Commercial real estate investment has several financial advantages over private real estate but high setup costs put it out of reach of many investors. Real Estate Investment Trusts (REITs) are one solution to that problem, allowing smaller investors to invest in large-scale commercial real estate projects such as hotels, resorts, shopping malls, and others.
What is a REIT?
Technically speaking, a REIT is a company that invests in various commercial properties and then sells shares that give shareholders a stake in the company’s entire real estate portfolio. By law, REITs are obligated to pay out 90% of their taxable earnings to shareholders.
REITs can be traded publicly on a stock exchange or they can be traded directly. Directly traded REITs are known as unlisted, non-traded, or non-exchange-traded REITs.
Although both types of REIT must register and file a prospectus with the SEC, and make regular SEC disclosures such as quarterly and annual reports, the lack of public trading opens the doors to more potential investor risks when buying shares of non-traded REITs.
Risks of non-traded REITs
You don’t own the real estate itself
When you buy shares in a REIT, you are buying shares in the investment program furnished by the investment company that operates that REIT. You are not buying an actual piece of property.
This is true of both listed and unlisted REIT shares, but might not be as clear to the investor when considering non-traded REITs because non-traded REITs aren’t purchased at a stock exchange, like other shares.
If your broker does not explain this clearly to you, then they are in violation of FINRA Rule 2210, “Communication With the Public,” which includes the statement, “No member may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.”
It’s not a REIT until it has 100 investors
Per the US Tax Code, a real estate investment program cannot call itself a REIT until it has at least 100 investors. It must also be registered as a corporation.
When advising clients, firms cannot use language that might lead investors to believe they are investing in a REIT when that program hasn’t yet reached REIT status as per the Tax Code.
Distribution rates don’t necessarily refer to yield
Real estate investment rates typically include distribution rates as part of their communications. But newer real estate programs often include repayment of the principal or loan proceeds as part of their distribution.
Even worse, sometimes REITs might pay distributions directly from other investors’ money which can significantly reduce cash flow and the value of shares.
It’s important to make sure your adviser communicates clearly what percentage of the expected distribution is the actual yield from the investment. The financial firm you deal with is under obligation to communicate this information to investors unambiguously.
Liquidity issues
One of the biggest pitfalls of non-traded REITs is that they are not liquid, often for eight years or more. If an investor needs to shed shares in a REIT fast, this may not always be possible.
Financial firms are obligated to give full and accurate information to investors about potential future liquidity events, particularly if the date of such events is not guaranteed, or if the event could be canceled for whatever reason.
Fees
Unlisted REITs can charge heavy fees, both in terms of upfront fees (as much as 15%) as well as fees for redeeming shares early.
Unlisted REITs are not transparent
Unlike publicly traded REITs, non-traded REITs suffer from a lack of transparency.
Determining the value of shares in a non-traded REIT can be difficult, whereas this information is openly available for publicly traded REITs. Investors sometimes don’t know the value of a non-traded REIT’s shares for as long as 18 months after the offering closes. This makes it challenging to make decisions about market volatility.,
Conflicts of interest
Non-traded REITs tend to utilize an external manager. These external managers might demand large fees depending on the number of property acquisitions or the amount of Assets Under Management (AUM). This could cause conflicts of interest with shareholders.
Risks of publicly traded REITs
Publicly traded REITs are also not without risk, but their risks are usually not related to a lack of transparency. One risk is that higher interest rates often trigger a REIT sell-off. And, like all investments, it’s important to choose the correct REIT before committing.
How to find more information about a REIT
A FINRA investigation into the matter discovered too little clear communication from financial firms and advisers when informing investors about unlisted REITs. Financial firms have a fiscal obligation to provide all necessary information to their clients.
But investors are not without power themselves. It is possible to find quarterly and annual reports, as well as the company’s prospectus via the EDGAR portal—the SEC’s Electronic Data Gathering, Analysis, and Retrieval system. Using EDGAR, investors can discover a plethora of information from company filings over the last 20 years, allowing them to perform any due diligence on the REIT they are considering.
For unlisted REITs, you need a broker in good standing
Because so much of the risk associated with unlisted REITs is due to miscommunication from advisers, it is imperative to deal only with brokers who take their fiscal duties seriously. There is a fine line between mere negligence and egregious securities fraud, but both can lead to immense losses.
Not only should investors investigate REITs for themselves, but they should also perform due diligence on the advisers and firms they hire. This can be done through FINRA’s BrokerCheck service which lists complaints and decisions against financial professionals who are registered with FINRA.
Dealing with financial advisers who are not registered with FINRA is the biggest red flag of them all. And it greatly limits an investor’s chances of receiving damages for gross negligence.
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