Non-Traded Real Estate Investment Trusts (REITs); Nothing But Fool’s Gold

Posted on May 6th, 2011 at 9:21 AM

Investors need to say, “No thanks” when presented with an opportunity to buy REITs that are not publicly traded.  Publicly traded REITs have their own issues, but at least those investments have relative transparency, liquidity, accurate share valuation and fees that aren’t outrageous.  The same cannot be said for non-traded REITs, yet the market for them is booming.  As the saying goes, those products “are sold, not bought”, by way of salesmen telling half-truths to unsophisticated investors and retirees over a free dinner presentation. 

Let’s examine why investors should stay clear of non-traded REITs, and if they unfortunately own them, what remedies they may have.

            First, all REITs invest in various types of real estate properties.  They buy the properties, manage and maintain the properties, attempt to rent the properties, and ultimately seek to sell the properties for profit.  That raises the first concern: REITs are concentrated in one market sector – real estate.  Whether the REIT invests in lodging, office, industrial, residential, health care facilities, or a combination thereof, the REIT portfolio neither is balanced nor diversified.  As such, REITs are subject to all of the real estate related investment risks and economic risks.

            Second, non-traded REITs suffer from conflicts of interest.  For example, the sponsor’s chairman or president may own or have duties as an officer of a third-party advisor, a manager, contractor or a competitor.  This problem is so widespread that the securities regulator FINRA has sent “targeted examination requests” to firms promoting non-traded REITs in order to investigate those conflicts of interest.

            Third, non-traded REITs commit “highway robbery” in charging egregious upfront fees of 12% to 15%.  One is hard-pressed to identify a higher-charging investment!

            Fourth, non-traded REITs are illiquid.  That means that there is no public market for sale.  Sometimes, but certainly not often, these products can be sold through a “secondary market”, but only at a small fraction of the offering price in a kind of “fire sale.”

            So, in light of the above, one naturally should ask, why on earth would anyone knowingly buy a non-traded REIT?  The answer is simple and unfortunate.  Unsophisticated and retiree investors have been told, over a steak dinner and through misrepresentations and omissions, that non-traded REITs are safe (non-volatile share price), that they distribute monthly income as high as 8% annualized in a market where CDs pay less than 2%, and that they are liquid typically after one year.  Let’s explore those tricks of the trade.

            First, many non-traded REITs trick investors by reporting the value of the investment at its original purchase price.  Securities rules are complicated in this regard, and sponsors have done everything that they can to hide the truth – the real value of the shares – so that on every monthly or quarterly statement the value miraculously is perfectly stable.  Recently some sponsors have marked to market their shares, and investors have witnessed the value of their safe, non-volatile investment cut in half!

            Second, over steak dinner, non-traded REIT promoters speak in terms of the investment “paying” or “yielding” 8%.  They neglect to inform their dinner guests that the 8% payment or yield actually may be from a partial or entire return of the investor’s own capital invested!  Worse still, they neglect to inform that the 8% payment or yield may be possible only because the non-traded REIT (in effect, the investors) took out a loan to make that payment.

            Of course, increasing indebtedness and returning capital do not bode well for safety for principal.  This is true without regard to whether and when the sponsor is willing or able to sell the underlying REIT properties and terminate the investment.  In that regard, most non-traded REITs have a finite life – usually not longer than ten years – at which time the properties must be sold.  One of the most deceptive tricks of the trade is to promote past, successful sales of other REIT issues, suggest that the underlying properties will be sold, yet in the fine print of a prospectus reveal that the sponsor has no obligation to sell the properties within any time frame.  After all, it is only when investors receive pennies on the dollar at such sale will the con job fully have been revealed!

            A final trick of the trade is to promote that, although illiquid and with no secondary market for sale available, the non-traded REIT sponsor will maintain a share redemption program for investors to liquidate the shares.  While sponsors never fail to promote their liquidation feature in sales presentations, they often fail to state that in their discretion they can modify the share redemption program, suspend it, or even terminate it.  And sponsors also often fail to state that they have the discretion to reduce the price per share paid to the redeeming shareholder.

            The good news is that investors who have invested in non-traded REITs do have remedies.  They can seek damages, rescission of their investment and other relief, through arbitration against the financial services firm that sold the investment.  Investors always have a claim for “suitability” when a recommended investment is not appropriate for their needs, objectives, risk tolerance and so forth, and it matters not whether adequate risk disclosure was contained in a prospectus.  Moreover, in over 15 years of regulatory notices, FINRA has made it clear that there is no “prospectus defense” when there was an unbalanced or otherwise misleading sales presentation.  Did someone say “Filet Mignon”?


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