(Re-casts 12th paragraph to clarify that both traded and non-traded REITs use mark-to-market techniques)
By James Saft
Jan 22 (Reuters) - When a financial advisor tried to sell my sister a fee heavy non-traded REIT last year, pitching it as an alternative to fixed income, I told her she ought to fire him.
Then, having thought it over, I told her she ought to fire him, re-hire him and fire him again.
Non-traded REITs are a species of real estate investment trusts, specifically ones which are not traded on an exchange and which typically lock investors in for seven or more years.
Like traditional REITs, non-traded ones invest in real estate, often in a market niche like college housing or medical office buildings, and then are allowed to not pay taxes so long as they pay out at least 90 percent of income to shareholders. Shareholders pay taxes on the income at their normal rates.
Sounds obscure, but actually more than $20 billion of non-traded REITs were sold in the U.S. last year, according to data from market tracking firm Robert A. Stanger, as investors desperate for yield met brokers happy to trouser fat fees.
Like so many dubious investments, non-traded REITs are sold not bought, in this case by aggressive brokers and financial advisors, often marketing to an unsophisticated retail audience who are a bit scared of equities and are unhappy with miserable fixed income returns due to low interest rates.
And while non-traded REIT returns have beat some other major asset classes in recent years on some measures, they have done so in a way and with a set of risks which rings warning bells.
They are illiquid. They lack oversight and safeguards that publicly traded REITs must follow. And they very typically feature a fee structure which is jaw dropping.
The Financial Industry Regulatory Authority, an industry funded oversight body, went so far as to issue an "investor alert" about non-traded REITs in May of last year, warning about inaccurate and mis-leading marketing of the vehicles as well as other risks.
Just to give a flavor of the company in which non-traded REITs are traveling, the most recent FINRA investor alert was about marijuana stock scams.
HOST OF RISKS
The first issue with non-traded REITs is the fact that they are illiquid. Unlike a regular REIT, you make a commitment for five, seven or even ten years and during that period you not only cannot choose to get your capital back, you enjoy less oversight and protection.
While both non-public and publicly-traded REITs use mark-to-market and other valuation techniques, investors in traded securities are able to see the value the investing public places on their shares every trading day.
"While it's true that the share prices for non-tradable REITs are less volatile, it's only because the company essentially decides on what the share price will be.
My advice is this: If you can't handle the volatility of a publicly traded REIT, just stop looking at the share price! "Or stick to safe investments like CDs," Ben Strubel, of wealth management firm Strubel Investment Management, wrote in a note to clients.
And then there are the fees. While some fees are capped by law, and there is great variation, they tend to be high. You might easily pay 12.5 percent off the top when you buy a non-traded REIT as an organizing and offering fee, with a further selling commission and sometimes high ongoing management fees.
And fees don't stop there. When non-traded REITs buy or build property they often pay 4-6 percent fees as part of those transactions. Then there are, sometimes, oversight fees, financing coordination fees and real estate commissions.
And while many non-traded REITs produce high streams of payouts to investors in early years, this is often done through leverage, borrowing money to fund dividends, or by simply giving investors some of their initial investment back.
As for performance, the data is skimpy but seems to indicate moderate returns, but less than you can get from a traded REIT.
A 2012 study by Blue Vault Partners and the University of Texas found that start-to-finish returns of a group of 17 non-traded REITS produced an internal rate of return of just above 10 percent, but a percentage point or so below publicly traded REITS, which enjoy superior liquidity and safeguards.
Seems to me if you are going to lock up your money for longer, you ought to get a better return.
Non-traded REITs are doubtless making a lot of people rich, but you are not likely to be one of them, and very likely can do better on a risk-adjusted basis elsewhere.
So, if your advisor tries to put you in a non-traded REIT fire him twice, or, if you want to hedge your bets just fire him once.
At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at http://blogs.reuters.com/james-saft)
(Jim Saft; editing by Clive McKeef)