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 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.”
The threshold or hurdle at which investors start to profit can be complicated. In the chart below, the Wells REIT II hurdle works like this: The charge to investors is 10% of net sale proceeds, after return of capital plus payment of an 8% per year cumulative, non-compounded return on the capital contributed by investors. To give a hypothetical example, say an investor invests $100,000 today. If the investment value is $140,000 five years from now, the 8% per year cumulative hurdle would be met, for an annual compounded rate of return of about 7%.
That means hurdles are barriers for investors to jump over before seeing profits on any eventual property sales. The higher the hurdle, including total expenses and commissions, the tougher it is to make money.
Lynne Strynchuk, a CFP with Moisand Fitzgerald Tamayo in Melbourne, Fla., says the liquidity trade-off has many anti-investor catches as well. “Such a deal! If one focuses on the expected years to redemption, the investment sounds terrific — good yields, well-known companies’ real estate in the portfolio and no apparent lock-in,” she says.
“However, if and when the shares are redeemed, the money is generally not given back in a lump sum — it is often paid out in quarterly, prorated redemptions. These payouts may also be dependent on the appraisal value of the holdings; the timing of the appraisal is done at the management’s discretion.”
That discretion may force investors to wait two or more years before they get their money back. What happens in the interim? Property values could drop. The REIT could have debt trouble or credit markets could contract. And redeeming investors may be paid by the capital from new investors, leaving less money for new investments. “I wouldn’t like my clients to be in this area,” says Ajay Kaisth of KAI Advisors in Princeton Junction, N.J. “The liquidity is small, it’s difficult to get out and value is hard to figure.”
PLANNERS HOLDING REITS
Not surprisingly, in light of the myriad drawbacks, many planners who have recommended unlisted REITs are cautious, yet many may be forced to hold them due to the steep penalties for selling them before they go public.
David Lamp, a CFP with BBJS Financial Advisors in Seattle, says he recommended the products to his clients and has “relatively small allocations (up to 3% in U.S. REIT holdings) in them after performing due diligence.” His firm has recommended the products over the past five years, but the majority of new investments have been made in 2009 through early this year.
Many of Lamp’s clients hold the Behringer Harvard Multifamily and KBS REIT II in their portfolios. It was a way to buy distressed real estate at good prices during the market downturn and invest in buildings that “supported the multifamily story based on demographics and a shift from homeowners to renters.”
Sapp says he had a relatively new client who came in with four unlisted REITs in his portfolio, but there was little he could do to restructure because of steep discounts and penalties that essentially locked him in for 10 years. “The client was led to believe the REIT was bond-like,” Sapp says. “Hopefully, they will turn out well and he can unwind his position as planned by the fund sponsors, at which point he’ll be 81.”
He is also concerned about how capital is returned to investors. “The return of capital makes these investments seem bond-like, but much of the money returned to investors is simply their initial investment. These ROC distributions are basically like giving yourself a blood transfusion with 15% of your own blood being spilled in the process.”
Some planners who avoid unlisted REITs still believe they’re a worthy asset class, but argue that greater diversification in domestic and international REITs could be found in low-cost ETFs or mutual funds. Two of the funds Kaisth suggested are Vanguard REIT ETF (VNQ) or SPDR DJ International Real Estate ETF (RWX).
“If you want access to real estate, you should be averse to individual security-specific risk, as diversification is still the only free lunch in investing,” notes Steve Curley, a CFP at Water Oak Advisors in Orlando, Fla. “Should you want to own a long-only allocation to real estate in your portfolio,” he adds, “individual investors should simply buy a publicly traded REIT index fund or ETF. With unlisted REITs, you’re about 10% behind the line before the gun goes off because of the excessive fees incurred during the sales process.”
The pushback by regulators, planners and investors may have already triggered greater transparency in newer private REITs. Clarion Partners Americas and American Realty Capital recently announced they are marketing non-traded REITs featuring daily net asset values with up to 20% of assets placed into liquid portfolios for redemptions.
In an effort to improve customer disclosure, FINRA has proposed new rules governing client statements. Broker-dealers must “deduct organization and offering expenses from per-share estimated values during the initial offering period.” FINRA also seeks to “prohibit a firm from using a per-share estimated value, from any source, if it knows or has reason to know the value is unreliable, based upon publicly available information or nonpublic information that has come to the firm’s attention.”
If approved, the new rules would improve transparency of pricing and expenses, although it’s not clear if they would reduce the high ownership costs to clients or improve returns. The comment period for the proposal ends Nov. 12. For more information, search Regulatory Notice 11-44 on the FINRA website.
What can you do for your client if they need to bail out of an untraded REIT? If you think your client was misled by a broker during the sale of the product, consider filing an arbitration claim through FINRA. Expect to hire an arbitration lawyer. If cashing out immediately is the goal, prepare your client for a likely loss (probably a steep one).
CTTAuctions.com opened an auction site for untraded REITs this year that’s designed to be an eBay-style site to facilitate liquidity in an illiquid market.
John F. Wasik, co-author of iMoney, is a columnist for Morningstar and Reuters.
Correction: An earlier version of this story misstated the return on capital to investors for Wells REIT II, as well as the returns on a hypothetical investment of $100,000. The chart also did not accurately list the REIT’s fees.