Earlier this week I voiced some concerns that I have with the brokerage industry and their model of business. Within the same post I also pointed out that many dually registered advisors abuse their quasi-fiduciary status to charge an assets under management fee while also collecting commissions from product sales. Commission based compensation creates a fundamental conflict of interest to those offering advice. Are they offered unbiased financial advice or selling a product?

Non-traded REITs (Real Estate Investment Trusts) are a product no fee-only investment advisor would ever recommend their clients. However, brokers and dually registered advisors glady push these products due to the enormous commissions attached to them.

FINRA published one of their “Investor Alerts” about these things. They summarize non-traded REITs saying:

“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. Furthermore, the periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal.”

Let’s analyze FINRA’s warning about non-traded REITs:

“Non-traded REITs are generally illiquid, often for periods of eight years or more. Early redemption of shares is often very limited…”

This means you’re not going to be able to sell this thing no matter how badly you want to. If you bought the sales pitch you’re probably wondering, “Buy why would I want to?”. I’ll get to that. Bottom line here: the guy or girl who sold it to you dug your grave and buried you in it.

“Fees associated with the sale of these products can be high and erode total return”

Here’s a real life example of non-traded REIT fees in action courtesy of Ben Strubel (emphasis mine):

“A client owned a Wells Capital REIT that was so bad that Chief Investment Officer of Yale University, David Swenson used it in his book Unconventional Success: A Fundamental Approach to Personal Investment as an example of how bad public non-traded REITs are for investors. Wells charged investors these fees: sales commissions of 7%; dealer management fees of 2.5%; and offering expenses of 3%. That means, for every $100 my client had invested only $87.50 actually made it into the fund. Every investor lost 12.5% of their money, right off the bat! But the largesse didn’t stop there. To buy the actual property, Wells charged another 3% for “review and evaluation of potential real property acquisitions” and another .5% as reimbursement for acquisition expenses. Once Wells actually purchased the buildings, investors’ wallets were 16% lighter.”

I think that example speaks for itself. Hypothetically, let’s just say a non-traded REIT actually performs how it’s supposed to: you’re still going to be underperforming because of all those unnecessary fees. Investing should never be that expensive. Fees of that nature put investors into a hole performance is unlikely to dig them out of. Personally, I think fees of this magnitude are egregious, especially if your “advisor” is dually registered and already collecting a fee for assets under management.

“The periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal.”

Non-traded REITs have grown in popularity throughout the low interest rate environment of recent years. Tom and I actually talked about high interest rate annuities this week on the podcast (https://mullooly.net/high-interest-annuities-may-not-work-how-you-think-they-do/7866), and the message for yield seeking investors was the same there as it will be here: if it sounds too good to be true, it is. There’s always a catch. In this case, the distributions paid to investors often come from other investors buying into the REIT and/or money not generated from earnings. In other words: unstable sources of income. Which leads us to another point: non-traded REIT distributions (AKA the yield you signed up for) are not guaranteed. They can be suspended or canceled by the Board of Directors whenever they want, and guess what? Your investment is illiquid and you’re stuck in it. Even if you are allowed to sell, suspension or cancellation of the distribution will mean getting cents on the dollar for your initial investment.

On top of being illiquid and unstable many non-traded REITs are also nontransparent. You have no idea what kind of properties it will invest in. One of the things we like so much about ETFs here at Mullooly Asset is their transparency. More transparency in the financial industry is a good thing. It’s very important to know what you own.

Another point to consider is why non-traded REITs have to pay brokers so much money to sell their shares? With a good business plan wouldn’t they be able to get some other type of funding? The answer is yes. I’d like to take this moment to remind everybody of Josh Brown’s Law of Brokerage Product Compensation: “The higher the commission or selling concession a broker is paid to sell a product, the worse that product will be for his or her clients”. Since these REITs do not have a solid business plan, their alternative is to offer brokers a ton of money to push their idea on uninformed individual investors.

Which sort of brings us full circle here: why are brokers and dually registered advisors selling these products? The answer lies in the flawed nature of their business model. For somebody who wants yield, they’ve provided a “yield-based investment solution”, thus fulfilling their suitability standard. Anybody with a fiduciary duty to their clients would never recommend non-traded REITs. As Bob Veres said of non-traded REITs in a recent Financial Plannning article:

“How could anybody believe that this toxic combination adds up to a viable investment? Unless, of course, the promoter is stuffing money in your shirt pocket.”

The high commissions offered on products like non-traded REITs, variable annuities, and mutual fund A shares entice brokers who rely on commissions to sell them. That’s the way their business is structured. If somebody fully understands that they’re not getting advice but being sold to, and decides to do business with a broker that’s one thing. Too often people go to their “financial advisor” without knowing that their title is just another name for salesperson or broker. That person has no obligation to your best interests, but investors see the word “advisor” and believe they’re receiving advice. That’s also why I have a huge problem with dually registered advisors. People believe they’re getting unbiased advice from a fiduciary, but if the advisor is receiving a commission too couldn’t that have an impact on their recommendations?

This is just one of many reasons why we believe in the fee-only investment advisory model of business that we provide at Mullooly Asset Management. A fiduciary investment advisor is going to keep you away from investments like non-traded REITs, and it’s often not what you own but what you don’t own that drives results.

Sources:

http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/REITS/P124232

http://www.valuewalk.com/2014/01/public-non-traded-reits/

http://www.financial-planning.com/news/reits/veres-the-next-great-market-meltdown-2691397-1.html

http://www.amazon.com/Backstage-Wall-Street-Insider-2019s-Investments/dp/007178232X