I wondered in this column recently whether anybody ever recommended nontraded REITs without the incentive of generous commissions. I soon had the opportunity to learn the views of advisors who do just that.

Because this is a professional publication, I can't actually print their comments verbatim. Let's just say that they expressed forceful opinions about my objectivity.

In case you're not familiar with nontraded REITs, these are investments that will remind many veteran advisors of the limited partnerships of the late 1980s and early 1990s. The products are generally blind pool accumulations of capital that will be invested in real estate, with the shares sold by advisors for upfront commissions - which, when you add in the various payments to the broker-dealers, can be as much as 10% of the money raised. Total upfront fees are capped at 15%.

By all accounts, these are popular investments. To get a quick read on the size of the segment, I checked out the statistics compiled by Robert A. Stanger & Co., an investment banking and consulting firm that was the dominant information resource on tax shelters and limited partnerships in the 1980s. It now functions as an investment banker for nontraded REITs and unlisted direct participation programs - sort of the equivalent of the old private placement limited partnerships back in the day. Stanger estimated the total value of the nontraded REIT market at $62.4 billion earlier this year.



The upfront fees are troubling in and of themselves. Even if the properties are managed astutely, it could take more than five years - assuming 2% annual returns - for investors to recover what they paid an advisor to persuade them to buy in the first place.

But in my mind, there are three bigger problems, and all of them were also serious issues with the limited partnerships that spectacularly went bust a couple of decades ago.

Illiquidity means investors are captive to the investment sponsor. The sponsor manages the property and pays itself - which is where, suddenly, we enter the land of temptation and perverse incentives. What incentive is there for a nontraded REIT promoter to keep a firm lid on management fees it is paying itself, or paying another entity that can share revenues with the promoter?

And when properties need repairs and maintenance, there may be the additional temptation to accept kickbacks from vendors and pad the bills to the operating entity. All these property management activities have the potential to become a gravy train for a sponsor.

That brings up yet another worry: These programs are sold with the idea that the promoter will eventually liquidate the properties or take the nontraded REIT public. But again, the incentives work against investors. Why would the sponsor decide to liquidate and derail the gravy train?

An additional concern is more basic. If a nontraded REIT buys properties that will become a cash cow for the operating entity, what incentive is there to argue about or negotiate hard on the purchase prices of the properties being acquired? The only goal that would make sense, if you are looking purely at a promoter's economics, is to shovel a lot of investor dollars out the door and get this gravy train in place as quickly as possible.

I'll add a bonus concern here: There is nothing preventing nontraded REITs from paying generous distributions to investors - well above what bonds are delivering - from their cash reserve accounts, rather than from actual operations.

In other words, a nontraded REIT could be promoting its next offering based on the remarkable distributions being paid by its last one, even if all the firm is really doing is paying the investors back some of their own money. (More on this in a moment.) How would the investors know?

You can call me a cynic for even suggesting that nontraded REIT promoters would do any of these sly or nefarious things. But I would point out that limited partnership sponsors succumbed to every one of these temptations.



The messages I received from advisors who have sold these programs made several points, which I assume are among their sales points with investors.

First: Look at those yields! Who else is offering yields like that? But the problem, again, is that it takes a lot of research to find out whether the cash flow from the properties - after management fees - is actually covering the yields being paid out.

Those research reports exist; I obtained one for background information. It listed a number of nontraded REITs with assets ranging from $1.18 billion to $10.9 billion, and compared the dividend with operating revenues after expenses. In all, only nine of the 20 nontraded REITs were covering their distributions from operations. Some of the coverage ratios were estimated to be 35%, 43%, 46%, 52% and 58%. In this yield-starved world, it's pretty easy for a nontraded REIT to create a great sales story by sending out cash payments that beat Treasuries to hell and back.

The advisors who complained also asked why I thought illiquidity was a bad thing. As one advisor put it, the single biggest detriment to long-term portfolio returns is emotion-driven selling. By preventing investors from seeing all those unsettling ups and downs they're viewing in their publicly traded REITs, or other investments, advisors can help them stay invested for the long haul. In fact, these instruments go further by making it virtually impossible for clients to sell.

I concede that emotion-driven selling is a grave danger to client returns. But if the solution is illiquidity, does that mean illiquid mutual funds would be superior to the kind we have now? Following this logic, shouldn't we restrict trading in stocks and bonds?

Finally, the aforementioned advisors suggested that I should learn to set aside my biases. I concede that my experience investigating limited partnership sponsors - back in the day when sales reps were touting the Stanger "deal terms ratings," which were the measure of whether these were good deals - probably colors my perception of similarly structured deals now.

In truth, I don't know the character of any of the nontraded REIT sponsors, haven't met them personally, and don't know how susceptible they are to manifest temptation. I hope their character is well above what these outraged advisors think of my own.



When I add it all up, I think one of the safest predictions I'll make this year is that the nontraded REIT world is going to end badly. Some of these programs will blow up and the promoters will skip away with investors' money, harming the good reputation of a lot of advisors who sincerely care about their clients.

The broker-dealer executives who are signing sales contracts for these deals are smart enough to know all of the things I've asserted here. Some of them remember firsthand the go-round with illiquid real estate packaged products. If and when the subpoenas from outraged investors land on their desks, they will almost certainly claim - as will their top-selling advisors - that there was no way they could have predicted the unpleasant consequences of selling nontraded REITs.

For those who are willing to listen, my advice is to keep away from this potential future mess, no matter how tempting the commissions and, for the broker-dealers, the revenue sharing. I really don't want your reputation to be dragged through a legal debacle.

For those who are holding their hands over their ears, well, don't try to say later that you weren't warned.



Bob Veres, a Financial Planning columnist in San Diego, is publisher of Inside Information, an advisory information service. Visit financial-planning.com to post comments on his columns or email them to bob@bobveres.com.