The Securities and Exchange Commission (SEC) approved a rule change proposed by the Financial Industry Regulatory Authority (FINRA) that will give investors greater insight into the costs of purchasing shares of non-traded real estate investment trusts (Non-Traded REITs).
As reported by InvestmentNews, the SEC approved FINRA’s proposal on October 10. The rule change would require broker-dealers to include a per-share estimated value for an unlisted direct participation program (DPP) or a REIT on customer statements in addition to other related disclosures. The current practice is to list the value of Non-Traded REITs at a per-share price of $10, or simply the purchase price of the investment.
As a background, a Non-Traded REIT is a security that invests in different types of real estate assets such as commercial real estate properties, residential mortgages of various types, or other specialty niche real estate markets such as strip malls, hotels, and other industries. REITs can be publicly traded and when they are, can be bought and sold on an exchange with similar liquidity to traditional assets like stocks and bonds. However, Non-traded REITs are sold only through broker-dealers and are illiquid, have no market, and can only be liquidated on terms dictated by the issuer, which may be changed at any time and without prior warning.
Increased volatility in the stock market has led to a growing number of investment advisors to recommend REITs as a purported stable investment during unstable times. In addition, these products are far more lucrative for the brokerage industry than either publically traded REITs or many other types of investments. However, claims that REITs are stable have been shown to be false. The stability of Non-Traded REITs only exists because brokerage firms and issuers have control over the value of the security listed on an investor’s account statements and not because the security will actually sell at that value or is stable over time.
Enter the proposed FINRA rule change. As we first reported in February, FINRA outlined two proposed methodologies that firms can use to calculate the per-share estimated value for a DPP or Non-Traded REIT including a “net investment methodology” or an “appraised value methodology.”
The net investment methodology would show the net investment value as revealed in the issuer’s most recent periodic report. This value would be the actual amount of the investment available for investing purposes. Where amount available for investment isn’t provided in the prospectus, the proposal would require the amount to be based on another equivalent disclosure that shows the estimated percentage that will be deducted due to commissions and other fees.
Many investors do not realize that only 85% to 90% of their investment funds actually go towards investment purposes. In other words, this value option would require brokerage firms to actually show that investors have lost 15% of their investment to fees and costs rather than the current assumption that such costs will be made up by future gains at some undetermined time in the future.
In addition, under the net investment methodology, broker-dealers would have to tell customers in a statement that part of their distribution includes a return of capital and that “any distribution that represents a return of capital reduces the estimated per-share value shown on your account statement.” Again, many investors do not realize that many of the dividends they receive are not entirely a return on capital and instead represents a return of capital that reduces the ability of the REIT to generate income and/or increases the investment’s debt or leverage.
The second method, the appraised value approach, requires the share value be based on a valuation of the assets and liabilities of the DPP or Non-Traded REIT. The valuations must be performed at least annually, be conducted by a third-party valuation expert, and come from a methodology that conforms to standard industry practice.
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