Dumb Investment of the Week: Public Non-Traded REITs (Real Estate Investment Trusts)

This week’s “Dumb Investment Idea” focuses on a class of assets known as Public Non-Traded REITs. A Real Estate Investment Trust, or REIT for short, is a company that owns, operates, or provides financing for real estate. REITs own almost every type of real estate asset from single family rental homes to offices and apartment buildings, hotels and casinos, shopping centers, timberland, and even warehouses and industrials buildings. REITs are designed to be the real estate equivalent of mutual funds and provide a tax-free corporate vehicle for investors to own real estate. If a company elects to be treated as a REIT and meets certain requirements, then it can avoid paying any corporate income tax.

One of the requirements is that the REIT must distribute 90% of its income to shareholders in the form of dividends. It’s these high dividend payouts that make REITs attractive to older investors seeking income. Unfortunately, it’s these high initial dividends that can also be used by unscrupulous brokers and financial advisors to sell some really dumb investments to unsuspecting clients. In fact, public non-traded REITs can be so dumb that even FINRA released a warning about them (and that’s saying something)! So let’s dig in and see what makes Public Non-Traded REITs “dumb.”

Public non-traded REITs are typically sold to investors using the same tried and true sales pitch. Financial advisors and brokers usually tell clients that the REIT will provide steady income and stability because the price of the shares won’t change every day, and they are a safe investment.

Problem 1: Hidden Fees and Expenses

Quick! How much of the money that you invested in a public non-traded REIT actually went to buying real estate and how much went to line the pockets of various brokers and middlemen? I bet you can’t tell me. Why? Because the REITs and the advisors that sell them go to great lengths to keep that information hidden behind confusing babble.

Let me give you a real-life example from a client I’ve helped.

A client owned a Wells Capital REIT that was so bad that Chief Investment Officer of Yale University, David Swenson used it in his book Unconventional Success: A Fundamental Approach to Personal Investment as an example of how bad public non-traded REITs are for investors. Wells charged investors these fees: sales commissions of 7%; dealer management fees of 2.5%; and offering expenses of 3%. That means, for every $100 my client had invested only $87.50 actually made it into the fund. Every investor lost 12.5% of their money, right off the bat! But the largesse didn’t stop there. To buy the actual property, Wells charged another 3% for “review and evaluation of potential real property acquisitions” and another .5% as reimbursement for acquisition expenses. Once Wells actually purchased the buildings, investors’ wallets were 16% lighter.

You would think that 16% of your money would be enough to satiate the greed of Wells and its brokers. If you own this REIT, then you probably think that at least you will have all the income the properties generate. But you’d be wrong.

Each year Wells helped itself to another 4.5% of revenues and another separate 3% fee for leasing newly constructed property. By now you probably can’t wait to be out of this investment. Surely, that is the end of the fees. Nope. When Wells exited the portfolio, it was entitled to take 10% of the potential profit after a certain minimum hurdle had been reached.

Wells is not just one bad apple in the bunch. High fees are endemic to the public non-traded REIT industry. Another recent client had several public non-traded REIT investments that charged upfront fees of 10%, 9.5%, 7%, 8%, and 6%, respectively.

Indeed, a study by University of Texas and Blue Vault Partner, LLC, showed public non-traded REITs underperformed the market by an average of 1.4% per year over the lifecycle of the REIT.

Problem 2: You Don’t Know What You Are Buying

Many public non-traded REITs start out as something called a “blind pool.” This means that the REIT takes in investor money before disclosing exactly how that money will be invested and what types of properties the REIT plans to buy. The REIT may disclose what types of properties they hope to buy, but they can’t tell you exactly what they—and you–will own.

For instance, at one point my client portfolios owned STAG Industrial, Inc. (NYSE:STAG), a publicly traded REIT. Before I bought it, I could look up the size and location of all of the company’s properties as well as all other pertinent financial information. With “blind pools,” investors are left just to hope for the best. And, as we saw with the mammoth fees and expenses charged, management might not have your best in mind!

