Nontraded REITs: Friend or Foe?

Nontraded REITs are generally unsuitable for older or retired investors because of their need for liquidity

KBS Realty's Charles Schreiber says nontraded REITs aren't complicated, despite the recent attention from regulators. KBS Realty's Charles Schreiber says nontraded REITs aren't complicated, despite the recent attention from regulators.

(Clarification appended)

With the current boom in real estate investment trusts, alternatives investors and their advisors are wondering whether it’s safe to re-enter the nontraded REIT market since FINRA’s warning on this illiquid investment.

The answer is: not if you’re a retiree or nearing retirement age. Nontraded REITs are generally unsuitable for older or retired investors because of their need for liquidity, including access to money in case of medical costs.

“Nontraded REITs are generally illiquid, often for periods of eight years or more,” the Financial Industry Regulatory Authority (FINRA) warned last August in an investor alert. “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.”

Of course, nontraded REITs have their defenders. The Investment Program Association (IPA) says that while nontraded REITs are illiquid, they typically go from offering to liquidation within four to seven years. The IPA also points out that every nonlisted REIT is an SEC-registered vehicle and files audited financials, so use of funds are certified by an auditor, often one from the Big Four.

In addition, the CCIM Institute, a trade group for certified commercial investment members, argues that nontraded REITs offer stability and portfolio diversification. Others point to nontraded REITs' advantages in reducing taxes while providing returns on real estate.

“While nontraded REITs have relatively limited liquidity, they offer the same benefits as their publicly traded counterparts,” according to an article in CCIM’s Commercial Investment Real Estate magazine. By definition, the key benefit of nontraded REITs is that they are not yet publicly traded. Subsequently, they offer the reasonably predictable cash flow of publicly traded REITs without the volatility incumbent in the public markets.

FINRA Warns of Risks

FINRA acknowledges that nontraded REITs offer selling points such as “the opportunity for capital appreciation, diversification and the allure of a robust distribution,” but it adds that these investments also carry complexities and risks. “Distributions are not guaranteed and may exceed operating cash flow,” with distributions possibly containing returns of investors’ principal, FINRA warns.

Also, fees can add up. Individual investors are drawn to the steady 7% annual returns of nontraded REITs, but initial fees may be around 10% of their investment, according to The Wall Street Journal.

FINRA’s concerns about the risks of nontraded REITs came to a head in May 2011 when it filed a complaint against David Lerner & Associates Inc. of Syosset, N.Y., charging the firm with soliciting investors to purchase shares in Apple REIT Ten, a nontraded $2 billion REIT, “without conducting a reasonable investigation to determine whether it was suitable for investors.” However, U.S. District Judge Kiyo Matsumoto dismissed a class action lawsuit against David Lerner's firm in April.

But now, as low interest rates on many investments stay stuck in the low single digits, investors are actively seeking higher risks along with higher rewards, according to the Investment Program Association (IPA), which is the trade group for the direct investment industry. The IPA asserts that high-net-worth investors surveyed expressed interest in securities such as nontraded REITs and business development companies (BDCs).

The past two years have seen record sales of nonlisted REITs and BDCs, the IPA says in a new report, citing data from the investment bank Robert A. Stanger & Co.  In 2012, the bank estimated total sales of nonlisted REITs to be $10.3 billion and sales of BDCs to be $2.8 billion. In the first quarter of 2013, total sales of nonlisted REIT sales were estimated to be $3.9 billion and BDC sales for the quarter were estimated to be $655.7 million.

“In a sign of strong confidence in real estate investing, a recent survey of over 500 high-net-worth investors found that 80% believe that commercial real estate will perform the same as or better than the equity market over the next five years,” the IPA reported. “These findings imply a 15 percentage-point increase in future ownership of nonlisted REITs and an 11 percentage-point increase in future holdings of BDCs.”

The nontraded REIT isn’t a complicated vehicle, but there have been plenty of misunderstandings about its benefits and challenges, said Charles Schreiber Jr., chief executive of Newport Beach, Calif.-based KBS Realty Advisors, a large office investor, and its affiliate KBS Capital Advisors, in an interview with AdvisorOne.

KBS CEO Schreiber Embraces ‘More Transparency’

KBS, a pension fund advisor founded in 1992 that launched its first nontraded REIT in 2005, is now one of the largest office investors and owners globally, at transactional volume of approximately $25 billion. The firm has five nontraded REITs, 14 separate accounts, six commingled funds and five sovereign wealth funds.

The nontraded REIT market is relatively new, with its period of greatest activity dating back only eight years, and it got slammed by the 2008 financial crisis and 2009-'10 drop in real estate, Schreiber admitted. Yet today’s low yields in fixed-income products “have directed advisors and investors to look seriously at REITs as an alternative way to invest in real estate products with the intent to diversify the investment portfolio,” he said.

Schreiber, whose firm’s chief compliance officer listened in on the phone interview, said he couldn’t comment on a class-action complaint filed in May against KBS REIT I. But he did say that he favors FINRA and the Securities and Exchange Commission’s efforts to advance numerous regulations and requirements in the reporting of investment activities within the REIT market.

“It requires more transparency. We embrace this, we applaud this. It complements the type of vehicle that the nontraded REIT is,” Schreiber said, pointing to changes now underway in the reporting of net asset values.

To be sure, investors have other ways to get exposure to REITs. Traditional REITs or exchange-traded funds (ETFs), for example have gained in popularity, Street One Financial’s vice president of ETF and options sales and trading, Paul Weisbruch, reported April 22 in ETFTrends.com.

“The REIT space thus far in 2013 has impressed in terms of garnering new assets, with the two largest products in the category, VNQ (Vanguard REIT [ETF], expense ratio 0.10%) attracting greater than $2 billion year to date, and IYR (iShares DJ U.S. Real Estate [index fund], expense ratio 0.48%) taking in north of $500 million,” Weisbruch wrote.

Even some in the nontraded REITs market are changing the way they do business since FINRA’s investor alert, issued in August. For example, the website for Clarion Partners Property Trust (CPPT), which launched on Nov. 1, provides shareholders with a daily net asset value (NAV) calculation, based on data from an independent valuation advisor.

But buyer beware: While CPPT’s daily liquidity is available, quarterly redemptions for the fund are capped at 5% of NAV. Disclosures on Clarion’s website state that because CPPT is a blind pool offering, “you will not have the opportunity to evaluate our investments before we make them.”

Further, since there is no public trading market for shares of CPPT’s common stock, “redemption of shares by us will likely be the only way to dispose of your shares,” Clarion states. “Because our assets will consist primarily of properties that generally cannot be readily liquidated, we may not have sufficient liquid resources to satisfy redemption requests.”

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Read FINRA Issues Top 10 Watch List for 2013 at AdvisorOne.

(The story has been clarified to reflect that the IPA itself is not asserting that investors "want in" on nontraded REITs and BDCs; their conclusion was drawn from a third-party survey of investors.)

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