REITs: A Wolf in Sheep's Clothing

June 6, 2016

In the world of finance, different types of investments go in and out of style much like you might see in the world of fashion. One type of investment that has become increasingly popular in the last few years is what is known as a non-traded REIT; a type of real estate investment. The appeal is obvious: higher returns at a supposed lower volatility, but all may not be as it appears. Unfortunately, the industry has become fraught with poorly constructed REIT instruments and the SEC has taken the step of issuing a broad warning in regards to them. Before you invest or you agree to invest in one based on your advisor’s recommendation, make sure you understand what you are getting and the potential for stepping into a major mistake.

 

What is a REIT?

 

REIT stands for Real Estate Investment Trust and is typically a company that owns and operates income-producing real estate properties. REITs are typically made up of either real assets such as commercial property and apartments or is made of real estate debt such as mortgages. Most REITs are specialized and focus on one type of real estate such as just apartment buildings or just medical buildings. Many are traded in the stock market much like how other companies are. This is known as being publicly traded. Since it is traded on the stock market, it is easy to know the price of your investment and it is easy to trade out of if you want to get out of it.

 

What is a non-traded REIT?

 

A non-traded REIT, on the other hand, does not trade in the stock market like the REITs described above. Instead, once you invest in the security it becomes very difficult to get out of until it is either sold or the company goes public (and is then traded in the stock market like the situation above). This inability to easily sell a security is known as illiquidity or liquidity risk. Essentially, you might not be able to get your money when you need it. Illiquidity, however, doesn’t need to be a major risk if planned for appropriately. If you can receive higher returns and don’t need the money anytime soon, the trade-off can often be worth it.

 

What then is the problem with non-traded REITs?

 

A non-traded REIT can be a good investment. Unfortunately, most of them are not. There are a variety of risks, some of which are listed below:

  1. High Fees – Relative to fees on other types of investments, the fees on REITs can be incredibly high. In a rare move, the SEC issued a warning to the public on the fees and eventually instituted limits on how much could be charged. Fees can often be double-digit percentages for the initial trading commissions alone and then another several percents in management fees annually. There can also be even more fees when the REIT is being sold or going public. This can be a huge drag on performance, often returning far less than the publicly traded version.

  2. Distributions can come from the principal – In a world where income is hard to come by, non-traded REITs can be extremely tempting because they often offer income rates of somewhere between 6-8% annually. However, that might not be all income you are receiving. Often it includes some of your principal being returned. That might mean the 6% income you are receiving is actually only 4% returns and 2% of your money back. This isn’t true of all non-traded REITs but it is important to keep an eye on.

  3. Lack of Share Transparency – Since the REITs are non-traded, it can be incredibly difficult to know what the shares are actually worth. Often you hold the investment at the price you paid for it which gives it the feeling of being stable. In reality, the underlying investment can be very volatile and could have dropped in value without you realizing it. For example, if the investment is paying back principal like above, it could be that the value of your investment is actually falling very consistently and it is just hard to see.

Why are advisors recommending an investment with so many issues? The truth is that even advisors can often miss the problems with non-traded REITs. We all struggle with wanting to make sure our clients get enough income to keep them safe in retirement and it is easy to fall for the seduction of an investment that seems safe and pays a much higher yield than the rest of the market. However, be very careful of falling into that trap. Not only are there issues like the ones above, these are, in the end, still real estate investments and often employ significant amounts of leverage and have large downside risks. Unfortunately, it is often too late and there's nothing you can do once they have gone bad. Be wary of any friend or advisor who is pushing too many of these, especially late in the investment cycle.

 

To see the SEC’s warning in regard to non-traded REITs, follow this link. If you have questions, never hesitate to reach out to one of our advisors.

 

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