Problem 3: You’re Trapped

A publicly traded REIT is just like it says: It’s a REIT that is listed on a major stock exchange that you can buy and sell just like a stock. You can hold a publicly traded REIT in any brokerage account and buy and sell as many or as few shares as you like at any time (unless your brokerage has a minimum order size).

For example, Vornado Realty Trust is one of the largest publicly traded REITs. Vornado trades on NASDAQ under the ticker symbol “VNO.” If you thought it might be a good buy but weren’t sure, then you could test the waters by buying just a few shares, maybe 10 to start, giving you an initial investment of a little less than $1,000. (VNO traded around $91 at the time of this writing, so multiplied by 10 gives us an initial investment of $910.) Maybe two weeks later you decided you didn’t like it and wanted to sell. No problem. Just place a sell order for 10 shares and you no longer own any Vornado Realty Trust stock.

Not so for a public non-traded REIT. When you buy one of these dubious products, you are locked in to the investment for what is usually a sizeable period. These REITs do not trade on any public exchange. That means for a period of years (from 5 to usually closer to 10) investors have no way of getting their money out. (Sometimes REITs will offer a redemption program, but these programs usually offer to buy only a limited amount of shares at a price lower than the original price paid.)

While you might think that you won’t need your money for the next 10 or so years, you never know. Show me a person who can predict the future, and I’ll show you an investor for whom a product they can’t sell is appropriate.

Problem 4: Hidden Self-Selection

What do I mean by hidden self-selection? Looking over the first three points, it’s clear that public non-traded REITs are a pretty bad deal for typical individual investors. Let’s suppose, though, that we are a group of reputable investors and property managers and we are going to start our own REIT. We have a high quality business plan and have our potential properties already identified. It would be relatively easy for us to approach large institutional investors, such as pension funds, hedge funds, banks, and insurance companies, for potential investments. Because these groups manage large amounts of money, we would be getting large initial investments and would have to meet with relatively few of these institutional investors to get it. (Technically, we would work with one or several investment banks that would arrange the meetings and the financing, but you get the idea.)

Now, imagine we are not quite as reputable and are more interested in lining our own pockets than managing a well-run REIT. It would be difficult for us to get large sophisticated institutions to invest with us. It would be easy for them to read through our prospectus and notice the exorbitant fees and myriad of other problems.

So where is a flim-flam man to turn? Unsophisticated grandma and grandpa might make prime targets! We can turn on the charm. The REITs pay big bucks in sales commissions to brokers and brokerages. (Remember Wells from our discussion of fees? They paid brokers 7%!) They also put on fancy presentations and free dinners at brokerages to lure unsuspecting customers, taking their carnival side show act from small town to small town.

See, it’s a problem of self-selection: A good group of businesspeople have a choice, while the baddies don’t. The good guys can either go to an investment bank and get financing through a few institutional investors or try to court thousands of individual investors. It’s going to be easier to go the investment bank route with the institutions, so that’s what most of the good guys do. The bad REITs don’t really have that choice; they can only pursue the thousands of unsuspecting individual investors. The bad REITs self-select. Although it’s not impossible, it is highly unlikely that you’ll find many good, high quality public non-traded REIT because of this self-selection factor.

Final Verdict

I can think of absolutely no reason why you would want to buy a public non- traded REIT.

There is no reason for public non-traded REITs to exist. Publicly traded REITs can do everything non-traded REITs can do, and they often do it with more transparency and lower costs. While it’s true that the share prices for non-tradable REITs are less volatile, it’s only because the company essentially decides on what the share price will be. My advice is this: If you can’t handle the volatility of a publicly traded REIT, just stop looking at the share price! (Or stick to safe investments like CDs.)

If your broker tries to talk you into a public non-traded REIT, run–don’t walk–out of the office! Investors should stick to publicly traded REITs and low cost REIT index funds or ETFs, such as the Vanguard Real Estate Index, for the real estate portion of their portfolios.