Non-Traded REITs: Risky, High-Fee Products
A real estate investment trust (“REIT”) is an investment product that holds and often manages a portfolio of interests in income-producing real estate, such as commercial office space, apartment buildings, or hotels. REITs are structured to allow individual investors to acquire interests in real estate, and can be traded or non-traded.
Because REITs are complex investments, many investors rely on brokers to explain the risks and costs. Unfortunately, proper guidance is not always given.
Non-traded REITs, which are not listed on a public exchange, are generally marketed as safe investments that offer attractive dividends to investors looking for better-than-average returns. However, investors are not always fully informed of the risks and costs associated with non-traded REITs – which can be substantial. As a result, investor returns often fall short of expectations. As a commentator recently explained to the Wall Street Journal, “non-traded REITs are costing investors . . . billions. They're suffering illiquidity and ignorance, and earning much less than what they ought to be earning.1
In particular, sellers of non-traded REITs often do not fully explain the significant upfront fees and expenses that investors must cover – which can amount to 15% or more of a non-traded REIT’s share price. These costs can significantly reduce returns, especially when coupled with the ongoing expenses that non-traded REIT investors must cover. As studies have determined, these costs cause many non-traded REITs to considerably underperform relevant benchmarks.2
Despite these structural concerns, the non-traded REIT market has been rapidly growing. While sponsors raised $6.9 billion from investors in 2009, more than double that amount was raised in 2014 – and there are few signs that this growth will slow.
In recent years, non-traded REITs have faced heightened scrutiny from federal and state regulators, who have investigated how non-traded REITs are structured and sold. Among other issues, high fees, a lack of transparency in pricing, and misleading marketing practices have all been the subject of government investigations. Prominent media outlets have additionally addressed high fees, risks, and misleading practices in the non-traded REIT industry.
Non-Traded REITs pose several significant risks. If you’re considering a non-traded REIT investment – or if you’ve already invested – consider the risks below.
Non-traded REITs require investors to pay upfront and ongoing fees that are higher than those associated with almost any other financial product – and these fees are not always fully explained. Upfront fees alone may comprise as much as 15% of an initial investment, and ongoing fees, commissions, and expenses further diminish returns. Indeed, a review of the SEC filings of 57 non-traded REITs in 2011 revealed that nearly 20 percent of every dollar invested in non-traded REITs is used to pay fees and commissions. Making matters worse, these fees are sometimes directed to affiliates of the entities involved in structuring and/or marketing non-traded REITs. Investor returns suffer.3
In many cases, some or all of the entities involved in structuring, selling, and overseeing non-traded REITs – including sponsors, advisors, brokers, property managers, and dealer managers – have overlapping interests. For example, non-traded REIT sponsors (i.e., the entities that organize and control investment properties) sometimes use affiliated brokers to market and sell shares in non-traded REITs to investors, and property managers and advisors are sometimes affiliated with the entities that structure the products they market.
In such circumstances, the opportunity for undue influence is large, and the potential for conflicts of interest is great. So too is the risk that financial incentives, in the form of commissions or shared revenues, may interfere with the legal duties owed to investors.
Because non-traded REIT boards of directors have considerable discretion regarding how and whether distributions are made to shareholders, non-traded REIT investors face considerable uncertainty regarding the amount of any distributions they may receive. In some scenarios, a non-traded REIT will make investor distributions out of profits generated by the non-traded REIT; in others, investor distributions are made from new investor capital or borrowed funds. Non-traded REIT boards may also increase debt, dip into cash reserves, or apply the proceeds of new sales to investor distributions – all of which can increase the risk of default or devaluation.
Furthermore, because a non-traded REIT’s distributions need not – and often do not – have any relationship to profits or funds from operations, a non-traded REIT’s prior distribution rates may present an inaccurate or misleading picture of actual performance. This only makes it more difficult for investors to obtain an accurate understanding of asset values.
While shares of a publicly traded REIT are listed on a stock exchange and can be easily bought or sold, shares in non-traded REITs generally cannot be transferred for periods of up to five years or more after an initial investment. During this period, investors usually cannot extract any part of their investment, and only receive discretionary distributions that need not be correlated with performance and can be halted at any time. As a result, non-traded REIT investors are severely limited in their abilities to respond to market changes and other developments.
Because non-traded REITs are not offered on a public exchange, and because the properties in which non-traded REITs invest are often themselves exceedingly difficult to value, accurately assessing the value of a non-traded REIT investment can be very challenging. This difficulty is only compounded by the fact that a non-traded REIT’s offering price often has little or no relationship to the value of the non-traded REIT’s underlying assets – and a non-traded REIT need not reevaluate share price until 18 months after an offering. Non-traded REIT investors, accordingly, frequently know very little about what their investments are actually worth.
When an investor purchases shares in a non-traded REIT, there is often little certainty regarding the types of properties that will be included in the investment pool. This is because the sponsor or seller may disclose to investors the types of properties that the non-traded REIT intends to purchase, but investor money is almost always collected before such purchases are actually made. This not only leaves investors in the dark, but may expose investors to sectors and/or properties they sought to avoid.
Non-traded REITs frequently focus on a specific property-market sector – for example, student housing, shopping malls, or resorts in a particular area – and sometimes limit their focus to just a single property or set of related properties. This narrowly focused approach can lead to significant investor losses when problems emerge in the subsector or region in which the non-traded REIT is concentrated – a problem that is only exacerbated by the fact that a non-traded REIT may ultimately invest in different sectors or properties than those initially described to investors.