Public Non-Traded REITs—Perform a Careful Review Before Investing
During extended period of low interest rates, investors often seek products offering more attractive yields. One such product is the publicly registered non-exchange traded real estate investment trust (REIT) or "non-traded REIT" for short. While non-traded REITs and exchange-traded REITs share many features in common, they differ in several key respects. Most significantly, as the name implies, shares of non-traded REITs do not trade on a national securities exchange. For this reason, non-traded REITs are generally illiquid, often for periods of eight years or more. Early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return. Furthermore, the periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal. This is in contrast to the dividends investors receive from large corporations that trade on national exchanges, which are typically derived solely from earnings.
FINRA is issuing this alert to inform investors of the features and risks of publicly registered non-exchange traded REITs and to help you avoid pitfalls and misconceptions these investments. If you are considering a publicly registered non-exchange traded REIT, be prepared to ask questions about the benefits, risks, features and fees.
What Is a REIT?
A real estate investment trust, or REIT, is a corporation, trust or association that owns (and might also manage) income-producing real estate. REITs pool the capital of numerous investors to purchase a portfolio of properties—from office buildings and shopping centers to hotels and apartments, even timber-producing land—which the typical investor might not otherwise be able to purchase individually.
REITs can offer tax advantages. For instance, qualified REITs that meet Internal Revenue Service requirements can deduct distributions paid to shareholders from corporate taxable income, avoiding double taxation. The REIT must also distribute at least 90 percent of its taxable income to shareholders annually. These distributions are taxable to the extent of any ordinary income and capital gains included in the distribution.
There are two types of public REITS: those that trade on a national securities exchange and those that do not. REITs in this latter category are generally referred to as publicly registered non-exchange traded, or simply non-traded REITS, which are the focus of this alert.
Features of Non-Traded REITs
Like exchange-traded REITs, non-traded REITs invest in real estate. They are also subject to the same IRS requirements that an exchange-traded REIT must meet, including distributing at least 90 percent of taxable income to shareholders. Like exchange-traded REITS, non-traded REITs are registered with the Securities and Exchange Commission and are required to make regular SEC disclosures, including filing a prospectus and quarterly (10-Q) and annual reports (10-K), all of which are publicly available through the SEC’s EDGAR database. While these two types of REITs share these similarities, there are also numerous differences between them, as illustrated in the chart below.
|Non-Traded REITs||Exchange-Traded REITs|
|Listing Status||Shares do not list on a national securities exchange.||Shares trade on a national securities exchange.|
|Secondary Market||Very limited. While a portion of total shares outstanding may be redeemable each year, subject to limitations, redemption offers may be priced below the purchase price or current price.||Exchange traded. Generally easy for investors to buy and sell.|
|Front-End Fees||Front-end fees that can be as much as 15% of the per share price. Those fees include selling compensation and expenses, which cannot exceed 10%, and additional offering and organizational costs.||Front-end underwriting fees in the form of a discount may be 7% or more of the offering proceeds. Investors who buy shares in the open market pay a brokerage commission.|
|Anticipated Source of Return||Investors typically seek income from distributions over a period of years. Upon liquidation, return of capital may be more or less than the original investment depending on the value of assets.||Investors typically seek capital appreciation based on prices at which REITs’ shares trade on an exchange. REITs also may pay distributions to shareholders.|
Valuation Methods and Disclosures
Broker-dealers involved in the sale of non-traded REITS are required to provide investors with a per share estimated value for the REIT using one of two methodologies described in FINRA Notice 15-02:
- Net Investment Methodology. When this method is used, the firm must disclose to you whether part of your distribution from the REIT includes a return of capital, which reduces the estimated per share value shown on your account statement. The net investment methodology can be used until 150 days following the second anniversary of breaking escrow in the public offering, at which time a firm must use the appraised value methodology.
- Appraised Value Methodology. The valuation method can be used at any time and consists of the appraised valuation disclosed in the issuer’s most recent periodic or current report filed with the SEC. FINRA’s rule requires that the per share estimated value disclosed in the REIT’s most recent periodic or current report be based on a valuation of the assets and liabilities of the REIT, and that the valuation be: performed at least annually; conducted by, or with the material assistance or confirmation of, a third-party valuation expert or service; and derived from a methodology that conforms to standard industry practice.
Firms that sell non-traded REITs are required to disclose some key aspects of the investment, including: that the securities are not listed on a securities exchange; that the securities are generally illiquid; and that, even if a customer is able to sell the securities, the price received may be less than the per share estimated value provided in the account statement.
There is another type of REIT—a private REIT, or private-placement REIT—that also does not trade on an exchange. Private REITS carry significant risk to investors. Not only are they unlisted, making them hard to value and trade, but they also generally are exempt from Securities Act registration. As such, private REITs are not subject to the same disclosure requirements as public non-traded REITs. The lack of disclosure documents makes it extremely difficult for investors to make an informed decision about the investment. Private REITS generally can be sold only to accredited investors, for instance those with a net worth in excess of $1 million. As with any private investment, it is a good idea to have the investment reviewed by an investment professional who understands the product and can offer impartial advice.
