Real Estate Investment Trusts (“REITs”) are common income generating investments bought by individual retail investors. REITs are defined as a company or investment trust that retains diverse portfolios of real estate assets.
A REIT both owns and operates real estate with 90% of the generated income paid out to its shareholders as dividends. They are popular as they are designed to provide a steady payout of dividends which investors are attracted to when interest rates are low.
Risks Associated with REITs
- Non-Traded REITs are not publicly traded investments. Because these REITs aren’t traded on any public exchange (such as the NASDAQ) it can be very difficult for investors to find out current information as well as prices.
- Non-traded REITs are generally “illiquid” making it very hard for investors to sell.
- Publicly traded REITs, those that are traded on an exchange, are subject to losing value when interest rates rise.
How REITs Operate
Since REITs are required to pay returns of at least 90% of their taxable income out to their shareholders, they generally pay out a higher yield as compared to other market alternatives. This makes them particularly attractive when interest rates are low.
While some REITs focus on a particular real estate sector, others invest in more diverse holdings. REITs are allowed to invest in many different types of real estate including:
- Residential apartment complexes
- Healthcare buildings
- Hotels and resorts
- Commercial office buildings
- Self-storage buildings
- Shopping centers and malls
REITs provide the investor an opportunity to earn dividend-based real estate income while not having to buy the actual underlying property. They are popular because the investor can participate in real estate opportunities without the headaches associated with being a property owner.
If a REIT has a proven and experienced management team, a good track record, and owns desirable properties, it can be a successful investment. But, there are many pitfalls and risks to investing in REITs that investors should be informed about before buying any REIT.
Risks of Non-Traded REITs
Non-Traded REITS, also known as non-exchange traded REITs, do not trade on a stock exchange. Because of this, there are special risks associated with them.
Because they are not listed on any exchange, investors are generally unable to perform research on these REITs. Significantly, it’s very difficult to determine the true price or value of the REIT’s. Its also hard to find out what assets the REIT holds at any given time.
Lack of Liquidity
When an investment is “illiquid” this means that there may not be buyers available when an investor wants to sell their REIT. Also, often the investor is prohibited from selling the REIT for a period seven years. While some REITs will all investors to redeem a small portion of their investment after one year, there is usually a cost to doing so.
The way that a REIT operates is that it has to pool the investor’s money to buy and manage properties. Sometimes, if there is not enough income generated from the property, the REIT may end up paying out dividends from other investors’ money. When this happens, this can limit the cash available to the REIT and reduce its value.
The upfront fees in a REIT can be staggering. Many can charge an upfront fee of between 9% and 10%. The fees can even run as high as 15%.Non-traded REITs can also charge external management fees. Such payments to an external manager can impact investor returns. Front-end fees generally come in two parts:
1. Selling compensation and expenses, which is not allowed to comprise more than 10 percent of the investment amount; and
2. Additional offering and organizational costs, which are sometimes referred to as “issuer costs.”
According to various state regulatory guidelines, the total for both of these types of fees cannot exceed 15 percent. FINRA has its own guidelines for member firms that limit the total for both types of fees to 15 percent.
Such fees can easily add up, reducing the amount of capital available for investment. For example, an investor pays a 15 percent front-end fee on a $10,000 investment, only $8,500 is being put to work. By comparison, the underwriting compensation associated with exchange-traded REITs is generally just seven percent.
Publicly Traded REIT Risks
Publicly traded REITs are considered safer than non-exchange traded REITs, but they still have risks.
Interest Rate Risk
Rising interest rates pose the biggest risk to REITs by reducing the demand. When interest rates are rising, investors typically flock to safer income-producing investments such as U.S. Treasuries pay a fixed rate and are government-guaranteed. Treasuries offer the investor a safe, guaranteed income. Also, investors commit their capital to other types of bonds as well when interest rates rise.
Bad Market timing
Real estate trends are fickle, so investors should research the underlying properties or real estate holdings within the REIT.
A good example of this during COVID is that suburban malls were declining in popularity. Thus, today’s investors may not choose to invest in a REIT-owning suburban malls. Because of the recent influx of young people with disposable income into more urban areas, REITs owning urban shopping centers might be a better idea.
The tax treatment of a REIT might be a significant issue for some investors. REIT dividends are usually taxed as ordinary income –which is the same tax rate as an investor’s income tax rate. This rate is likely higher than individual taxpayers would pay on dividend income or capital gains. However, things might change with the new Presidential administration.
When choosing to invest in a REIT, it’s important to look for ones which have solid management teams, hold quality properties that follow current market trends, and are traded publicly. If you are concerned about taxes, you should consult with an accountant.
FINRA requires brokers selling Non-Traded REITs to make certain disclosures. These disclosures require a valuation of the REIT. This can be done according to two methods:
1. Net Investment Methodology. The firm must disclose whether part of the distribution from the REIT includes a return of capital, reducing the estimated per share value which is shown on the investor’s account statement. This investment methodology can only be used until 150 days following the second anniversary of breaking escrow in the public offering. Thereafter, the firm must use the appraised value methodology.
2. Appraised Value Methodology. This valuation method can be used at any time and is comprised of the appraised valuation disclosed in the issuer’s most recent periodic or current report filed with the SEC. FINRA’s rule requires that the per share estimated value disclosed in the REIT’s most recent periodic or current report be based on a valuation of the assets and liabilities of the REIT, and that this valuation be performed at least annually; be conducted by, or with the material assistance or confirmation of, a third-party valuation expert or service; and be derived from a methodology that conforms to standard industry practice.
Additionally, firms that sell non-traded REITs must disclose key aspects of the REIT including:
- The securities are not listed on a securities exchange;
- The securities are generally illiquid; and
- Even if a customer is able to sell the securities, the price received may be less than the value provided in the investor’s account statement.
Brokerage firms have been fined for improperly selling non-traded REITs.
If you or a loved one have suffered losses from your REIT investment, or are stuck in a non-traded REIT, you may have the legal right to recover your investment losses. Our REIT fraud lawyers are here to help you evaluate your claim .
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If you or your loved one has suffered investment losses as a result of investment fraud or broker negligence, contact the offices of Investment Fraud lawyer Melanie Cherdack for a free consultation. Because she has been in the trenches as a former Wall Street attorney, Melanie Cherdack and her team of experienced attorneys have seen just about every type of investment fraud or investment scam. While almost every investment carries a degree of uncertainty and risk, you may have been unnecessarily exposed to such risk. Former Wall Street securities attorney Melanie S. Cherdack and her team of lawyers represent individual and institutional investors who are unwitting victims of investment fraud and broker negligence. She heads up a group of attorneys who represent investors across the United States and the Americas. Contact us by filling out our online contact form, or calling 844-635-1609.