwriters may prefer a primary offering to raise the proceeds to advance the REITs business. Similarly, a secondary offering could be created for shareholders who are looking to exit pre-IPO investments. There is no right or wrong answer here, the offering could also be a combination of both. The decision is driven by the combination of goals that all stakeholders agree on.

The public offering process is divided into three periods: the pre-filing period, the waiting or pre-effective period, and the post-effective period. The pre-filing period is a “quiet period” where the company is subject to potential limits on offering related public disclosures. The waiting period is when the company may make oral offers, but may not enter into binding agreements to sell the offered security. The post-effective period is the time between the effectiveness and completion of the offering.

The registration statement, which is the primary selling document, is filed with the United States Securities Exchange Commission. In addition to becoming an SEC reporting issuer, If the company intends to be publicly traded, the company also needs to file a listing application with the applicable stock exchange. Amongst a plethora of other items, these documents contain the prospectus, financial statements, business plan, and regulatory and contractually required consents and approvals. It also contains exhibits, including basic corporate documents and material contracts. There is a lot to it, and most of it has to be tailored to fit a REIT's structure, its business philosophy, and its investment thesis.

Even if all of the above is crafted into stellar documentation, in our experience, the most complex component of this process is finding the right directors and officers, especially if a real estate company is transitioning into a REIT or a REOC, followed by filing to go public.

Secondary Market Offerings

Secondary offerings are a common way for REITs to raise additional capital, often to finance new acquisitions, reduce debt, or fund other strategic initiatives. In a secondary offering, the REIT issues new shares to investors. Unlike an initial public offering (IPO), where a company's shares are sold to the public for the first time, secondary offerings involve the sale of new shares after the company is already publicly traded.

In some ways, a secondary offering follows a similar process to an IPO in that it involves engaging an underwriter and filing a registration statement with the SEC. However, the documentation is generally simpler and the process is shorter, especially if you’re filing an S-3 registration statement because of its simplified reporting standards. Nonetheless, you are not required to file a listing application.

Secondary offerings are also referred to as seasoned equity offerings or follow-on offerings. They generally comprise either common or preferred stock (or a combination of both) offerings. Preferred share issuances carry different rights and characteristics from common, which vary from deal to deal. However, each class of preferred stock carries the same features, for example, all shares of a REIT's Series A preferred stock offer the same shareholder rights. Some notable features of preferred stock can include:

1. Fixed Dividends: Preferred shares usually offer a fixed dividend, which makes them similar to bonds.
2. Dividend Priority: Preferred shareholders may have a higher claim on dividends than common shareholders. This means they will receive dividend payments before any dividends are paid to common shareholders.
3. Liquidation Preference: Preferred shares typically have a seniority to common stock in the event of a liquidation.
4. Voting rights: Preferred shares may carry special voting rights that could range from superior to no voting rights. Common stock generally carries a single vote per common share.
5. Conversion Feature: Preferred shareholders may have conversion rights to convert stock into common shares, which, in the absence of any pre-emptive or special rights (such as anti-dilution), results in dilution to the common shareholder base.
6. Redemption Rights: Preferred shareholders may have the right to call the company to redeem their preferred shares for cash or other securities.
7. Registration Rights: Registration rights allow shareholders of the stock to (i) force the REIT to conduct an offering for the registration of a holder's shares (demand registration rights) or force the registration of the holder's shares under an existing or upcoming offering that is being made by the company (piggy-back registration rights).

Some of these features can also be offered in the common stock class.

Secondary Markets: At-the-Market (ATM) offering

An At-the-Market (ATM) offering is another way for REITs to raise capital. ATMs are generally more cost effective than traditional offerings. An ATM offering, also known as an equity distribution program, allows a publicly traded REIT to sell shares directly into the secondary trading market through a designated broker-dealer at prevailing market prices. This strategy is conducted under a shelf registration statement filed with the Securities and Exchange Commission (SEC). This "shelf" approach allows a company to fulfill regulatory requirements for an offering without specifying the number of shares to be issued or the time frame in which they will be sold.

ATM offerings provide a REIT with the flexibility to raise capital as and when it is needed. If a REIT is planning for incremental capital needs or managing a project with uncertain future expenditures, an ATM offering can be an excellent tool. ATMs allow REITs to raise just enough capital for current needs and wait to sell additional shares only when more funds are required. This helps in minimizing dilution by not selling too many shares early on at a lower share price, instead encourages using capital from the initial tranche to grow the REIT's NAV and consequently its share price before a follow-on sale, whereby more capital can be raised at a higher share price and for a smaller number of shares.