Complexities and Risks
When it comes to investing in non-traded REITs, selling points such as the opportunity for capital appreciation, diversification and the allure of a robust distribution can be enticing. But investors should balance these selling points against the numerous complexities and risks these investments carry.
- Distributions are not guaranteed and may exceed operating cash flow. Deciding whether to pay distributions and the amount of any distribution is within discretion of a REIT’s Board of Directors in the exercise of its fiduciary duties. Distributions can be suspended for a period of time or halted altogether. Many factors may influence the composition of these payments. For example, in newer programs, distributions may be funded in part or entirely by cash from investor capital or borrowings—leveraged money that does not come from income generated by the real estate itself, such as rents or hotel occupancy fees. The REIT’s articles of incorporation often allow it to increase debt, dip into cash reserves and apply proceeds of the sale of new shares to sustain or even increase distributions. Some REITS even allow borrowing in excess of 100 percent of net assets. Leveraging, including the use of borrowed funds to pay distributions, can place the REIT at greater risk of default and devaluation, which can result in investment losses when it comes time to redeem or liquidate shares, as well as a reduction in, or suspension of, distributions.
- Tip: Understand the REIT’s borrowing policies, outlined in the prospectus, and use the SEC’s EDGAR database of company filings to research how heavily leveraged the REIT may be, as well as how it is financing distributions. If Net Cash from Operations (what the company earns through its real estate alone) is less than the distribution (usually found in the Financing Activities section), then other sources, including borrowed funds, may be supporting the distribution. Before investing, be sure to ask the person offering the investment how much the REIT may have borrowed and whether the distributions include, or are likely to include, a return of principal. Ask how these factors might impact your investment. Keep these same factors in mind when deciding whether or not to reinvest distributions. Caution: If a REIT issuer is behind or incomplete in its SEC filings this can be a red flag.
- Distributions and REIT status carry tax consequences. Distributions for all REITS that are from current or accumulated earnings and profits are taxed as ordinary income, as opposed to the tax rate on qualified dividends, which generally carries a tax rate of 15 percent. But that rate can be 20 percent for people in the highest tax bracket or 0 percent for those in the lowest two tax brackets. If a portion of your distribution constitutes a return of capital, that portion is not taxed until your investment is sold or liquidated, at which time you will be taxed at capital gains rates.
- Tip: Take steps to obtain an understanding of the tax consequences associated with this investment. Consider speaking with a tax advisor prior to inve sting and on an ongoing basis.
- Lack of a public trading market creates illiquidity and valuation complexities. As their name implies, non-traded REITs have no public trading market. However, most non-traded REITS are structured as a "finite life investment," meaning that at the end of a given timeframe, the REIT is required either to list on a national securities exchange or liquidate. Even if a liquidity event takes place, there is no guarantee that the value of your investment will have gone up—and it may go down or lose all its value. Indeed, valuation of non-traded REITS is complex. Many factors affect the pricing, including the portfolio of real estate assets owned, strength of the trust’s balance sheet (assets versus liabilities), overhead expenses, cost of capital and more. The boards and managers of non-traded REITs might even rely on third-party sources to estimate a per-share value.
- Tip: Ask your financial professional to explain the risk of illiquidity. Review the Risks section of the prospectus to find out more about the investment's expected holding period and potential liquidity events. Also ask if the offering has concluded—and, if not, when it is expected to conclude. Check your brokerage statements or with your financial professional to see if there has been a fluctuation in the per-share price. Whether the value fluctuated or not, ask the brokerage firm how—and how recently—the share price was valued.
- Advisory: If the value of the REIT’s portfolio has changed materially during the offering period, then new investors may be paying a per-share price above or below the per-share net value of the underlying real estate.
- Early redemption is often restrictive and may be expensive. Most public non-traded REIT offerings place limits on the amount of shares that can be redeemed prior to liquidation. Redemption provisions can be as restrictive as 5—or even 3—percent of the weighted average number of shares outstanding during the previous year. In addition, shares may have to be held for some period, typically one year, before they can be redeemed. Redemption programs may be terminated or adjusted, so investors should not count on them, even as an emergency exit strategy. While a redemption program may allow you to sell your shares prior to a liquidity event, the redemption price is generally lower than the purchase price, sometimes by as much as 10 percent.
- Tip: When investing in non-traded REITs investors must consider their short-term needs for capital before investing in a long-term, illiquid security and should carefully review the section explaining the terms and limitations of the REIT’s share redemption plan.
- Advisory: Investors may be solicited to sell a stake in their non-traded REIT investment outside of the sponsor’s redemption program through a process known as a “mini-tender offer.” Mini-tender offers are offers for less than 5 percent of a company's stock, and they typically carry far fewer protections to investors than traditional tender offers. For instance, there is no requirement to identify who the buyer is, provide disclosures to the SEC or provide competing bids. Investors can wind up receiving a price well below the sponsor’s estimated per-share value or, if available, the early-redemption program price. For more information, see the SEC’s information on Mini-Tender Offers.
