(In the first installment we looked at direct ownership, small partnerships and limited partnerships. The final two Shades are versions of real estate investment trusts, commonly referred to as REITs.)

REITs pool the capital of numerous investors to make investments in income-producing commercial real estate in which the individual investor might not otherwise be able to invest. REITs own and may manage properties such as retail, industrial, multifamily housing, office, hospitality, healthcare, storage and others.

Most REITs meet IRS requirements to gain “qualified REIT” status. Qualified REITs can deduct distributions paid to shareholders from their corporate taxable income, avoiding double taxation at the corporate and shareholder level; only the shareholder must pay taxes on that distributed income (and even the shareholder can avoid paying taxes on the income if the REIT is held in an IRA or other tax-deferred account). The REIT must also distribute at least 90% of its taxable income to shareholders annually, making REITs a popular income investment. REITs also offer the potential for long-term growth through property value appreciation.

Non-traded REITs (NTRs) – NTRs are similar to other REITs in that they are subject to the same IRS requirements, are registered with the Securities and Exchange Commission and are required to make regular publicly-available SEC disclosures. The major difference is that NTRs are not traded on a national securities exchange and their price is determined through periodic valuations rather than by the market. NTR’s generally provide limited opportunity for shareholders to sell their shares and usually have a five- to seven year lifespan, after which they will either become exchange-traded or sell all the properties and distribute the proceeds to shareholders.

Since NTRs are valued through real estate methodologies including initial cost, comparable sales, cash flow and replacement cost, they are somewhat insulated from market sentiment that can influence prices dramatically in the short term. Because of the limited ability to sell shares, NTRs are only appropriate for investors who anticipative owning them for the NTR’s entire life. Because NTRs are typically sold to investors through brokerage networks, they may be able to raise capital more consistently than other REITS that may struggle to raise capital when the real estate sector is out of favor. And the absence of short-term speculators may allow NTR managers to focus on long-term returns rather than quarterly earnings and investor expectations.

NTRs are not without their problems, though, and were the subject of an Investor Alert from FINRA (the self-regulatory body for brokers) in April, 2016. FINRA warns that private-placement REITs, which are not registered with the SEC and not subject to disclosure requirements, can be confused with NTRs. FINRA is also concerned that the selling points for NTRs (diversification, opportunity for capital appreciation, robust distributions) may cause investors to overlook the complexities and risks of NTRs, including:
• Distributions are not guaranteed, may exceed operating cash flow and may be suspended or halted altogether. Distributions may also come from investor capital or borrowed money rather than income generated by the real estate.
• Lack of a public trading market makes early redemption restrictive and expensive. Most NTRs have required holding periods and limit redemptions to 3% to 5% of outstanding shares in any given year. Frustrated NTR investors may be solicited to sell their shares outside of the NTR’s redemption program, but these solicitations are usually not subject to SEC protections and are at prices well below the NTR value.
• Most NTRs start out as “blind pools” so the properties to be acquired may not be fully specified. Owning just one NTR can limit property diversification.
• Because NTRs often rely on liquidation to return investor capital, this return of capital may be more or less than the original investment depending on the value of the assets.
The biggest concern regarding NTRs is the potentially high fees. NTRs are sold by brokers, and selling compensation and expenses often approach the limit of 10%. This compensation creates a conflict of interest between the selling brokers and the best interests of the investor. Additional costs, sometimes referred to as “issuer costs”, can boost the total fees up to the state regulatory limit of 15%. These costs reduce the capital that is available for actual real estate investment, and this step back must be made up before the investor sees a real return.

The increased scrutiny has had an effect on the NTR market, with sales of $19.6 billion in 2013 falling to an estimated $5 billion in 2016.

Exchange-traded REITs (ETRs) – ETRs trade on a national securities exchange and share many of the advantages and disadvantages of NTRs, with some significant differences. While ETR’s are initially sold to the public through an initial offering, the front-end fees are usually no more than 7% of the offering price. Investors who subsequently buy ETRs on the open market simply pay a brokerage commission similar to any other stock transaction.

The disadvantage of ETRs is the flip side of their big advantage – their listing on a securities exchange and the ability to easily buy or sell. While ETRs often trade at a slight premium to their underlying value because of their liquidity, the public markets can become overheated and prices can artificially jump. By the same token, if ETRs fall out of favor, prices can artificially fall and an investor who must sell may not realize true value. This trading capability also enables short-term trading and speculation, which is contrary to the fundamental advantages of all REITs. Having market prices constantly available subjects ETR investors to the fear and greed that can cause anxiety and lead to bad decisions.

The FINRA Investor Alert encourages investors to understand the risks of real estate in general, the types of properties the REIT holds and the strategies the REIT uses, such as their borrowing policies. Sales pitches highlight the simplistic reasons for buying REITs, such as high yields and stability, while glossing over the lack of liquidity, market risks and fees. Always review the initial prospectus and, for NTRs, be clear on how long your investment will be locked up and how any redemption program works. Most of all, be aware of all fess and incentives for the person recommending the REIT in the first place.

Real estate can be a positive addition to a portfolio but all these approaches have significant pros and cons. Direct investment requires the most effort but also the highest level of control. Small partnerships support more direct investment but add the complexities of close working relationships. Limited partnerships are more opaque and are a vehicle to invest in larger real estate projects.

As for REITs, buy ETRs for the long term, look past daily market activity and avoid any short term speculation. NTRs are easy – never buy one.