ATMs allow a REIT to mitigate pricing and volatility risks associated with its publicly listed shares by raising capital over an extended period without causing a significant disruption to the market price of its shares. The same allows for the REIT to continually manage its debt-to-equity ratio and the credit rating and covenants of any rated instruments that the REIT is using to raise debt.

As with any capital-raising method, a REIT must evaluate its specific circumstances, strategic goals, and market conditions when deciding to utilize an ATM offering.

Private Placements

Private placements are a method used by REITs to raise capital directly at the REIT entity level from select investors, who are either accredited individual investors or institutional investors such as mutual funds, private equity funds, or pension funds. Commons structures of private placements include Direct Investments, Private Investment in Public Equity (PIPE), Convertible Debt Private Placements, and Corporate Bond Offerings.

Private Placements bypass the arduous and costly regulatory requirements of public offerings, including the necessity to prepare and file a registration statement with the SEC. Issuers, though not required to, typically provide potential investors with a private placement memorandum or offering memorandum that introduces the investment and discloses information about the securities offering and the issuer. Typically, Private placement memoranda and other offering documents are not reviewed by any regulator.   This allows REITs to raise capital in a more time and cost efficient format.

Private placements are flexible in that they allow REITs to offer a variety of securities types - from common and preferred shares to convertible bonds and warrants, each with customizable features: dividends or interest, convertibility, voting rights, and more.

Furthermore, a private placement provides greater control over the timing and size of the offering. For example, a REIT can conduct a private placement when public market conditions are unfavorable, or it can raise a smaller amount of capital that might not justify the fixed costs of a public offering.

Several regulatory provisions permit private placements, including Regulation D (Reg D), Rule 144A, and Section 4(a)(2) of the Securities Act of 1933. Each has different requirements and conditions that allow the offerings to be exempt from the usual registration and disclosure requirements of public offerings.

However, securities sold under these exemptions are considered restricted securities and cannot be resold by the investors without the company filing a registration statement with the SEC or through a qualification under another exemption.

The SEC offers various exemptions for companies to raise capital. These exemptions are not entirely different from each other but understanding the nuances and their differences will help you pick the right one: the one that aligns with your capital needs. In addition to the brief overview of certain exemptions below, we have also included certain other exemptions in the Crowdfunding section further below. We are happy to save you valuable time, feel free to schedule a free consultation with CIEL's Capital Markets Advisory team here.

Regulation D (Reg D)

Reg D provides several exemptions that permit the sale of securities without registration with the Securities and Exchange Commission (SEC). The most commonly used are Rules 506(b) and 506(c).

Rule 506(b) allows an unlimited amount of capital to be raised from an unlimited number of accredited investors and up to 35 "sophisticated" non-accredited investors. The SEC defines sophisticated investors as investors who, either alone or with a purchaser representative, must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment. However, the issuer cannot use general solicitation or advertising methods to market the securities, and non-accredited investors must be provided with disclosure documents that are generally the same as those used in registered offerings.

Rule 506(c) also permits raising an unlimited amount of capital, but only from accredited investors. However, unlike Rule 506(b), the issuer may use general solicitation or advertising methods but must take reasonable steps to verify the accredited status of investors.

Rule 144A

Rule 144A allows the resale of privately placed securities to certain institutional investors, known as Qualified Institutional Buyers (QIBs), without the registration of securities with the SEC. QIBs are entities that own and invest at least $100 million in securities on a discretionary basis. REITs may use Rule 144A offerings to sell securities directly to QIBs or to facilitate the resale of securities from an initial private placement.

Section 4(a)(2)

Section 4(a)(2) of the Securities Act exempts transactions by an issuer "not involving any public offering" from registration. This exemption is generally used for offerings to a small number of offerees, who are taking the securities for investment purposes and not for resale.

Corporate Credit Facilities

Corporate credit facilities, including revolving lines of credit and term loans, provide vital financial resources for REITs and play a significant role in their capital management strategies. Let's delve into these forms of credit facilities and how they fit into the REIT financial model.

Revolving Lines of Credit

A revolving line of credit is a flexible lending arrangement between a REIT and a financial institution that allows the REIT to draw on the facility, repay the loan, and redraw funds up to the credit limit and as needed. This kind of credit facility provides a pool of substantially discretionary funds and essentially works like a credit card for a corporation.

