Investor Protection Clinic

Evaluating REITs: What is the difference and how do I decide?

Real-estate Investment Trusts, or “REITs,” can range from sensible offerings to a quazi-Ponzi schemes. Investors should do their research to know what they are buying. This post aims to explain the basics about how a REIT works and how to evaluate whether a particular REIT makes sense for your situation.

  1. What is a REIT?

The SEC describes a REIT in its Investor Bulletin on Non-traded REITs from August 31, 2015 as a company that owns and often operates “income-producing real-estate or real-estate assets” like mortgages or commercial buildings or apartments that earn money from rent. Essentially these companies pool investor money and invests in different types of real-estate or real-estate related products.  As the SEC also notes, most REITs specialize in one type of real-estate or real-estate product, so you may see a REIT that specializes in apartment communities, where another may buy hotel-type properties. Many REITs with retail investors are registered with the SEC and must file regular reports — available to the public online at https://www.sec.gov/search/search.htm. REITs must also distribute at least 90% of their taxable income. Some REITs consistently distribute funds to investors, seemingly returning 6% or higher annually. In the past, some of these distributions have been a return of principal or simply another investor’s money, not profit earned.

Ideally, a REIT generates profits off its real-estate investments and then pays a large percentage of that profit back to its investors.  Outcomes are not always good for investors due to problems like poor management, conflicts of interest, market fluctuations, and accounting problems.  

REITs can be publicly-traded or non-traded. Publicly-traded REITs trade like typical stocks on exchanges, such as the New York Stock Exchange or NASDAQ. These publicly-traded REITs are liquid investments and can be easily bought or sold. And because they can be easily bought or sold, you know exactly how much your investment is worth at any given moment because you can look to the most recent market price. 

In contrast, a non-traded REIT is typically considered illiquid and is not listed on an exchange. That makes the value of the shares difficult to determine because there is no readily available market price. Similarly, you may only be able to sell the shares back to the REIT itself or to speculators who will pay you only pennies on the dollar.

  1. How do I know whether a REIT is right for me?

Do your research.  Look up the REIT online and also read through the prospectus.  The prospectus provides much of the information you may want to know. Because a prospectus may span hundreds of pages, here are some things to consider.

Is the REIT traded or non-traded?

Consider whether you will ever want to get your money back when deciding to buy a non-traded REIT.  Because no ready market exists for the shares, you may not be able to sell your shares easily. A limited secondary market may exist with third parties willing to buy the shares.  These speculators assume a large risk by purchasing the shares, because they may not be able to sell the shares to anyone else and, in some instances, may not be eligible for certain distributions.  Ultimately, the combination of elevated risks and limited returns means that these secondary market purchasers will typically pay pennies on the dollar for the share. 

 

Additionally, non-traded REITs have been found to significantly underperform their traded REIT counterparts.  For example, in an article from the July/August 2015 edition of Investments & Wealth Monitor titled “Fiduciary Duty and Non-Traded REITs,” Craig McCann, PhD., found that investors were “at least $45.5 Billion worse off as a result of investing in the 81 non-traded REITs [investigated] compared to investing in a diversified portfolio of traded REITs.”  In another article published in the Summer 2016 volume of The Journal of Wealth Management, called “An Empirical Analysis of Non-traded REITs” McCann and his co-authors found that non-traded REIT’s average return was only 4.0% in comparison to the 11.3% annual returns found in traded REITs.

 

What are the fees and costs?

There are many types of fees that are mentioned in prospectuses, they can also be called a “sales load.”  Importantly, the up-front fees are the ones to initially look for. That is because these fees typically range from 10-15% for non-traded REITs, according the 2016 SEC Investor Bulletin mentioned above. Fees can also include ongoing management fees, and also back-end fees, such as a fee to sell your shares before they have satisfied the holding period. The McCann articles found that the average up-front fee for non-traded REITs are 13.2%. That is, on average, that the moment you purchase a share, your investment is only worth 86.8% of the money you spent. 

 

Fees are a crucial component to look at because the fees may be taken out of your investment immediately reducing the value of your investment.  Say, for example, you invested in a REIT with a 10% up-front fee.  If you wrote a check for $100,000, the investment starts off with only $90,000 going to work to generate future returns. The 10% may be used to pay sales commissions and offering costs.   

 

Are there any risk factors or conflicts of interest that make you nervous?

Every investment will have risks associated with it. So, it is important to analyze and consider an investment’s particular risks and weigh them independently.  The REIT’s prospectus will list the risk factors associated with the REIT. 

 

A typical risk that an investor in a non-traded REIT must be aware of is external management.  Typically, publicly-traded REITs are managed by their own employees, which may improve management decisions. But non-traded REITs will often be externally managed. That is, another company will manage the non-traded REIT’s operations.  As the SEC notes in their August 30, 2016 investor bulletin, these management companies may be paid by significant transaction fees from the REIT. These arrangements create conflicts of interest.  One example of this is where the management companies are paid based on the amount of property acquired or the number of assets managed.   This creates an incentive for the management company to buy as much as possible in order to maximize fees, even where those purchases are not in the interest of the REIT or its investors. 

 

Another problem with the externally managed REITs, is that the management company may be owned by the same individuals who own the REIT. This leads to those individuals essentially getting paid twice — once for owning and hiring the management company, and once for owning the management company — where they would only be paid once for the same work if the REIT was managed by its own employees.

Finally, a major consideration is whether purchasing a REIT is a wise decision for your investment portfolio. Ask yourself, “Does this investment align with my financial situation?”

You may want to consider the benefits offered by holding a well-diversified portfolio.  Diversification reduces the risks an investor faces because losses on one investment may be offset by gains on another. If a disproportionate percentage of your wealth is wrapped up in one type of asset and market for that asset crashes, then a significant portion of your wealth may be lost. A good example of this occurred in the 2008 Great Recession.  Many people had become too much of their wealth concentrated in real-estate, and when the market crashed, they lost nearly everything because most of their money was tied up in investments that were worth only a fraction of what was originally paid.

A typical, middle class investor’s home is likely a major percentage of her net worth. Purchasing shares of a REIT may concentrate more wealth into real-estate, which increases that investor’s exposure real estate market fluctuations.

And so, it is important to take a good look at your own financial situation, keeping in mind your risk tolerance, your investment timeline, and any other factor you feel is important when making your decision as to whether to invest in REITs.  Ultimately, if you decide a REIT is a company you would like to invest in, do your research and understand the REIT.

 

Resources

The following a list of resources that you may find helpful in doing your research. 

Posted by Eric Duhon on Friday, April 20, 2018.