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

shutterstock_27710896This post continues our investigation into whether or not brokerage firms have a basis to continue to sell non-traded real estate investment trusts (Non-Traded REITs). Non-Traded REIT sales have exploded becoming the latest it product of Wall Street. However, 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 reported in the Wall Street Journal, Craig McCann, president of Securities Litigation & Consulting Group, a research and consulting company, “Nontraded REITs are costing investors, especially elderly, retired, unsophisticated investors, billions. They’re suffering illiquidity and ignorance, and earning much less than what they ought to be earning.” In conclusion, “No brokerage should be allowed to sell these things.”

According to his analysis, shareholders have lost about $50 billion for having put money into Non-Traded REITs rather than publicly exchange-traded funds. The data comes from a study of the difference between the performance of more than 80 Non-Traded REITs and the performance of a diversified portfolio of traded REITs over two decades. The study found that the average annual rate of return of Non-Traded REITs was 5.2%, compared with 11.9% for the Vanguard REIT Index Fund.

What’s the culprit here causing investor under performance? According to the analysis the high upfront fees your broker earns make all the difference. The true costs of the high fees are then masked from investors through the opaque nature of Non-Traded REITs that helps to cloak their dismal performance. “If you’re selling a high-cost product, typically you make it opaque,” McCann said.

Regulators have recognized that the increased sales of Non-Traded REITs are a problem but, as usual, have taken only baby steps to protect investors. FINRA has issued investor alerts telling investors to “Perform a Careful Review Before Investing” in Non-Traded REITs and have enacted rule changes on how Non-Traded REIT values are listed on account statements. But these actions do little to nothing to protect investors faced with a broker intent on making a sale.  As reported by InvestmentNews, Peter Maftieu, a compliance consultant and principal at Sound Compliance Services, stated that Non-Traded REIT sales guidelines should be reformed and that FINRA should be doing more to police them.

In the wake of FINRA’s lack of leadership on the issue, The North American Securities Administrators Association Inc. (NASAA) circulated a list of 33 proposed changes to its REIT policy that are designed to better protect investors. One of the recommendations would limit investors Non-Traded REITs to the client’s net worth. Already a majority of states have moved to limit Non-Traded REITs in investor accounts. The typical limitation concentration is 10%.  However, these changes have yet to materialize.

The slow moves by regulators highlight how agencies are reluctant to regulate blockbuster Wall Street products that are little more than the equivalent of high cost water pills for investors that could have significant negative side effects during market downturns.  Fundamentally, the premise for selling Non-Traded REITs is flawed.  For all the risk an illiquid Non-Traded REITs represents one would expect that investor return would be enhanced. That’s the normal trade off.  If you are going to be invested in an illiquid and speculative product you should, on average, earn a return above comparable liquid alternatives.  That’s the free market rational investor hypothesis that no investor would purchase a higher cost/risk product without being adequately compensated.  However, markets become dysfunctional when advisors are highly compensated to recommend the sale of inferior products to consumers.  As the McCann analysis shows investors cannot expect to profit in Non-Traded REITs and in fact are destined to lose money compared to publicly traded funds.

Yet, regulators are conflicted and divided on how and even if to protect investors from the conflicts of interests the brokerage industry has in selling Non-Traded REITs.

The law offices of Gana LLP represent investors in disputes with their brokerage firms concerning a variety of investment abuses. Our consultations are free of charge and the firm is only compensated if you recover.