REITs might use revolving lines of credit for a variety of reasons:

1. Short-Term Funding Needs: Revolving credit can address immediate cash requirements or cover unexpected expenses. It's particularly beneficial for managing the timing mismatch between incoming rent and outgoing expenditures.

2. Acquisitions: It can serve as a bridge financing mechanism for property acquisitions until long-term financing is secured or the property is sold.

3. Working Capital: It ensures there is sufficient working capital to maintain smooth operations, including property maintenance, staff salaries, or renovations.

Term Loans

Unlike revolving lines of credit, term loans provide a lump sum amount upfront, which the REIT repays over a specified period with interest. These loans are often used for significant capital investments, such as property acquisitions or large-scale renovations.

Here's why a REIT might opt for a term loan:

1. Fixed Asset Purchases: Term loans are ideal for financing significant, long-term investments like new property acquisitions or capital-intensive improvements on existing properties.

2. Lower Interest Rates: Term loans often carry lower interest rates compared to revolving lines of credit, which makes them cost-effective for long-term financing needs.

3. Debt Refinancing: REITs may use term loans to refinance existing high-cost debt, thereby reducing interest expense and potentially extending the maturity profile of the REIT's debt.

Raising Capital Through Corporate Bonds for REITs

Bonds are a key financing instrument that many REITs use to raise capital. They are essentially a form of debt. The REIT borrows money from investors and promises to pay them back with interest at set intervals. Here are some of the main types of bonds that REITs utilize:

Public Bonds

Public bonds are bonds that are registered with the U.S. Securities and Exchange Commission (SEC) and sold on the open market. The bonds may be purchased by a wide range of investors, from large institutional investors to individual retail investors. Alternatively, REITs can explore foreign markets for raising capital in a public bond structure - such public bonds would be regulated by authorities in the jurisdiction where the offering is registered or rated.

1. Investment-Grade Bonds: These are bonds issued by REITs that have a high credit rating (BBB- or higher according to rating scales of agencies like Standard & Poor's). These REITs are considered low-risk, and as such, their bonds typically have lower interest rates. An example of this is Prologis, a logistics-focused REIT, that issued $1.25 billion of investment-grade bonds in June 2020.

2. High-Yield Bonds: These are bonds issued by REITs with lower credit ratings (BB+ or lower). They are seen as riskier investments, and therefore, offer higher interest rates to compensate investors for the added risk. For instance, in 2019, the New York City-focused REIT SL Green Realty Corp. issued $500 million in high-yield bonds.

Private Bonds (Private Placements)

Private bonds, also known as private placements, are debt securities sold to a small number of select investors - typically institutional investors like pension funds and insurance companies. These bonds are not registered with the SEC and are not publicly traded. See the section above on Private Placements for more information.

Capital Channels at the Asset/Portfolio Level

When looking at capital raising at the asset or portfolio levels, REITs have a range of options at their disposal - from acquisition and bridge loans to various forms of debt and equity transactions. Let's take a closer look at these methods.

Acquisition/Bridge Loans

Acquisition loans are used specifically for purchasing new properties. REITs often use these short-term loans as a temporary financing solution - necessary capital to secure a property quickly. Following this, the REIT might refinance the acquisition loan with a longer-term mortgage loan or sell the property to repay the loan.

Bridge loans also offer short-term financing solutions. They can bridge the gap between a REIT's immediate need for funds to make an investment and the time it takes to secure more permanent financing or complete a property sale.

First Mortgage Debt

This is a loan secured by a first lien on a property. In the event of default, the first mortgage holder has the primary claim to the property. This is often used as a long-term refinancing solution for acquisition or bridge loans.

Mezzanine Debt

A form of debt that combines elements of equity and senior debt. It is typically secured by a lien on the equity interest in a property-owning entity, rather than the property itself. Mezzanine debt is typically used in larger, more complex transactions.

Preferred Equity (Asset Level)

This is a hybrid form of financing that has characteristics of both debt and equity but is principally equity financing by design. Preferred equity holders have a claim on the property's earnings in advance of common equity holders but second to debt holders.

Joint Venture (JV) Equity Transactions

Joint ventures are strategic partnerships where two or more entities collaborate to pursue a common objective. In the context of REITs, a JV often involves partnering with another real estate company, a private equity firm, or a large institutional investor to acquire, develop, or manage properties.

