Putting on the REITs: Private real-estate funds with outsize gains attract scrutiny

NASAA
MARCIN CYMMER

Advisors who urge clients to diversify their portfolios by investing in alternative products such as non-publicly traded real estate investment trusts can now point to exceptional returns to support their recommendations. But scrutiny by regulators suggests there are reasons to be cautious of an investment product they say is little understood.

The oft-cited Stanger NAVE REIT Total Return Index — which follows 16 non-traded REITs — rose 71.1% over the five years leading through Sept. 30, 2022, the Shrewsbury, New Jersey-based investment bank Robert A. Stanger & Co. reports. That compares with an increase of 15.52% for the MSCI US REIT Index — which tracks publicly-traded REITs — over the same period.

REITs, both traded and non-traded, have been gaining popularity with financial advisors. A survey from the research firm Chatham Partners found that 83% of the 349 advisors who responded channel clients into the investments. The main reason cited was a desire to diversify portfolios and take advantage of the stable values often associated with real estate.

All REITs provide investors with a means of putting money into office buildings, warehouses, apartments and other types of physical property. The traded variety offers shares that are bought and sold on open exchanges, just like stocks. By contrast, non-traded REITs are sold directly to investors, typically through financial advisors. 

Critics of the non-traded type complain that they are illiquid; unlike shares in traded REITs, which can be sold at any time, an interest in a non-traded REIT can usually be unloaded only at set intervals. There are also usually limits to how much of a share in a non-traded REIT an investor can sell at once.

Alternative investments like REITs have been gaining favor as both stock and bond markets crash. Last month, a Bank of America survey of 1,052 high net worth respondents — people with at least $3 million — found that 80% were investing in alternatives such as real estate, private equity and commodities. 

Proponents of alternatives might tout them as hedges against market volatility. But critics are starting to question if non-traded REITs are overpriced. They note that the real estate appraisals and sales transactions used to value the property held by non-traded REITs are almost always backward-looking and not a reflection of the market's current state.

Hugh Berkson, the new president of the Public Investors Advocate Bar Association, an international association that represents investors in disputes with the securities industry, said the risks of REITs are still underestimated by many investors.

"The disappointment and frustration our clients experience is really overwhelming and all too common," he said. "But firms get paid a lot to sell these things. There's a financial incentive to push these."

The Financial Industry Regulatory Authority, which regulates brokers, warns on its website that, "REIT fraud is real. Sales tactics might include using false information, overpromising returns and underplaying risks, and promoting REIT-like products that are, in fact, not REITs and have less liquidity and additional areas of risk."

Industry advocates and lobbyists argue that subjecting non-traded REITs to the stricter regulation that some groups are considering will deprive investors of a way of getting away from stocks and the related volatility.

"Your value doesn't fluctuate with the stock market the way a publicly traded REIT would," said Anya Coverman, the president and CEO of the Institute for Portfolio Alternatives, which sponsors Stanger's research into alternative investments. "Also, you might want to invest in these types of assets as a hedge against inflation, as well as to provide some diversification and balance in your portfolio."

The Institute for Portfolio Alternatives has been locked for months in debate with the North American Securities Administrators Association, which represents state and provincial regulators in the U.S., Canada and Mexico, who want tighter oversight of non-traded REITs. NASAA officials are now considering a  proposed statement of policy that, among other things, would adjust for inflation the net income and net worth thresholds used to determine who can invest in non-traded REITS. In a letter to the editor of the Wall Street Journal published on Oct. 17, NASAA executive director Joseph Brady wrote that "REITs remain near or at the top of products generating disputes between investors and their brokers."

Coverman said she and others at the Institute for Portfolio Alternatives met with NASAA officials on Oct. 31 and remain optimistic that the regulatory agency will eventually soften its stance toward non-traded REITs.

"We are hoping that they consider some significant and meaningful revisions if they indeed go forward with this," she said.

Non-traded REITs have long been subjected to criticism over allegations that fail to produce the sorts of returns that can be had from other, more standard investments.

The industry has shifted away from so-called "lifecycle" REITs and toward a better-performing alternative investment known as net asset value REITs. Lifecycle REITs, which allow investors to reclaim their money only after a fund has gone through its lifecycle — meaning it is sold, merged with another fund or listed on an exchange — tend to be more illiquid than NAV REITs. NAV REITs, by contrast, are designed to last into perpetuity and allow investors to cash in as much as 20% of the total outstanding share in a given year. 

Of the 16 non-traded REITs tracked in the Stanger index, the best performer was Ares Industrial Real Estate Income Trust. Its REIT, which invests in warehouses and distribution centers, saw a 38.81% in the year leading up to Sept. 30. The well-known Blackstone Real Estate Income Trust, a NAV REIT also tracked by Stanger's index, had a 17.09% gain for the same period. In a comment letter on NASAA's regulatory proposal, Stanger reported that NAV REITs now account for 99.9% of all the capital raised by non-traded REITs, Gannon said, citing data gathered from SEC reports and direct communications with institutions like Blackstone.

In an email, NASAA corporate finance chairman Bill Beatty said that he and colleagues were continuing to review comments on the  proposal and meet with "interested parties. We will decide whether to make changes to the proposal," he said.

NASAA's proposed regulation would change a threshold now barring investors from putting money into non-public REITs unless they have a minimum net income of $70,000 along with a minimum net worth of $70,000; or a total minimum net worth of $250,000. NASAA contends these limits should be raised to $95,000 and $340,000 to keep pace with inflation.

NASAA's proposal also calls for the institution of a "concentration limit" that would prevent advisors from putting more than 10% of an investor's liquid net worth in a non-traded REIT. And it would set limits on institutions' ability to take money intended for investment in real estate through a non-traded REIT and use it to pay cash distributions back to investors. Critics contend both proposals would either further deprive investors of diversification opportunities or unnecessarily complicate dealers' and brokers' management of non-traded REITs.

–Tobias Salinger of Financial Planning contributed to this article

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