Sales of Real Estate Investment Trusts (REITs) have exploded in recent years. Many public REITs are now traded like stock – investments that can be sold in the marketplace and valued by the marketplace daily. However, there are major differences between publicly traded REITs and non-traded REITs. Non-traded REITs are packed with massive conflicts of interest, obscene fees and other problems.
Simply put, we believe that some non-traded REITs are financial engineering schemes. Non-traded REITs entice retired investors with the appeal of both owning a “piece of Real Estate” without many of the headaches of owning real estate, while simultaneously getting a constant stream of solid income for a number of years. Non-traded REIT investors also purportedly receive the added benefit of owning an investment that won’t be affected by market volatility (unlike REITs that are publicly traded), and the flexibility to redeem their shares if needed (i.e. have the REIT buy back their otherwise illiquid shares).
Through investigations conducted by Vernon Healy, we are finding that many of these non-traded REITs perform far differently than what is described in the sales pitch.
So far, twelve of the biggest non-traded REITs have already suspended their redemption policy, meaning they will not buy back the otherwise illiquid REIT investment upon request of the investor. Another sixteen non-traded REITs have significantly reduced or suspended distributions – that fixed income payment so crucial to the sales pitch. This means that many investors are now stuck indefinitely with investments that are paying out little or no money, and there is no certainty that investors will ever get their money back.
Many of these non-traded REITS have initial commissions, fees, and other expenses that effectively skim 15 percent or more of the investors’ funds off the top, based on a Vernon Healy analysis of dozens of offering documents for non-traded REITs. As a result, in some cases, there is only a little over $8 dollars out of the initial $10 per share investment available to be invested in real estate. Regrettably, the amount of fees and commissions investors have to pay does not stop with the initial fees, costs, and expenses. Many non-traded REITs collect up to 4 percent of the gross revenue for property management and leasing fees and up to 3 percent of the total transactional value each time the REIT acquires or sells a property. Additionally, if the REIT goes public, many non-traded REIT operators are entitled to up to 10 percent of the entire net asset value of the REIT.
Non-traded REITs are sold through REIT-owned broker dealers, many of whom also engage independent broker-dealers. These products would seem to be a hard sell to investors due to the potential illiquidity and high fees, but with financial advisors and REIT related entities receiving high sales commissions on these products, it’s no wonder there is no shortage of advisors hawking them.
Possibly the most troubling aspect of non-traded REITs is the funding of investor distributions (i.e. the “steady income” allure). What is so troubling about these payouts is the fact that they are often made up primarily of new investors’ money or from loans made to the REIT. This practice is similar to that of a Ponzi scheme that uses new investors’ money or borrowed funds to pay prior investors.
The dangers of using new investors’ money to fund older investors’ dividend payments are many, including the fact that distribution amounts to existing investors often plummet once the REIT closes share offerings to new investors. In fact, Vernon Healy’s investigation has identified more than 10 non-traded REITs that have suspended all distributions indefinitely. This means that many non-traded REIT investors are currently stuck in this investment, and their only way out is to sell their shares in an inefficient secondary market at a deep discount.
FINRA Regulatory Notice 09-09 now requires REITs to re-assess the value of their shares no later than 18 months after the conclusion of the offering. Per this FINRA Rule, many non-traded REITs are now re-assessing share value and notifying investors that their shares are worth far less than they paid for them, despite the initial sales pitch of price stability. Quarterly reports reviewed by Vernon Healy, reveal that this re-pricing has uncovered billions of dollars in investor losses. Despite the free fall in value, many investors cannot sell their shares because the REIT has frozen redemptions.
With respect to the practice of using new investor funds or borrowed money to pay regular distributions to existing investors, here are some of the statements several REITs disclosed via SEC filings:
• Apple REIT TEN (Currently in Registration): “While we intend to make monthly distributions, we may use the proceeds of the offering to fund distributions to our shareholders. There is no limit on the amount of distributions that may be funded with offering proceeds or proceeds from debt, as opposed to cash generated from operations.” (Registration Statement filed August 20, 2010)
• Behringer Harvard REIT I (Redemptions Currently Suspended): “Until proceeds from our final offering are fully invested and generating cash flow from operations that are sufficient to make the full distributions to stockholders, we have and may continue to pay all or a portion of our distributions from the proceeds of our final offering or from borrowings in anticipation of future cash flow.” (Annual Statement filed March 18, 2010)
• Cole Credit Property Trust (Redemptions Currently Suspended): “We may use other sources to fund distributions, as necessary, such as proceeds from available borrowings under our revolving line of credit.” (Quarterly Report filed November 11, 2010)
• Wells Real Estate Investment Trust II (Redemptions currently at 60 percent of original cost): “Until our properties are generating sufficient cash flow, we may fund our distributions from borrowings or even the net proceeds from our ongoing public offering.” (Annual Statement filed March 25, 2010)
• Hines REIT (Redemptions Currently Suspended): “In our initial quarters of operations, distributions we paid to our shareholders were partially funded with advances or borrowings from our Advisor. We may use similar advances, borrowings, deferrals or waivers of fees from our Advisor or affiliates, or other sources in the future to fund distributions to our shareholders. We cannot assure shareholders that in the future we will be able to achieve cash flows necessary to repay such advances or borrowings and pay distributions at our historical per-share amounts, or to maintain distributions at any particular level, if at all.” (Annual Statement filed March 31, 2010)
The Real Estate Investment Securities Association (REISA), a non-profit organization that provides education and information to professionals who offer and distribute real estate securities, held a REIT webinar on January 21, 2010. During the Q & A session, the following question was asked: “How is paying dividends from new equity being raised as opposed to cash flow not a Ponzi Scheme? What if the properties never attain sufficient cash flow to pay the dividend?” The answer given by the presenters was as follows:
“The Prospectus (or PPM) discloses that dividends may be paid from equity (unlike a Ponzi scheme where what is done is not that which was promised). If a REIT never attains sufficient cash flow to pay dividends, runs out of reserves and is unable to borrow, it will quit paying dividends.”
This demonstrates that non-traded REITs often produce artificial yields that may be unsustainable while simultaneously pricing their shares at a level that does not reflect the amount an investor would receive by selling the product on the secondary market.
Non-traded REITs are so defectively designed that big brokerage firms like Merrill Lynch, Morgan Stanley Smith Barney, and Citi among others do not sell them. This identifies yet another problem: Based-on Vernon Healy’s experience speaking to many investors looking for legal representation, non-traded REITs are promoted and sold by REIT related firms and lower tier brokerage firms that oftentimes do not carry enough insurance nor maintain enough capital to compensate clients who pursue claims related to the inappropriate promotion and recommendation of these products.
If you are an investor considering non-traded REITs, we strongly urge you to seek a second opinion before investing in a non-traded REIT.
Christopher Vernon is a Naples-based attorney with the law firm Vernon Healy. He advocates for the rights of investors throughout the United States and abroad. Mr. Vernon currently holds an AV rating by Martindale-Hubbell, has been repeatedly recognized by his peers in The Best Lawyers in America and has also been consistently recognized in the Florida editions of the Super Lawyers publication. Mr. Vernon has spoken at both national securities and national trial attorney conventions and has also conducted continuing education for CPAs, CFAs, CFPs, investment professionals, board certified business litigation lawyers, board certified trust and estate lawyers, and securities regulators. Mr. Vernon has also testified as an expert on issues relating to FINRA arbitration.
This article was co-written by Victor Bayata. Mr. Bayata is also with the law firm of Vernon Healy.