For years, the non-traded REIT industry was small, but over the past two decades the market has grown considerably. At first glance, these investments seem to have several advantages over publicly traded REITs—they typically sport higher yields than publicly traded REITs and appear to be less volatile. However, there are important risks that are often overlooked when investors purchase these products. The SEC and FINRA have taken notice, increasing the disclosure requirements and even publishing information on their Web sites to better inform individual investors of the complexities, common misconceptions, and risks of these products.
Non-traded REITs—companies that own commercial real estate, but whose shares are not freely tradable—are owned by thousands of retail investors in the U.S. Like publically traded REITs, non-traded REITs allow the general public access to the commercial real estate market, an industry that previously had only been available to institutional investors and wealthy individuals through direct real estate investment. There are approximately 70 non-traded REITs that own about $85 billion of assets.
Key benefits and potential drawbacks
Key benefits and potential drawbacks
Although non-traded REITs have gained in popularity, many investors are unaware of the risks associated with these products. The table below outlines the potential benefits and drawbacks:
|Potential benefits||Potential drawbacks|
|Portfolio diversification||High up-front costs/overhead costs|
|High yields relative to publicly traded REITs||Dividends may be unsustainable|
|Lower share price volatility||Illiquidity|
|Inflation hedge||Properties may not be specified|
- High up-front costs: Investors typically pay 10% of the share price in up-front fees and commissions, which can be difficult to make up over the life of the investment. For example, a 15% front-end fee on a $10,000 investment means that $8,500 is going to work at the time of investment. By comparison, the underwriting compensation associated with exchange-traded REITs is normally 7% of the offering proceeds.
- Dividends are often unsustainable: Distributions can be suspended for a period of time or halted altogether. Periodic distributions that help make non-traded REITs so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal. This is in contrast to the dividends investors receive from corporations that trade on national exchanges, which are typically derived solely from earnings.
- Illiquidity: Shares of non-traded REITs do not trade on a national securities exchange. For this reason, non-traded REITs are generally illiquid, often for periods of eight years or more. Early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return. In addition, shares may have to be held for some period, typically one year, before they can be redeemed. Redemption programs may be terminated or adjusted, so investors should not count on them, even as an emergency exit strategy. While a redemption program might allow investors to sell shares prior to a liquidity event, the redemption price is generally lower than the purchase price, sometimes by as much as 10%.
- Properties might not be specified: Most non-traded REITS start out as blind pools, which have not yet specified the properties to be purchased. Others might specify a portion of the properties the REIT plans to acquire, or they might be in various stages of acquisition. In general, the fewer the number of properties that have been specified for purchase or that have actually been acquired, the greater risk an investor incurs, because the investor hasn’t had the opportunity to assess the nature and quality of the REIT’s assets before investing.
Non-traded REITs face increased scrutiny
Investors of non-traded REITs were often unaware of the risks highlighted above, prompting increased scrutiny from FINRA and the SEC over the past five years. Several new requirements have been put in place in an effort to increase the transparency of these products. In addition, many non-traded REIT sponsors are modifying their structure to address some of the perceived shortcomings, and are increasingly targeting the 401(k) and institutional markets rather than individual investors.