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Investing in Commercial Real Estate: Understanding Non-traded REITs

In addition to the traded options most investors are familiar with, institutions and the extremely wealthy have diversified their investment portfolios in search of returns from less liquid, alternative assets and investment strategies.

General Investment Options

High-net-worth individuals and large institutional investors, like pension funds and university endowments, have pursued investments in alternative assets typically unavailable to the average, retail investor.

As markets have become more unpredictable, retail investors have sought assets that are less correlated with the daily price variations experienced in the stock market. This has advanced an allocation model with four general investment options (refer to Figure 1):

  1. Traded stocks, where a company issues securities representing ownership in a company.
  2. Bonds, where a company borrows money from the investor for a specific time period at a fixed interest rate.
  3. Cash equivalents, such as actual cash or assets that can be quickly converted into cash.
  4. Alternative investments, such as real estate, commodities, hedge funds, private debt and private equity.

It's important to note that institutions and high-net-worth investors have different investment goals than retail investors and often invest with different terms and conditions, particularly with regard to fees and expenses. Additionally, benefits and risks for each asset class should be considered prior to investing.

Figure 1. General Investment Options

The diagram is for illustrative purposes only. Asset classes can be allocated in varying amounts to help meet an individual's personal investment needs.

Commercial Real Estate as an Investment

Commercial real estate — or property that is used for business purposes — is one example of an alternative investment option. Examples of commercial real estate include malls, office and medical parks, seniors housing communities, hotels and restaurants (refer to Figure 2).

There are two main reasons why retail investors have expanded their investment universe to include real estate. First is the potential for ongoing rental income from properties leased to creditworthy tenants. Well-located commercial properties in supply constrained markets may provide future returns by attracting and retaining long-term tenants.

Second is the potential for investment growth. One of the most obvious growth opportunities is to buy a high-quality property that is undervalued due to economic conditions and sell it when markets improve. But growth opportunities exist even in up markets. For example, a building in a prime location may require renovations or operational improvements to meet its full potential or a business - critical property may be undervalued because real estate demand is focused elsewhere.

POTENTIAL BENEFITS TO INVESTING IN COMMERCIAL REAL ESTATE

Beyond income and growth, commercial real estate offers other investment benefits. Real estate may:

Offer Diversification
Investing in real estate may provide diversification into an asset class outside the stock market that has a low, historical price correlation to traditional investments, such as stocks and bonds.

Enhance Returns
Adding commercial real estate to an investment portfolio may provide competitive returns in a long-term investment strategy.

Mitigate Exposure to Rising Inflation
Hard assets such as real estate have generally performed well during periods of high inflation. This is one of the reasons why investors have often looked to more tangible, hard assets when traditional investments start to decline in value.

POTENTIAL RISKS TO INVESTING IN COMMERCIAL REAL ESTATE

Along with the potential benefits, direct ownership of commercial real estate comes with risks:

Less Liquidity
Selling commercial real estate may be complicated and time - consuming as a limited number of buyers and sellers exist at any given time.

Complex and Difficult Underwriting Criteria
Economic, legal, regulatory and tax factors, which may vary by market, must be taken into account before investing.

Real Estate Value Fluctuations
As with all investments, the values associated with commercial real estate can fluctuate.

As with any investment, individuals should discuss their options with a financial advisor.

Traded and Non-Traded Options

Today's market offers options for retail investors seeking to add commercial real estate to their portfolios. Traded options include real estate mutual funds and traded real estate investment trusts (REITs), among others. Although traded real estate investment options offer higher liquidity to investors, they experience daily stock market volatility based on consumer sentiment.

There is an alternative that provides retail investors access to commercial real estate outside the stock market — non-traded REITs. Although these investments are less liquid than their traded counterparts, the REIT structure is aligned with the long- term nature of the real estate in which they invest. Non-traded REITs also seek to provide the diversification benefits that are frequently associated with commercial real estate.

HOW REITs WORK

Figure 3 shows the basics of how a REIT works:

  1. Investors purchase shares in the REIT's common stock offering. As capital is raised, the REIT acquires properties and builds an asset portfolio consistent with its investment strategy.
     
