A real estate investment trust (or REIT) is a security that invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields. A traded REIT is usually offered on one of the major exchanges and can be bought and sold just like a stock. A non-traded REIT is not offered on an exchange. This makes non-traded REIT investments generally illiquid - severely limiting the investors’ ability to access their funds should the need arise. This also often makes non-traded REIT investments unsuitable for retirees who need liquidity for any unforeseen expenses, such as medical expenses. Non-traded REITs are often less regulated than other types of investments as well (such as mutual funds, equities, etc.) and generally pay a higher commission than other investment vehicles (often explaining a financial advisor’s motivation for recommending the investment).
Notwithstanding the suitability problems of non-traded REITs for certain investors, investment in privately offered non-traded real estate investment trusts (REITs) continues to boom. It has been reported that non-traded REITs have raised around $10 billion in 2011 alone and investors seem likely to continue to pursue the investments due to their potentially attractive yields. The market for and investment in non-traded REITs has also been a hot topic of discussion in the past couple years within the securities industry.
My firm, The White Law Group, LLC, a national securities arbitration law firm dedicated to investor protection, has represented many investors in non-traded REIT related litigation and we have been carefully following the trend in the securities industry towards the sale of more alternative investments like non-traded REITS. Over the past couple years, we have seen litigation related to the improper sale of non-traded REIT investments increase, and have seen securities regulators, like the Financial Industry Regulatory Authority (FINRA), begin to pay closer attention to the investment vehicle.
Since the market for non-traded REITs is unlikely to disappear, the question is, will those who market and sell non-traded REITs learn from past mistakes and the resulting litigation? Also, will FINRA put in place the necessary regulations to ensure that the investment in non-traded REITs by future investors is as transparent as possible?
A recent article by Bruce Kelly on investmentnews.com indicated that even though 4 major non-traded REITs have closed to new investments or will do so shortly, others will almost certainly step up and take their place. Mr. Kelly noted that some industry executives believe, “The REITs' closure will likely open the door for some new nonlisted REITs to capture a share of the $9- billion-a-year market.” These same industry members told Kelly, “the change in the landscape will be a reminder for broker-dealers and registered representatives to be vigilant about due diligence on the products.”
If history is any indication, it will be imperative for firms to go above and beyond what they have done previously in performing due diligence on the non-traded REITs they are offering. Just about the time the market for non-traded REITs was expanding, the real estate market across the country began to struggle mightily and this resulted in significant problems for many non-traded REITs. The difficult real estate market forced many non-traded REITs to adjust distributions and suspend the “buy-back” of shares from investors (often called the redemption program). One non-traded REIT, Desert Capital REIT, even went bankrupt (filing for Chapter 11 bankruptcy earlier this year). President of MTS Research Advisors, Michael Stubben, was recently quoted on investmentnews.com regarding the impact of the rough condition of the real estate market on non-traded REITs. He said, “As a result, the market values of their assets have declined, and these nREITs have experienced declines in occupancies and rents.”
Some troubled investors in non-traded REITs have filed FINRA arbitration complaints against the brokerage firms and financial professionals who sold the investments (at least in part on the basis that they failed in their responsibility to do adequate due diligence on the investment). We have seen a significant uptick in litigation related to non-traded REITs. We are currently representing many investors in claims related to the improper sale of non-traded REITs, including Desert Capital REIT, Cornerstone Real Estate Funds and REITs, Wells REITs, Behringer Harvard REITs and others. It seems, from our experience, that many of brokerage firms that sold non-traded REIT investments failed in their fiduciary duty to perform suitable due diligence before selling these investments to investors.
Desert Capital REIT, which filed for bankruptcy in 2008, is a prime example of the trouble that can come from a failure in due diligence and why there must be a change in how these investments are sold moving forward. Not only have many investors lost a significant portion of their life savings due to their investment in Desert Capital, but additionally, many smaller brokerage firms that sold the Desert Capital REIT have since been put out of business due, in large part, to the deluge of litigation related to the sale of Desert Capital.
