By James J. Eccleston
Eccleston Law Offices P.C.
FINRA (the Financial Industry Regulatory Authority) has issued an Investor Alert warning investors to be on guard when considering an investment in nontraded REITs. The warning is helpful advice as it discusses what is a REIT, what are the different kinds of REITs, what are the material risks of investing in a nontraded REIT and how investors can protect themselves better fromunwarranted or exaggerated sales pitches. Let's examine the key points discussed by FINRA in its warning.
A REIT is a real estate investment trust. The REIT is a trust, a corporation or an association that owns (and also may manage) income- producing real estate. An investor's money is pooled with money from other investors to enable the REIT to buy properties like hotels, office buildings, shopping centers and more obscure properties like timber-producing land. Investors need to understand that there are three types of REITs. They are: exchange-traded, public and SEC-registered REITs; nontraded, public and SEC-registered REITs; and nontraded, private placement, non-SEC-registered REITs. FINRA's alert focuses upon nontraded, public and SEC-registered REITs (commonly known as nontraded REITs).
FINRA discusses "numerous complexities and risks" that nontraded REITs carry. The first risk relates to distributions, which sometimes misleadingly are labeled "income," "dividends" or "yield." FINRA warns investors that "the periodic distributions that help make these (nontraded REIT) products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal." FINRA cautions, "This is in contrast to the dividends investors receive from large corporations that trade on national exchanges, which are typically derived solely from earnings." In addition, the use of borrowed funds to pay distributions (known as leveraging) "can place the REIT at greater risk of default and devaluation, which can result in investment losses when it comes time to redeem or liquidate shares as well as a reduction in, or suspension of, distributions."
Another risk that FINRA highlights is illiquidity and the related problem of valuation. There is no public market for nontraded REITs. At the end of what normally is a "finite life investment," the REIT must list on a national exchange or liquidate. Even if either liquidity event occurs, FINRA cautions that the value of the investor's REIT investment may be less than the purchase price. FINRA points out that valuations of nontraded REITs are complex. It notes, "Many factors affect the pricing, including the portfolio of real estate assets owned, strength of the trust's balance sheet (assets versus liabilities), overhead expenses, cost of capital and more." FINRA warns investors, "Nontraded REITs are rarely, if ever, suitable for short-term investors and even long-term investors must be willing to bear the risks of illiquidity."
A third risk is that early redemption often is restrictive and may be expensive. According to FINRA, redemption provisions can be as restrictive as only 3 percent of the weighted average number of shares outstanding during the previous year. Often investors first must hold the shares for a minimum period, typically for one year. Further, any redemption price usually imposes a haircut of as much as a 10 percent a share value deduction. Finally, and perhaps most notable, redemption programs can be terminated or adjusted. As a result, FINRA cautions that investors "should not count on them, even as an emergency exit strategy." Excellent examples of "redemption-gone-bad" are found with the Apple REITs exclusively offered by David Lerner Associates or with the Behringer Harvard REITs.
Fourth, fees are excessive. FINRA outlines how a $100,000 investment can be worth just $85,000 right away! That is due to two sets of fees. First, selling compensation and expenses can be as high as 10 percent of the investment amount. Second, additional offering and organization costs (sometimes referred to as "issuer costs") can be as high as 5 percent of the investment amount. FINRA compares this high level of fees — as high as 15 percent — to the more modest 7 percent fees typically associated with an exchange-traded REIT.
Fifth, FINRA discusses a host of risks associated with investing in real estate. Among those is the risk that a nontraded REIT normally has not specified the properties for purchase. It is a blind pool. Another risk is that any one REIT is not diversified; that is, the REIT may well buy only hotels, or even concentrate its purchases in just a specific subset of hotels, like extended-stay hotels. Finally, FINRA reminds investors that they are investing in real estate and thus face the uncertainties and the volatility of the real estate market.
In view of all of the complexities and risks associated with nontraded REITs, FINRA advises investors to do what they can to protect themselves. Investors can protect themselves in a much better manner, FINRA urges, by being "wary of pitches or sales literature offering simplistic reasons to buy a REIT investment." FINRA states that it is because "(s)ales pitches might play up high yields and stability (of share price) while glossing over the product's lack of liquidity, fees and other risks." In short, nontraded REITs are "nothing but fool's gold."