In a JV, the REIT can bring its operational expertise, property management skills, and established market presence to the table. The REIT's JV partner can contribute capital, additional real estate, or perhaps a strategic market opportunity. Such an arrangement allows the REIT to undertake larger projects or enter new markets with less financial risk.

For example, in 2020, industrial REIT Prologis Inc. entered into a JV with a large group of Korean investors, led by the National Pension Service of Korea, to acquire a 22 million square foot portfolio of properties.

Life Company Placement

Life insurance companies often invest in commercial real estate as a part of their investment portfolios. They offer mortgage loans, mezzanine loans, and equity investments to REITs. In comparison to traditional bank loans, life company loans have more favorable terms, including longer durations and lower interest rates.

Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are government-sponsored entities (GSEs) that provide liquidity to the mortgage market. They purchase mortgages held by a REIT, pool them together, and sell them as mortgage-backed securities to investors.

THE role of GSEs in mREIT and Equity REIT ecosystems

• Mortgage REITs (mREITs) generate income through the interest earned on their investments in mortgage loans or mortgage-backed securities. mREITs often buy mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac. These securities come with a guarantee from the issuing GSE that principal and interest will be paid, which reduces the risk for the mREIT. In essence, mREITs serve as investors in the securities that Fannie Mae and Freddie Mac issue.
• For example, Annaly Capital Management and AGNC Investment Corp. are two of the largest mREITs that hold significant investments in GSE-issued MBS.
• Equity REITs own and operate income-producing real estate. They raise capital by selling mortgages originated from their properties to GSEs or by borrowing from them to finance the acquisition or renovation of multifamily properties.

CMBS (Commercial Mortgage-Backed Securities)

CMBS are investment instruments that comprise of multiple commercial real estate loans bundled together and securitized into a single bond for sale to investors. When REITs securitize the mortgage loans that they've issued into CMBS, they effectively transform illiquid assets (loans) into liquid ones (securities) that can be sold on the market.

This practice offers REITs an immediate influx of cash, which can be funneled back into acquisitions or operational costs, and offloads the risk of borrower default from the REIT to the security holder. A notable example of this is Starwood Property Trust's $1.1 billion CMBS issuance in 2019.

FHA/HUD Loans

The Federal Housing Administration (FHA) insures private lenders against defaults on certain home mortgages which creates easier access to financing. It is a part of the Department of Housing and Urban Development (HUD).

HUD/FHA loans are attractive to REITs, particularly those investing in multifamily and healthcare properties, due to their favorable terms, such as long amortization periods, low-interest rates, high loan-to-value ratios, and non-recourse loan structure.

New Online Investment Platforms: Crowdfunding

Crowdfunding platforms have emerged as a novel way for REITs, especially smaller or newer ones, to raise capital. These platforms allow individual investors to contribute relatively small amounts of capital. In recent years, several online platforms have emerged that specialize in REITs and real estate crowdfunding. These platforms, including Fundrise, RealtyMogul, and CrowdStreet, have made it easier for individual investors to invest in both publicly traded and public non-traded REITs.

For instance, Fundrise offers eREITs - REITs that are sold exclusively on its platform. These eREITs allow individual investors to invest in diverse portfolios of real estate assets with a relatively small amount of capital.

CrowdStreet, on the other hand, provides a platform for accredited investors to invest directly in specific commercial real estate projects, often structured as a form of private REIT.

Most of these platforms are built around exemptions in securities laws, particularly Regulation A (Reg A) and Regulation Crowdfunding (Reg CF).

Regulation A (Reg A)

Regulation A, as an exemption from registration with the SEC, offers two tiers of offerings for companies looking to raise capital:

• Tier 1: For securities offerings of up to $20 million in a 12-month period.
• Tier 2: For securities offerings of up to $75 million in a 12-month period.

This exemption allows companies, including REITs, to raise funds from the general public, not just accredited investors. Companies making a Reg A offering must provide an offering statement that is subject to SEC review and qualification.

In the context of crowdfunding, this regulation has enabled companies such as Fundrise to offer eREITs to both accredited and non-accredited investors. eREITs can be seen as an innovative use of Reg A; they have enabled Fundrise to pool funds from a large number of investors to invest in real estate, while also providing investors with a new method to invest in real estate.