Failure in due diligence, however, has not been the only problem with the sale of non-traded REIT investments. Issues stemming from how non-traded REIT investments are sold and represented have spelled trouble for investors and financial professionals alike. Our firm has found several common issues related to the sale of the investments that have contributed to the continued litigation surrounding the vehicle. Non-traded REITs are inherently risky investments, as they are tied to the real estate market, and should not be represented as safe and secure. Also, investors should not be over concentrated in a particular market sector, like real estate, but due to the high commission offered by non-traded REITs to brokerage firms, financial advisors often recommend that an investor put too large a percentage of their investable assets in these products. The commission offered by non-traded REIT companies to brokerage firms is often between 10-15% (for a comparison, financial advisors generally make 2% for selling a mutual fund). This high commission may in some cases explain the brokerage firm and registered representative’s motivation for selling the investments to clients contrary to what may be suitable.
It is critical that brokers live up to their responsibility to recommend investments that are suitable for their clients in light of their age, investment experience, investment objectives, and net worth. If they fail to live up to their fiduciary responsible, they may be liable for the investment losses through FINRA dispute resolution claims.
While investing in non-traded REITs can be appropriate for certain investors, it is imperative that regulators and financial professionals step up to help to protect investors for whom these investments may not be suitable. It now seems that regulators are beginning to do exactly that.
FINRA recently issued an “investor alert” related to the sale of non-traded REITs. FINRA stated that, “While investors may find non-traded REITs appealing due to the potential opportunity for capital appreciation and the allure of a robust distribution, investors should also realize that the periodic distributions that help make non-traded REITs so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal. Additionally, early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return.” FINRA is aware that the income producing aspects are particularly attractive in today’s economy and that makes it even more important for investors to be fully aware of all aspects of the investment vehicle.
FINRA has also been taking action on another aspect of non-traded REITs; rules and regulations surrounding their valuation and listed par value. It appears that FINRA’s interest in this aspect of the vehicle first became clear when they filed a complaint against David Lerner Associates, Inc. last May related to the sale of the Apple Real Estate Investment Trusts. FINRA stated, “…that the longtime $11 a share value of Apple real estate investment trusts was unreasonable in the face of market fluctuations and other events.” In September it was reported that FINRA was proposing regulatory changes that would affect the valuation of non-traded REITs and how the par pricing of the investments is listed on investor account statements.
FINRA would like to shorten the current grace period of 18 months after the close of offering period before the price of the shares must have a new estimated market value. They would like, instead, for pricing to be based on the information from the REIT’s most recent annual report. Currently, given that the sale of a non-traded REIT can go on for several years, investors may not have a market price for their investment for 3-5 years.
FINRA would also like to require the costs and commissions associated with the initial purchase of the investment to be reflected in the par value of the stock as indicated on the investors account statements. This proposal indicates that FINRA would like “all per-share estimated values, including those that are based on the offering price, reflect a deduction of all organization and offering expenses (net value).” If this rule is implemented it would serve to help investors understand some of the fees and costs associated with the purchase of the investment more clearly.
These most recent proposals by FINRA and the attention being brought to non-traded REIT investments by securities fraud litigation seems to be good news for future investors in non-traded REITs. There is also one more piece of good news for the future of transparency in the non-traded REIT market. It appears that well known research firm, Morningstar Inc., is considering offering research services in the non-traded REIT market next year. The Morningstar REIT specialist looking into the market was quoted in the investementnews.com as saying, “Morningstar decided to look into the information needs of non-traded- REIT sellers because of persistent shortfalls in information needed to analyze the products, including how they communicate to the public.” According to that same article, some financial professionals associated with the sale of non-traded REITs hope that Morningstar’s research would “…bring non-traded REITs into the mainstream.” I certainly feel that having more information available to financial professionals (and investors) will be helpful as future investors evaluate whether to invest in a non-traded REIT.
I have witnessed non-traded REITs cause trouble for many investors and financial professionals in recent years. However, it is clear that the market for these investment products is not going away and may continue to expand. In order for this investment vehicle to continue moving forward, the recent attention being given to non-traded REITs throughout the securities industry needs to result in more transparency in all facets of the sale of these investments. It is my hope that the current momentum for change will lead to a more transparent non-traded REIT market for investors, but only time will tell.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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