(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."