Regulation Crowdfunding (Reg CF)

Regulation Crowdfunding permits eligible companies to offer and sell securities through crowdfunding. It permits companies to raise a maximum aggregate amount of $5 million in a 12-month period from individual investors. While this ceiling is lower than Reg A, Reg CF is cheaper and simpler, preempts state securities laws and offering requirements, and enables raising capital from any investor, accredited or not. Furthermore, crowdfunding campaigns can boost a company's visibility and outreach to potential customers and investors.

Under Reg CF, transactions must be conducted through an intermediary, either a broker-dealer or a funding portal. Platforms like RealtyMogul, which is a licensed broker-dealer, facilitate such transactions, whereby investors can buy into specific property deals or a diversified portfolio in a REIT structure.

To comply with Reg CF, a company must disclose information about its operations, business plan, financial condition, and more. It's important to note that companies raising capital under Reg CF have ongoing disclosure requirements.

Reg A and Reg CF offer a democratized approach to real estate investing: allowing individuals to participate in a sector previously often reserved for accredited or institutional investors.

Blockchain and Capital Raising in the REIT Industry

In recent years, blockchain technology has begun to make its mark on the REIT industry, particularly in the realm of capital raising. This is largely facilitated through the advent of tokenization, a process whereby a real estate asset, or a share in a REIT, is converted into a digital token on a blockchain. These tokens represent fractional ownership of the asset or a REIT and can be bought and sold.

A. Tokenization and Fractional Ownership

Traditionally, real estate investments, including REITs, have faced challenges such as high entry costs and illiquidity. Tokenization addresses these issues by enabling fractional ownership. An investor can buy tokens representing a portion of a property or a REIT without having to invest in the entire asset. This democratizes access to real estate investments and enables smaller investors to participate in and contribute to the trading and liquidity of the token markets.

B. Capital Raising Through Security Token Offerings (STOs)

REITs can leverage tokenization to raise capital through Security Token Offerings (STOs). In an STO, a REIT issues digital tokens (REIT shares) on a blockchain. These tokens are considered securities and are subject to securities regulations.

STOs can streamline the capital raising process for REITs. Given the borderless boundary-less nature of blockchains, STOs can reach a global pool of investors. Thanks to the immutable and transparent nature of blockchain, STOs offer improved transaction efficiency and transparency.

C. Examples of Blockchain in REIT Capital Raising

Aspen Coin is the first and most notable example of a REIT raising capital through blockchain. Aspen Coin, through a single-asset REIT, represents indirect ownership in the iconic St. Regis Aspen Resort. The resort has 179 units (keys) and was appraised for $224 million at the time of the offering. The resort's asset manager was looking to raise $18 million in equity capital. As traditional efforts of raising capital did not garner significant investor interest, the asset managers turned to blockchain. Aspen Coin was distributed to investors through an STO on the Ethereum blockchain. Aspen Coin raised the required $18 million equity capital in 2018 by utilizing Regulation D (Reg D) Rule 506(c) exemption discussed above under Private Placements. Later, Aspen Coin commenced trading on tZero, a tokenized securities exchange.

Are REIT investments classified as alternative investments?

Alternative investments encompass a diverse range of investment vehicles, including Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), Interval Funds, Nontraded Closed-End Funds, and Private Placements. Alternative investment programs and assets include 1031 Exchanges, Qualified Opportunity Funds, Nontraded Preferred Stock issued by REITs, hedge funds, tangible assets, and derivatives. One of the primary appeals of these alternative investments lies in their low correlation with the performance of conventional asset classes, like publicly traded stocks and bonds.

Although real estate is considered an alternative asset class due to its characteristics of low liquidity and high capital commitment compared to traditional investments (like stocks and bonds), publicly-traded REITs blend aspects of both traditional and alternative investments. Their shares are traded on major stock exchanges, providing liquidity like traditional equities. However REITs share certain typical characteristics of alternative investments: REITs are mandated by regulation to primarily invest in real estate, and the value of a REITs portfolio is tied to dynamics of the real estate markets. Thus, publicly traded REITs can be seen as a bridge between traditional and alternative asset classes.

Public-non traded REITs and Private REITs can be viewed as an alternative asset class.

How CIEL Can Help

Each method of raising capital has its advantages and trade-offs, and the choice of which methods to use can depend on a variety of factors including the REIT's size, its stage of growth, the state of the real estate market, and the condition of the broader economy. To learn more, feel free to schedule a free consultation with us.

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