Wall Street Potholes. Simon А. Lack

REIT that drew my attention to this sector. Penelope held an investment in the REIT that had been recommended by her broker at Ameriprise. Disclosure is a great defense. It turns out you can do some pretty egregious things to your clients if you tell them you'll do so in a document. IAR's prospectus discloses many of the unattractive features that characterize how they run their business. Because they are registered, their registration and many other documents are publicly available. They don't necessarily represent either the worst or the best of the sector, but they are one of the biggest non-traded REITs, so it's useful to examine their public filings.

      For example, underwriting fees on the issuance consisted of a 7.5 % “Selling Commission,” a 2.5 % “Marketing Commission” and a further 0.5 % “Due Diligence Expense Allowance,” adding up to a fairly stiff 10.5 % of proceeds. But it didn't stop there. In some cleverly crafted prose, the document goes on to explain that “…our Business Manager has agreed to pay…expenses that exceed 15 % of the gross offering proceeds.” In other words, up to 15 % of the investor's money could be taken in fees.

      The registration statement is full of tricky English language such as this. The entire document is 132,192 words, approximately twice the length of this book. It's absurd to think that any investor who's not employed in the industry will read and digest such a thing. The 15 % in fees were disclosed around 20 % of the way through the document, so in a legal sense the client was informed, but not in a way that represents a partnership between the advisor and the individual.

      There are other little gems, too. The company will invest in property that will then be managed by an affiliate. So in other words, the sponsors of IAR will make money from managing the assets owned by IAR as well as for running IAR itself. “Management Fee” occurs 45 times throughout the document, and includes fees on the gross income (i.e., rent). There's also a 1 % management fee on the assets. The investors do have to receive a 5 % return first, but that return is “non-cumulative, non-compounded,” which means that if they didn't earn the 5 % return for investors in one year, they don't have to make it up the next year in order to earn their management fee. There are fees of 2.5 % to the business manager if they buy a controlling interest in a real estate business. There's also a 15 % incentive fee, basically a profit share, after investors have earned 10 % (although it's not on the excess profit over 10 %, but on the whole profit). The simple word fee occurs 528 times.

      There are 40 matches for “conflict of interest,” including most basically that the buildings owned by IAR will be managed by an affiliate of the sponsor with whom they do not have an arm's-length agreement. Said plainly, don't expect that the management of properties is done at a fair price, but be warned that it may be unfairly high.

      Now, to be fair, whenever companies issue securities to the public they hire lawyers to construct documents whose purpose is to protect the company from the slightest possibility of being sued after the fact. Glance through the annual report (known as a 10K) of almost any company and you'll find a whole list of “risk factors” telling you why you might lose money on your investment. Even Warren Buffett's Berkshire Hathaway, as honest a company as you'll find, includes a list of risk factors in its 10K that seem fairly obvious, such as, “Deterioration of general economic conditions may significantly reduce our operating earnings and impair our ability to access capital markets at a reasonable cost.” You'd think any investor would be aware of this, but it's in there anyway just so they can say they warned you.

      IAR mentions “risk factors” 44 times. It warns the investor that it is operating a “blind pool,” in that they don't yet know (at the time of the offering) what real estate assets they're going to buy. They go on to warn that there may be little or no liquidity for investors to sell (how true that turned out to be).

      Another common problem with non-traded REITs is that the high dividends that attract investors may not be backed up by profits. Interest rates have been low now for years and are likely to remain historically low for a good while longer, as I wrote in my last book, Bonds Are Not Forever: The Crisis Facing Fixed Income Investors. Low rates benefit people and governments who have borrowed too much, which applies widely in the United States as well as other countries. The low yields on bonds mean investors are starved of opportunities to earn a reliable, fair return with relatively low risk.

      Non-traded REITs are sold because of their high dividend yields. However, there's no requirement that the dividends they pay are backed up by profits. They can simply be paid out of capital. This issue isn't limited to REITs, of course. Any company can pay out dividends in excess of its profits, at least for a while. Many companies follow a policy of paying stable dividends even while their profits fluctuate, recognizing the value investors place on such stability. As long as their profits are sufficient to pay dividends and reinvest back in their business for growth over the long term, paying dividends in excess of profits in the short run may not do any harm.

      But non-traded REITs can pay a dividend that's higher than they can sustain even in the long run. It's like having a savings account that pays 2 %, taking out 3 % of it every year, and calling it a dividend. Part of the dividend is your own money coming back to you. Calling it a dividend misleads investors into thinking it's from money earned, which it's not. On top of that, non-traded REITs can often invest in properties that pay high rent but depreciate. An example might be a drug store such as Walgreen's, which could hold a ten-year lease on a property that has no obvious alternative tenants should Walgreen's decide not to renew the lease at its termination. It will pay above-market rent to compensate the building owner (i.e., the REIT) for the possibility that in ten years the building will have to be expensively reconfigured or even torn down in order to find a new tenant. As such, the building may well depreciate during the term of the lease, given the specialized nature of its construction. The depreciation often won't show up in the REIT's financials, leading to a delayed day of reckoning.

      In fact, non-traded REITs are notorious for maintaining an unrealistically stable net asset value (NAV). They simply don't update the value of their holdings, and because their securities are not traded there's no way for investors to know if the value of their holding has fluctuated.

      Disingenuous Advice

      Some advocates of the sector, with utterly no shame, argue that the absence of a public market is a good thing. Sameer Jain, chief economist and managing director of American Realty Capital and someone who really ought to know better, praises “illiquidity that favors the long-term investor” (Jain 2013) as a benefit. Sameer Jain surely must know that illiquidity never favors any investor, long term or otherwise. This is why illiquid investments always require an illiquidity premium, a higher return than their more liquid cousins, to appropriately reward investors for the greater risk they're taking. Inability to sell what you own is never a good thing. He adds that non-traded REITs are “not subject to public market volatility,” as if that's a further benefit. That's like arguing that closing the stock market is good for investors so they can't see their investments fluctuate. Sameer Jain is a graduate of both Massachusetts Institute of Technology (MIT) and Harvard University, so I know he must be smarter than these statements make him sound. If you don't want to know what your portfolio's worth, don't look! In any case, as long as you haven't borrowed money to invest (rarely a smart move), fluctuating prices need not compel you to do anything you'd rather not do. Looking at an old valuation that's wrong and not updated should not provide comfort to anyone. It's head-in-the-sand, ostrich investing.

      For example, in July, 2014 Strategic Realty Trust, another non-traded REIT, reduced the valuation of their REIT by 29 % (InvestmentNews 2014), from $10 per share to $7.11. The previous $10 value had remained unchanged since it was launched in August 2009, at what should have been a great time to be investing in anything. It's doubtful any of the hapless investors in Strategic Realty would agree with Sameer Jain that five years of no reported changes in valuation had been helpful.

      The reality is that the value of the underlying assets fluctuates depending on the economy, shifts in demand for real estate, location of properties, competition, successful retention of tenants and other reasons. Failing to change the NAV of the security in no way shields investors from their exposure to all these factors, it simply shields them from the knowledge of how their investment's value may have shifted. Publicly traded REITs provide a market perspective on