  2. The REIT's management team oversees the property portfolio and may be involved with its day-to-day operations.
     
  3. Rental income is collected from tenants, which the REIT passes along to investors in the form of distributions.

Non-traded REITs are complex and varied. Please read the REIT's prospectus carefully. In the early stages of a REIT, the investment typically exhibits greater risks which include: few or no properties, limited operating history, and having not yet elected or qualified as a REIT to obtain lower portfolio taxes to improve shareholder returns. Due to the high levels of investment costs and fees incurred with the REIT, early distributions will not be fully covered by cash flows from operating activities and will be paid from expense waivers, borrowings and offering proceeds. After the REIT has a couple of years operating history, the majority, if not all of the distributions should be covered by cash flow from operations. The REIT's limited redemptions and distributions are not guaranteed and subject to suspension, modification or termination by the REIT at any time. During the middle stages of the REIT's life cycle, leverage will typically increase and shareholders' votes are typically limited to a rare vote on major portfolio changes and members of the board of directors, as detailed in the prospectus and proxy. The REIT's management team and board of directors exercise independence over managing the portfolio's investments.

In the case of a non-traded REIT, the REIT ultimately seeks to provide liquidity to investors as it nears the end of its life cycle. This is done by either listing its shares on a public exchange or by liquidating its assets and distributing any available proceeds to investors.1

It is important to note that investing in commercial real estate is a long-term activity. As such, there might be liquidations at less than the original amounts invested and illiquidity throughout the REIT's multiyear life cycle. However, this frees the REIT from some of the short-term pressures associated with the traded market, thus enabling the REIT's management team to focus on a long-term strategy.

SUITABILITY STANDARDS AND OTHER RISKS

Non-traded investment options are not suitable for all investors. Suitability standards are extensive and generally require an investor to have a net worth of at least $250,000, or an annual gross income of $70,000 and a net worth of no less than $70,000.

Besides limited liquidity and possible illiquidity, investments in non-traded REITs are subject to significant risks. These risks include limited operating histories, reliance on the advisors, conflicts of interest and payment of substantial fees to the advisors and their affiliates. An advisor should determine whether the risks associated with investing in a non-traded REIT are compatible with their client's investment objectives.

In Brief

Individuals should discuss all investment options with their financial advisor — there may be room for traded and non- traded investments options in a portfolio depending on their liquidity and diversification needs. Detailed information about an investment, including its benefits and risks, can be found in the offering's prospectus.

CNL Healthcare Properties II is a non-traded REIT2 that provides an opportunity for investors seeking income and growth for their portfolios. For more information about CNL Healthcare Properties II, please visit cnlhealthcarepropertiesii.com, or contact the managing dealer, CNL Securities, member FINRA/SIPC, at 866-650-0650. For additional information about real estate or non-traded REITs, visit cnlsecurities.com.

1 Liquidity events are not guaranteed and may be changed at the program management's discretion.
2 CNL Healthcare Properties II intends to qualify and elect REIT tax status beginning with the first year in which it commences material operations, the taxable year ending Dec. 31, 2017, although there is no assurance the REIT tax status will occur within the stated time frame. If the company fails to meet the REIT qualification standards now or in the future, the company will be subject to increased taxes, which will decrease investors' returns.

No offering is made to residents of New York, Maryland or any other state, except by a prospectus filed with the Department of Law of the state of New York, the Maryland Division of Securities or the respective state securities administrator. Neither the U.S. Securities and Exchange Commission, the attorney general of the state of New York, the Maryland Division of Securities nor any other state securities administrator has passed on or endorsed the merits of the REIT's offering or the adequacy or accuracy of this piece or the REIT's prospectus. Any representation to the contrary is unlawful.

This is not an offer to sell nor a solicitation of an offer to buy shares of the REIT. Only the prospectus makes such an offer. This piece must be read in conjunction with the prospectus in order to understand fully all the objectives, risks, charges and expenses associated with an investment and must not be relied upon to make a decision.

The information herein does not supplement or revise any information in the REIT's public filings. To the extent information herein conflicts with the prospectus, the information in the prospectus shall govern. The prospectus is available on sec.gov and cnlhealthcarepropertiesii.com.

Forward-looking statements are based on current expectations and may be identified by words such as believes, expects, may, could, and terms of similar substance and speak only as of the date made. Actual results could differ materially due to risks and uncertainties that are beyond the REIT's ability to control or accurately predict. Investors should not place undue reliance on forward-looking statements.

Managing dealer of CNL Healthcare Properties II is CNL Securities, member FINRA/SIPC. Shares are offered to the public through selling firms. Selling firms are reminded that the REIT's communications must be accompanied or preceded by a prospectus.

This material is provided by CNL and its affiliates and is intended for general use with the public. CNL and its affiliates cannot provide investment advice for any individual or any individual situation, and are not acting in a fiduciary capacity to any investor. Do not look to this material for any investment advice. CNL and its affiliates have financial interests that are served by the sale of CNL Healthcare Properties II's shares.

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