Volatility in the stock market and low interest rates have caused investors to seek alternative investment products offering attractive yields. One such product is the non-exchange traded real estate investment trust (REIT).
A real estate investment trust, or REIT, is an entity that owns (and may also manage) income-producing real estate. REITs pool funds from many investors to purchase a portfolio of properties, which may consist of office buildings, shopping centers, hotels, apartments, timber-producing land, et cetera.
There are two kinds of REITs – exchange-traded and non-traded. Like exchange-traded REITs, non-traded REITs must distribute at least 90 percent of taxable income to shareholders.
Non-traded REITs differ from exchange-traded REITs in several respects. As the name implies, shares of non-traded REITs do not trade on a national securities exchange. For this reason, they are illiquid, often for periods of eight years or more. Illiquidity makes them hard to value and trade. The secondary market, if any, is very limited. They are often falsely valued on account statements at the price the investor paid for them. This creates the false appearance that they are immune to market downturns. Given the persistent downturn in the real estate market, investors in non-traded REITs should be skeptical of valuations at or near their cost basis.
Early redemption of shares is restricted and may be expensive. Redemptions may be priced below the purchase price or current price. Fees are high and erode returns. Distributions may consist of borrowed funds and return of investor principal, rather than being derived from earnings. Distributions can be suspended or stopped altogether.
Non-traded REITs may be either public or private. Public 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.
A private placement, non-traded REIT is not required to register with the SEC or file disclosures. 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, such as those with a net worth in excess of $1 million.
The non-traded REIT business is big. Sales were $11.8 billion in 2007, $6.4 billion in 2009, and $8.3 billion in 2010. As with other alternative investments, high commissions and fees (often 15% or more) drive sales of non-traded REITs.
Non-traded REITs present a number of risks and problems, including a lack of transparency that makes investing in one like buying a “pig in a poke.” The Financial Industry Regulatory Authority (FINRA) has issued an Investor Alert to inform investors of risks of non-traded REITs. The SEC is reportedly investigating disclosures regarding how non-traded REITs are valued.
FINRA recently filed a disciplinary proceeding against an independent broker-dealer, David Lerner Associates, Inc. (“Lerner”), related to its marketing and sales of public non-traded REITs named Apple REITs. Lerner also faces a multitude of arbitrations filed by aggrieved investors. According to FINRA, Lerner recommended and sold hundreds of millions of dollars of Apple REITs without performing adequate due diligence in violation of its suitability obligations, and further misled investors by repeatedly valuing the Apple REITs at $11 per share, the price the investors paid for them, on account statements sent to customers, despite years of market fluctuations and performance declines. Lerner further misled investors by not disclosing that income from the REITs was insufficient to support their 7-8 percent distributions, and that the distributions were partially funded by debt and return of capital. FINRA also accused Lerner of misleading and “targeting unsophisticated and elderly customers with unsuitable sales of this illiquid security” and misled them regarding the record of earlier Apple funds.
In October 2003, the NASD (FINRA’s predecessor), sanctioned Wells Investment Securities (n/k/a Piedmont Office Realty Trust) for rewarding broker-dealer representatives, who sold the company’s REITs, with lavish entertainment and travel perquisites, in violation of NASD rules. Leo Wells was also suspended from acting in a principal capacity for one year and fined $150,000.
David Swenson, Yale Endowment’s chief investment officer, described Wells’s fees and expenses as follows: “The most generous characterization of Wells’s offering fees range from obscene to despicable. Selling commissions of 7.0 percent of gross offering proceeds, dealer management fees of 2.5 percent of gross proceeds, and organization and offering expenses of 3.0 percent of gross proceeds combine to consume up to 12.5 percent of investor funds.”
Perhaps because of these types of incentives, broker-dealers often fail to perform adequate due diligence on the investments they sell. This is very dangerous for the broker-dealers that sell private non-traded REITs as well as the investors who buy them. A number of brokerage firms have cut the number of non-traded REITs on their shelves, following the FINRA disciplinary proceedings and investors arbitrations against Lerner, as well as the recent closures of scores of independent broker-dealers in the wake of investor arbitrations and lawsuits related to failed private placement offerings.
If you have investment losses or problems involving nontraded REITs, call the lawyers at Page Perry for experienced representation at (404) 567-4400 or (877) 673-0047 (toll free).