The Perils of Non-Traded REITs

Illiquid. Expensive. Unreliable distributions. Which investment vehicle falls into this mix? Try non-traded real estate investment trusts (REITs), the “evil twin” of exchange-traded REITs. Yet they’re estimated to bring in $20 billion of capital flows by the end of this year, twice as much as last year! Folks are clearly being enticed, but a careful look at the pros and cons suggests most investors probably shouldn’t bite.

REITs pool investors’ capital to purchase properties like office buildings, shopping centers, hotels and apartments, letting folks invest in real estate that otherwise wouldn’t be available to the typical retail investor. They can be useful, depending on an investor’s long-term goals and general market outlook. But, it’s crucial to differentiate between the different types—exchange-traded REITs, which are listed on a national exchange, and non-traded REITs, which aren’t. They’re peddled straight from the issuer or a dealer’s inventory.

Non-traded REITs are typically advertised as exclusive, high-yielding securities. Because they aren’t traded, they claim to be insulated from market volatility, and those selling them argue their prices can’t be inflated by investors the way traded REITs can. It all smacks of “no risk, high reward”—usually an investor’s cue to run screaming the other way. No investment is safe, and no return is guaranteed—especially not one in shadowy markets whose value is tethered to real estate. It’s subject to risk of loss, just like any investment, and those attractive yields aren’t guaranteed.

As you can imagine, not being publicly traded carries some significant drawbacks. For one, valuing non-traded REITs is difficult. When a security is traded on an exchange, you know its price up to the minute. When it isn’t listed, investors have no way of knowing the last price at which it changed hands. The REIT’s management and third parties do conduct infrequent property valuations, but there is no guarantee the securities will trade anywhere near their underlying value (which isn’t guaranteed to match the manager’s assessment). Further, investors typically can’t conduct their own evaluation of the individual investments as these REITs typically start out as blind pools—they’re buying on blind faith and a broker’s recommendation, which may be influenced by factors beyond the investment’s quality (more on this in a bit).

One of the biggest drawbacks of not being publicly traded is perhaps the most obvious: If something doesn’t have a market, it’s extraordinarily difficult to offload. Non-traded REITs are very illiquid. Offloading shares before the holding period ends can be challenging. Holding periods can be up to eight years, and only a very limited portion of shares (if any) are redeemable each year. So if you need your money for an unforeseen expense, or you want to move into something else, things get tricky. If you can’t redeem your shares, you might be able to trade them over the counter, but then you’re highly unlikely to find a good deal—most change hands at a significant discount. If you can redeem your shares, redemption offers may be priced below purchase- or current-price—sometimes as much as 10%. And the redemption process can take months, with reams of paperwork! Lastly, fees associated with the sale can be quite high.

Redemption fees aren’t the only cumbersome cost. Front-end fees can be as much as 15%—far exceeding fees associated with exchange-traded REITs. Fees typically fall in two categories: selling compensation and expenses, not exceeding 10% of the investment amount, and additional administrative fees, like offering and organization costs. The broker commissions can be a major conflict of interest—they’re an incentive to sell a product, regardless of the investor’s long-term goals and financial circumstances.

While many non-traded REITs advertise steady distributions, these aren’t set in stone. According to a recent alert from FINRA, “Deciding whether to pay distributions and the amount of any distribution is within discretion of a REIT’s Board of Directors in the exercise of its fiduciary duties.” Read: Distributions may be halted or even funded in part or entirely from investor capital or borrowings. Yes, many non-traded REITs’ articles of incorporation allow them to increase debt or pull from cash reserves, placing them at greater risk of default and devaluation. In short, return of capital isn’t guaranteed, either.

Investors considering non-traded REITs should to do their due diligence, just as they would with any type of investment. Review the risks and costs of non-traded REITs, and you’ll likely find you can reach your goals with something far less restricted and costly.