FINRA Issues Investor Alert Regarding Non-Traded REITs
Posted on Tuesday, September 25, 2012 at 12:55 PM

Recently, FINRA (the Financial Industry Regulatory Authority) issued an Investor Alert for investors (and their financial advisers) relating to public non-traded real estate investment trusts (REITs).  The Alert focuses on “misleading information” and lack of “adequate investigation” by financial advisers and their firms in connection with ensuring that their purchase recommendations are suitable.  Recommending an unsuitable investment is a violation of securities industry standards and a frequent cause of action alleged in arbitration cases filed by investors.

 

In highlight fashion, FINRA’s Alert distinguishes non-traded REITs from exchange-traded REITs, noting several important differences.  For example, FINRA warns of several risks related to non-traded REITs:

  • Non-traded REITs “generally are illiquid”, often for periods of 8 years or more;
  • Early redemption of shares “is often very limited”;
  • Fees associated with the product “can be high and erode total return”; and
  • Distributions can be “heavily subsidized by borrowed funds and include a return of investor principal” (in contrast to stock dividends, which typically are derived solely from earnings).

 

FINRA warns that non-traded REITs carry “numerous complexities and risks.”  Let’s examine five major risks.

 

            First, there is the risk that distributions are not guaranteed and may exceed operating cash flow.  Investors need to understand that the REIT’s board of directors has discretion to suspend or halt distributions.  To the extent that REITs make distributions, they are not from earnings.  FINRA states: 

           

For example, in newer programs, distributions may be funded in part or entirely by cash from investor capital or borrowings—leveraged money that does not come from income generated by the real estate itself, such as rents or hotel occupancy fees. The REIT’s articles of incorporation often allow it to increase debt, dip into cash reserves and apply proceeds of the sale of new shares to sustain or even increase distributions. Some REITS even allow borrowing in excess of 100 percent of net assets. Leveraging, including the use of borrowed funds to pay distributions, 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.

            A second risk is that a “lack of a public trading market creates illiquidity and valuation complexities.”  Non-traded REITs are structured as a finite life investment, but that life lasts for years.  During that life, there is no public trading market and thus they are illiquid.  At the end of that life, non-traded REITs either must list on an exchange or liquidate.  When it comes to listing or liquidating, the value is not certain.  FINRA further cautions:

Even if a liquidity event takes place, there is no guarantee that the value of your investment will have gone up—and it may go down or lose all its value. Indeed, valuation of non-traded REITS is complex. 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. The boards and managers of non-traded REITs might even rely on third-party sources to estimate a per-share value.

Third, early redemption programs are “often restrictive and may be expensive”, according to FINRA.  The regulator cautions that investors “should not count on” early redemption programs, “even as an emergency exit strategy.”  In particular:

Redemption provisions can be as restrictive as 5—or even 3—percent of the weighted average number of shares outstanding during the previous year. In addition, shares may have to be held for some period, typically one year, before they can be redeemed.

An additional risk is the fact that the redemption price generally is lower than the purchase price, sometimes as much as 10% lower.

            Fourth, FINRA warns that fees can be expensive.  First, there are selling compensation and expenses, which can be as high as 10 percent of the investment amount.  On top of that, there are additional offering and organizational costs.  While they are known as “issuer costs”, they are paid from the offering proceeds.  FINRA guidelines limit the total costs and fees charged to 15 percent, but that is very expensive.  By comparison, FINRA notes that total underwriting compensation for exchange-traded REITs normally is just 7 percent of the offering proceeds.

            Fifth, the underlying investments in the non-traded REITs are high risk.  FINRA warns that particular properties for investment may not yet be specified, that real estate diversification within the REIT can be limited and that real estate investments -- especially those concentrating on a particular subset of the real estate market (such as hotels or shopping centers) -- carry risk.

            In conclusion, non-traded REITs likely are not suitable for most investors.  For example, investors needing capital preservation, real yield or return (not illusory), or the ability to liquidate the investment should not invest in expensive non-traded REITs.

   

 

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