What are non-traded REITs?

Non-traded REITs are in the headlines as brokers push them for their high yields, and FINRA investigates the investments for their robust claims. Here's what you need to know about non-traded REITs before you consider an investment.

Non-traded REITs 101

Much can be made of these investments from their name. A REIT is a Real Estate Investment Trust, or a type of investment vehicle which buys and holds real estate – commercial or residential – for rental income and appreciation. A REIT is a tax-advantaged entity which is required by law to pay out 90% of its earnings in the form of distributions, or dividends.

Investors like REITs for their high yields (virtually all income is returned in monthly, semi-annually, or annual payouts) and consistency. However, non-traded REITs differ from most REITs in that they are not listed on a public exchange like the NYSE or NASDAQ marketplace. Non-traded REITs are instead sold on an illiquid secondary market between individual brokers, meaning they can be much more difficult to buy or sell.

Why non-traded REITs are in the news

Because non-traded REITs are not listed on the stock market and outside the scope of most institutional and professional investors, they can operate very differently (often aggressively) than public REITs which are under the spotlight of investors around the country.

Non-traded REITs are known for:

1. Using far more leverage to make investments: Whereas a publicly-traded REIT might use 50% owner's equity and 50% debt to buy property, non-traded REITs are known to leverage with much higher ratios, meaning any drop in real estate prices or cash flows from rent is magnified for the investor.
2. Returning capital in distributions: One of the hottest marketing gimmicks is high yields. Non-traded REITs could advertise high annual yields by returning an investor's principle back with each distribution. Investors and advisors alike are fooled into believing that distributions are gains, and over time all the equity of the REIT is drained, leaving the investor with nothing but the cash returned in the past and already spent.
3. Borrowing for distributions: Non-traded REITs often used leverage in order to pay out larger distributions. This not only increases the risk in owning the REIT as equity is replaced with debt (think about this like constantly refinancing your mortgage for spending money) but it also reduces the amount of money the investor has working for them in the trust.
4. Poor information and limited prospectuses: Information is everything when it comes to making a sound investment. Non-traded REITs often disclose little to no information to private investors compared to the public filings required of publicly-listed REITs. Also, unlike publicly-listed REITs, there exists only a very small pool of investors to do collective due dilligence on their investment.
5. Difficulty in selling: By their very nature, non-traded REITs can be difficult or costly to sell as they are sold over the counter between brokers, not on any major exchange. Selling a position could take weeks or months, require the payment of a large commission to a broker, or force the seller into significantly discounting his or her investment in order to make the sale.
6. Higher returns than public REITs: Sophisticated investors with a background in finance or accounting can find higher returns in non-traded REITs as limited information and illiquidity gives opportunity for “diamond in the rough” finds. Of course, for investors with little to no investing experience, non-traded REITs were used to find investment dollars for projects and real estate portfolios that would never attract the attention of professional investors.

Should you invest in a non-traded REIT?

99% of investors would be wise to avoid non-traded REITs entirely. Not only are there plenty of high-yielding public REITs on the market, they are also more liquid, more transparent, and more diversified than a non-traded REIT.

If you are interested in investing in a non-traded REIT be sure to know:

• What's in the deal for your broker. Non-traded REITs can generate large commissions for brokers who sell units to clients.
• The financial reports for the company as well as a background of company management. This should be in any prospectus.
• Proof of ownership of each property and some familiarity with the property in question. Just as you wouldn't throw a dart at classified ads to buy a rental property, you shouldn't invest in a non-traded REIT without knowing what it owns, either.
• An understanding of the risks in investing in an illiquid REIT that may or may not provide any returns for investors. Non-traded REITs are substantially more risky than public REITs as a whole.

If you're a banker or accountant by day, a non-traded REIT may be an interesting entrepreneurial investment. If you can't claim finance or accounting as your favorite past times, a non-traded REIT should be dumped for investments that are more easily understood and better investigated. Publicly-traded REITs should be the first place to start for alternatives.