Both FINRA and the SEC have started warning investors about non-traded real estate investment trusts (REITs), which are growing in popularity but expose investors to very serious risks. We at SLCG have had a variety of cases involving non-traded REITs and would like to describe our experience analyzing these investments and what they mean for regulators and retail investors.
In the most general sense, REITs are simply companies that hold almost entirely real estate assets. These companies can obtain special tax treatment if they distribute most of their earnings as dividends. REITs have been around since the 1960s, but became especially popular in the late 90s and early 2000s.
There are three distinct types of REITs:
- Traded REITs are listed on a major stock exchange and are subject to all of the disclosure requirements of any other publicly-traded company. Traded REITs can have very large market capitalizations and have extensive analyst coverage and liquidity.
- Non-traded REITs are not openly traded on any public market, but are sold through brokers directly to investors. Non-traded REITs are required to file with the SEC, but have considerable leeway as to how they market their shares to investors.
- Private REITs are sold only to accredited investors. They do not file with the SEC, and little is known about the size or extent of the market for these private placement investments.
For example, traded REIT shares can be purchased based on their trading price set by the market. Non-traded REIT shares can typically only be purchased at the initial sale price, regardless of the value of the REIT's real estate portfolio. This discrepancy between value and price became especially acute in the last few years, when real estate values plummeted but price of most non-traded REIT shares remained exactly the same. Also, because there is no public market for non-traded REIT shares, they are almost entirely illiquid investments. Making matters even worse for investors, many non-traded REITs show evidence of paying dividends from new debt, not out of operating income, and have fee structures that pose significant conflicts of interest.
Many of the problems of non-traded REITS were exposed by a FINRA complaint filed against David Lerner & Associates (DLA) in January 2011. FINRA charges included the selling of securities without regard to suitability concerns and the marketing of securities with inaccurate returns data. Apple REIT Ten, the DLA REIT, had maintained a constant price of $11 per share since 2004 and had incurred debt to finance its dividend payments to investors.
Non-traded REITs are an active area of research at SLCG and we will keep posting on related subjects. There are many informative websites regarding non-traded REITs, including the SEC and IRS websites as well as REITWrecks.com.