EagleTribune.com, North Andover, MA

November 23, 2013

Beware of non-traded REITS

Financially Speaking
John Spoto

---- — In today’s low-interest rate environment, individuals -- especially retirees who depend upon their portfolio to help meet spending needs -- are turning to “alternative” investments in search of higher returns. One such investment is the non-listed real estate investment trust (REIT).

Individuals invest in real estate to improve the diversification of their portfolios and to own a share of assets such as land and buildings that have tangible value. For those who understand the risks of real estate ownership, these are valid reasons to make such an investment. Stretching for higher yield on a portfolio, however, is not.

A REIT is an operating company that pools the capital of many investors in exchange for ownership shares. The company then purchases and often manages a portfolio of properties such as shopping centers, office buildings and apartment complexes. REITs offer the average investor an opportunity to own property without the large investment and responsibility associated with buying and managing it directly.

With these benefits, however, comes additional risk. REITs are volatile investments that behave more like stocks than bonds. Anyone substituting REITs for bonds in their portfolio to generate higher income will have created a more aggressive, stock-heavy allocation.

There are three basic REIT classifications. First are private issues sold through exclusive offerings to investors who meet certain income and net worth criteria. Second are issues available to the public that trade on a national exchange. Third are issues available to the public that do not trade on those exchanges. It is this latter group, known as non-traded REITS, that has been most aggressively sold by Wall Street firms through commission-based sales reps. Sales of these products have surged over the last few years and are on pace to reach $17 billion in 2013, with much of them finding their way into the portfolios of retirees and other unsophisticated investors desperately seeking higher income.

Investors are typically told that these non-traded securities allow ordinary people to participate in commercial real estate that will generate a steady stream of income substantially higher than bonds. Furthermore, because these shares are not publicly traded, they are protected from the volatility that publicly traded REITs or other stock investments experience. Generating high stock-like returns with the price stability of bond investments and improving the diversification of the portfolio have been major selling points for these products and make for a compelling argument. Let’s take a look at why this argument does not withstand scrutiny.

The main reason investors are drawn to these products is the yield. When the typical annual REIT distribution of 6 percent or more is compared to the miniscule income generated from high-quality bonds, it is easy to understand the appeal. Quality and reliability of yield matter, however. Equating the “expected” distributions of non-traded REITs to the guaranteed interest payments on an investment-grade bond is flawed analysis. The periodic distributions that make these REITs so attractive are in many cases heavily subsidized by money raised from new investors (i.e. borrowing from Peter to pay Paul) rather than from the real estate operations. Investors need to understand the source of distributions and the risk it represents.

Non-traded REITs are touted as less volatile than those that trade on the exchanges. Remarkably, the share price remains stable at around $10 throughout the life of the REIT, regardless of company profitability, quality of underlying investments or market conditions. Although a constant share price gives the illusion of stability it doesn’t mean the actual investment value hasn’t changed; it just means you don’t know what it is. This has led to increased scrutiny from state and federal regulators.

In finance, the term liquidity means the ease with which an asset can be readily converted to cash at its current value. A key difference between exchange-traded REITs and non-traded REITs is that the former can be sold anytime on a national exchange and, therefore, are highly liquid. Non-traded REITS on the other hand are structured with a predetermined timeframe, usually seven to 10 years.

A “liquidity event,” which can involve listing on a national securities exchange, selling the company, or liquidating the underlying real estate investments is the opportunity for investors to reclaim all or at least some of their original investment. Those who lose patience and decide to sell before the liquidity event may be in for a surprise.

Early redemption options when available will be restrictive and expensive. The terms of the share purchase agreement stipulate that you may not be able to get out when you want and, even if you do, it will likely be at a substantial cost. For this reason, these products are euphemistically called “long-term investments,” but a more accurate term is illiquid. There is no evidence that investors are compensated with higher returns for the risk they accept.

Shareholders face excessive investment costs and significant conflicts of interests between themselves and management.

Front-end sales commissions and transaction fees, which alone can top 15 percent of the invested amount, incentivize sponsors, management and the sales organization to aggressively sell these products to unsophisticated investors -- unfortunately regardless of their suitability for a particular individual.

To make matters worse, these companies are characterized by complex ownership structures and questionable compensation arrangements that create conflicted financial incentives for managers to the detriment of shareholders. For example, operational costs that are paid by shareholders and often pocketed by management for buying, selling and managing properties come directly out of investor returns.

If non-traded REITs are such great investments you would assume that company insiders would own substantial shares of these businesses. After all, this would allow them to reap the same benefits of ownership that they are offering to retirees and other small investors. Surprisingly, however, a recent study commissioned by the periodical Investment News found they only own about 3 percent of outstanding shares.

John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.

This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.