In an investment world awash with plain-vanilla offerings and obscure flavors, unlisted REITs are among the most exotic choices. There are vocal camps for and against — those in favor point out that, for clients hungry for yield, private REITs can offer steady income and low volatility. Diversification through ownership in commercial and multifamily residential real estate is also often cited as a plus.

Over the last year, though, these vehicles have come under extra scrutiny from regulators and worried planners. They are highly illiquid, charge high fees and can be difficult to analyze. Yet some planners still choose them for clients.

Mostly sold through broker-dealers, private REITs are similar to their publicly traded siblings. They buy and sell properties such as office buildings and multifamily units. But unlisted REITs lock in investors for eight to 12 years during what’s called a capital-raising period. At the end of this time, the REIT declares a final liquidity event, when the entity will either go public or liquidate and make distributions.

Some private REITs do go public, while others may sell their portfolios to institutional investors. Or portfolio parts may be liquidated over several years.

 Until recently, one of the most attractive features for conservative, income-oriented investors had been the fixing of a share price designed not to vary during the lockup. Private REITs have typically promised to pay out property income in the form of dividends during that time.

 The insulation from open-market pricing has been a boon for unlisted REIT marketers and managers. More than $70 billion of the vehicles were sold over the past decade, according to the National Association of Real Estate Investment Trusts, with $8.5 billion in the past year alone.  In a climate in which many investors were leery of stocks as well as historically poor yields from bonds, CDs and savings accounts, the unlisted REIT seemed to be a product ripe for its time.

Despite their seeming appeal, many unlisted REITs have been criticized by planners, regulators and investor advocates for their pricing policies, expenses and illiquidity. FINRA has been monitoring unlisted REITs since at least 2009 and has been investigating broker-dealer practices after a few REITs cut dividends and ended redemption programs.

In May, FINRA filed a complaint against David Lerner & Associates, a major unlisted REIT marketer, for “soliciting investors to purchase shares in Apple REIT 10 without conducting a reasonable investigation to determine whether it was suitable for investors, and with providing misleading information on its website regarding Apple REIT 10 distributions.”

THE PITFALLS

The chance to earn a consistent 6% dividend (or more) when insured savings vehicles were earning less than 1% attracted thousands of investors over the past decade. But there is a trade-off for the relatively high dividends and virtual lack of volatility. Most unlisted REITs limit redemptions to just 5% of assets annually. If you want to get out but there are other investors at the front of the line, you’ll likely be stuck. You can try to find a buyer on your own for the shares — which will likely sell at a discount — or you may be locked in for years. The final liquidity event is at the complete discretion of management.

There are also layers of fees that make non-traded REITs among the most expensive vehicles to own. If sold through broker-dealers, commissions range up to 7% in addition to manager, advisory and operating fees. The REIT charges the investor for buying and selling the properties within the portfolio, tacking on many incidental charges.

Troy Sapp, a planner at Commencement Financial Planning in Tacoma, Wash., has analyzed several unlisted REITs to peel apart the layers of expenses. He says the high costs and embedded conflicts of interest make them difficult products to recommend.

“Assuming full subscription, the average front-end total fees charged on the funds I’ve examined is approximately $400 million each,” Sapp says. “One thing is clear to me: The only parties guaranteed to make enormous sums of money on untraded REITs are the brokers, dealer manager, officers/directors, advisors, property managers — most of whom are essentially the same people.”

 “The high fees and conflicts of interest might not be too disturbing if insiders were also investing in these funds, but total insider ownership averages 0.02%,” Sapp says, citing prospectuses he reviewed. “To make matters worse, insiders and employees also hold warrants and options that will dilute investor value further if the funds do well. These untraded REITs hit unaware investors with fees at every turn.”