Controversy Over Non-Traded REITs: Should These Products Be Sold to Investors? Part I

shutterstock_112362875As longtime readers of our blog know we have reported numerous instances of sales and other practice violations regarding how brokers and brokerage firms sell non-traded real estate investment trusts (Non-Traded REITs). See list of articles below. As Non-Traded REITs have become the latest darling product of the financial industry experts and regulators have begun to question the basis for selling these products. And if Non-Traded REITs are to be sold, should there be a limit on the amount a broker can recommend.

As a background, a Non-Traded REIT is a security that invests in different types of real estate assets such as commercial, residential, or other specialty niche real estate markets such as strip malls, hotels, storage, and other industries. There are publicly traded REITs that are 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, are illiquid, have no or limited secondary market and redemption options, and can only be liquidated on terms dictated by the issuer, which may be changed at any time and without prior warning.

Investors are also often ignorant to several other facts that would warn against investing in Non-Traded REITs. First, only 85% to 90% of investor funds actually go towards investment purposes. In other words, investors have lost up to 15% of their investment to fees and costs on day one in a Non-Traded REIT. Second, often times part or almost all of the distributions that investors receive from Non-Traded REITs include a return of capital and not actual revenue generated from the properties owned by the REIT. The return of capital distributions reduces the ability of the REIT to generate income and/or increases the investment’s debt or leverage.

Yet, despite the significant risks and draw backs to these products, the Non-Traded REIT industry has grown by leaps and bounds in large part due to a concerted effort by the brokerage industry to increase sales of these products in order to pad their bottom lines. According to an Investment News report independent broker dealers saw a 13.2% year over year increase in revenue in 2013 with chief executive of Cambridge Investment Research explaining, “There were two reasons for last year’s results. The stock market was up 30%, and there was an unusually high percentage of dollars in alternatives and REITs being sold.”

According to the Wall Street Journal, in 2009 there were approximately $6 billion in Non-Traded REITs sold. Today, there was $4.2 billion raised in the first quarter of 2015 alone, a pace that could see the amount of Non-Traded REITs nearly triple since 2009 alone.

How does the brokerage industry justify the sales of these products and pitch them to investors. The industry uses two primary pitches. First, increased volatility in the stock market makes investing in a stable Non-Traded REIT a great investment. In reality the stability of Non-Traded REITs is an illusion created by the fact that the funds only have to change their listed value once every 18 months. In fact, Non-Traded REITs are just as volatile as investing in any publicly traded REIT. Second, due to the low interest rate environment, brokers pitch Non-Traded REITs as a safe and stable way to earn a high rate of return.  However, as shown in part II, Non-Traded REIT investors do not profit as much as comparable publicly traded REITs.

As we will show in part II, analysts and regulators are increasingly challenging the brokerage industries message on Non-Traded REITs and questioning the value of these products for investors. First, analysts have found that over time those who invest in Non-Traded REITs earn a significantly reduced return as compared to publicly traded REITs. Second, in light of the brokerage industries binge on Non-Traded REIT sales regulators seek to limit the amount of Non-Traded REITs brokers can peddle into client accounts.