- Fees can add up. Non-traded REITs can be expensive. Front-end fees generally come in two parts:
- Selling compensation and expenses, which cannot exceed 10 percent of the investment amount; and
- Additional offering and organizational costs, sometimes referred to as “issuer costs,” which are also paid from the offering proceeds. According to state regulatory guidelines, the total for both types of fees cannot exceed 15 percent. FINRA guidelines also limit the total for both types of fees to 15 percent in offerings that are sold by an affiliated broker-dealer. All investments carry fees, and they add up, reducing the amount of capital available for investment. For example, a 15 percent front-end fee on a $10,000 investment means that $8,500 is going to work for you at the time of investment. By comparison, the underwriting compensation associated with exchange-traded REITS is normally seven percent of the offering proceeds.
- Tip: Non-traded REITs are rarely, if ever, suitable for short-term investors and even long-term investors must be willing to bear the risks of illiquidity. You should consider the front-end cost relative to the sales costs you would incur to buy and sell other securities during the same holding period as the life of the REIT. You may also want to consider how much share price appreciation and distributions you will need to receive to overcome these front-end charges.
- Properties may not be specified. Most non-traded REITS start out as blind pools, which have not yet specified the properties to be purchased. Others may specify a portion of the properties the REIT plans to acquire, or they may be in various stages of acquisition. In general, the more properties that have been specified for purchase or that have actually been acquired the less risk an investor incurs because the investor has the opportunity to assess the nature and quality of the assets of the REIT before investing.
- Tip: Ask what percentage of a non-traded REIT’s properties have been specified for acquisition or actually acquired.
- Diversification can be limited. While REITs as an investment class may help diversify your portfolio, putting all of your intended real estate investment in one REIT—including investments in different issuances or phases of the same REIT—can expose you to the risk of underdiversification.
- Tip: Review the offering document relating to the REIT’s investment policies to evaluate the intended diversification of the REIT’s portfolio. Read ongoing disclosure documents to track how well the REIT is executing its business plan. As with any investment, avoid putting all your eggs in one basket.
- Remember Real Estate Risk. There are risks associated with both the real estate market as a whole and any specific subset of the real estate market on which a particular REIT concentrates.
- Tip: Understand risks associated with the types of properties the REIT holds (for instance, hotels have a different set of risks than shopping malls), the geographical area it concentrates in and the strategies the REIT uses, including leveraging to acquire assets. Have an in-depth discussion with your financial professional about risks and carefully read the prospectus.
Before You Invest
Be wary of pitches or sales literature offering simplistic reasons to buy a REIT investment. Sales pitches might play up high yields and stability while glossing over the product’s lack of liquidity, fees and other risks. Ask whoever is recommending that you purchase a REIT how much they (and their company) are receiving in selling commissions or other fees. Also ask them to explain why they think the REIT is the right investment for you and how will it help you achieve your specific investment objectives and goals1.
Always ask to review the initial prospectus and any prospectus supplements, as these documents will contain a more extensive and balanced discussion of the risks involved than any sales material you receive or pitches you hear. You can obtain a prospectus by going to the SEC’s EDGAR database of company filings and typing in the name of the REIT, then search for entries titled “Prospectus.” Remember that the fact that a company has registered its securities or has filed reports with the SEC does not mean that it will be a good investment—or that it will be right for you.
Ask about fees associated with the product. Also ask how the distribution is being funded and whether a portion of that distribution is comprised of a return of investor capital. Make sure you understand that you will be locking up your investment, with only limited avenues for redemption. If the REIT offers a share redemption program, make sure you understand how the repurchase price for your shares will be determined and, most importantly, the limitations of the plan. Review with your financial professional the risks associated with real estate investment and evaluate other products that could meet your investment objectives (investment income, for instance). Understand the various liquidity events specific to the REIT you are considering.
Remember to only invest if you are confident the product can help you meet your investment objectives and you are comfortable with the associated risks.
If you are suspicious about an investment or investment offer, or if you think the claims might be exaggerated or misleading, please contact us.
- SEC Investor Bulletin: Publically Traded REITs
- FINRA Rule 2340
- FINRA Rule 2310
- FINRA Regulatory Notice 09-09, Unlisted REITs and DPPs
- FINRA Investor Alert, "Free Lunch" Investment Seminars—Avoiding the Heartburn of a Hard Sell
- SEC EDGAR database
- SEC Mini-Tender Offers
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1 FINRA initiated a disciplinary complaint against a brokerage firm, charging that the firm solicited investors to purchase shares in a non-traded REIT without conducting a reasonable investigation to determine whether it was suitable for investors. The complaint also alleged that the firm provided misleading information on its website regarding the REIT’s distributions. The case was settled, and the firm agreed to pay a fine and restitution to investors.