Dennis Boyle is a FINRA Arbitrator and member of the Public Investors Arbitration Bar Association (PIABA). He has been practicing securities law for more than twenty years.
Investing in real estate has a certain appeal to many people. The investment is, or at least appears to be, tangible—he investor can visit the shopping mall or condominium complex. The investor can participate in developing something, building buildings, or providing housing, all with an expectation of a reasonable return. But real estate investing is also an area ripe with fraud. It is often based on valuations that are subjective and earnings that are projections. These valuations and projections often prove to be wildly inaccurate. Construction costs, regulatory hurdles, management costs, and plethora of other expenses are often not stated or grossly underestimated.
Very few investors have the financial resources available to purchase an apartment building or commercial property, and those that do are frequently saddled with substantial debt. There is another option, however, the Real Estate Investment Trust (REIT). A REIT allows an investor to participate in real estate investment without purchasing property by going into debt. Instead, an investor can purchase shares or an ownership interest in a REIT and indirectly own the real estate in question and benefit from the profits generated by the real estate. Better yet, the REIT is professionally managed, alleviating the need for the investor to actively manage the investment. In some instances, the REIT will “guarantee” a rate of return, often marketed as a “minimum” return.
At least, that’s what the brochures say, and investment advisors or stockbrokers will often tout these investments as a way to diversify a portfolio. There can be advantages to REITs. In some instances, income earned by the REIT can be passed through to the investor without being taxed at the corporate or trust level. These tax benefits, however, are complex, and the investor should consult a CPA before investing to understand the tax implications of investing in a REIT. The reality is that REITs are often a poor investment, and as with other forms of real estate investment, fraud does exist. Before investing in a REIT, the investor needs to understand the pitfalls associated with investing in these financial products.
The Different Types of REITs.
A REIT is a security that is generally regulated by the SEC and FINRA. The REITs available to public investors and pushed by investment advisors and stockbrokers fall into two categories: publicly traded REITs and on-traded REITs. SEC regulations require both publicly traded and non-traded REITs to file financial disclosures with the SEC. These filings are available on the SEC’s EDGAR database and are available for the public to view. Every REIT is different with different governing documents, and each investment in a REIT must be individually scrutinized so that the investor understands the investment.
 There are also private REITs. These investment vehicles are not regulated by the SEC or traded on a national stock exchange. They are primarily sold to institutional or accredited investors. Like other REITs, private REITs can be used to defraud investors, and extreme caution and due diligence should be used with investing in private REITs.
Let’s look at the differences between publicly traded and non-traded REITs. Publicly traded REITs are traded on an exchange much like shares in any other company, and issues involving suitability, misrepresentation, negligence, and other violations of FINRA rules. They are not, strictly speaking, backed by real estate and are subject to market force, such as rising interest rates (which can increase operating costs), inflation, etc. In 2022, for example, the average value of publicly traded REITs fell by 22%.
Non-publicly traded REITs are worse. Although regulated by the SEC, they suffer from a variety of issues, and the investor should not be lulled into a false sense of security because non-publicly traded REITs are regulated by the SEC. Investing in non-publicly traded REITs are governed by the investment contract or agreement. Every investment agreement is different, but, in general, the dictate the timing for a withdrawal of an investment, have the investor waive rights to the greatest extent permitted by law, and limit damages, recovery, and the ability to sue the REIT in court. There are other issues as well, such as a lack of liquidity.
Frequently, the investment agreement for a non-publicly traded REIT will limit the ability of the investor to withdraw funds or sell the investor’s interest in the REIT. It may be that an investor cannot withdraw any of his or her investment from the REIT for years, and even then, only with the payment of substantial penalties. The investor is, for all practical purposes, stuck with the REIT, and, in many cases, the REIT will keep the investment even if there has been fraud or financial mismanagement. It doesn’t even matter if the investor suffers an emergency and needs the funds that were invested.
In addition to a lack of liquidity, it is also difficult to value a non-publicly traded REIT. The value of real estate is often subjective, and the anticipated profits are usually based upon projections. The absence of firm, reliable metrics means that the anticipated return may be based on little more than aggressive, or even false or fraudulent financial data.
In the matter of David A, Lerner Associates (DLA), the creators of the non-publicly traded Apple REIT valued the REIT at a constant over a period of years valuation despite performance declines, market fluctuations and increasing leverage. Throughout its existence, the REIT paid distributions of between seven and eight percent. This return, however, came from increased borrowing as well as the gradual return of the investor’s investment to the investor. Ultimately, FINRA determined that the valuation of this non-publicly traded REIT was far less than its reported value. FINRA ordered DLA to pay $2 million in fines and over $12 million in restitution.
In addition to problems with valuation, non-publicly traded REITs are often highly leveraged, meaning they carry substantial debt. Thus, although they may be making distributions to investors, at least initially, these distributions may be coming from accumulation of additional debt, or, they may simply be giving the investor a portion of his or her investment back. Often, the public investor is not aware of the leverage.
Another problem associated with non-publicly traded REITs is possible conflicts of interests that arise in the REITs operations and the fact that these conflicts of interests are frequently waived in the investment agreement. For example, a non-publicly traded REIT is typically run by a manager of some sort who contracts with a management company to actually run the day-to-day operations of the property owned by a REIT. The management company will typically take a percentage of monthly revenues, sometimes as much as 6%. The conflict of interest arises when the management company is owned by the same person or people who control the REIT. In essence, they may be siphoning off the profits the REIT would otherwise be earning and directing those profits to the management company they own. If the investment agreement provides for a waiver of conflicts of interests, however, there is little the investor can do.
The investor should also understand that there are no “guaranteed” returns—a frequent sales pitch used to sell the REIT. If a REIT is offering a guaranteed return, it is possible that this return is cannibalizing the equity in the investment. A REIT may or may not be profitable, depending on a wide variety of factors applicable to the REIT and its position in the market. Rising interest rates can increase the cost of borrowed money, squeezing profit margins. Occupancy rates may decline, reducing monthly operating revenue. Anyone wishing to invest in a non-publicly traded REIT, needs to understand the market in which the REIT operated and the market forces that can change the REIT’s profitability.
Why Do Stockbrokers and Investment Advisors Recommend Non-Publicly Traded REITs?
If investments in non-publicly traded REITs are so fraught with danger, why then would any broker or advisor sell them? In most cases, it does not appear to be for the benefit of the investor. The broker or advisor received a huge up-front commission, sometimes as high as 15%, and often times, the REIT will pay the broker or advisor an additional 5% of the investor’s value every year. These fees are extraordinary and make it difficult for the investment to ever become profitable.
Too often, unscrupulous or incompetent advisors of brokers will put their own financial interests over those of the investor he or she is supposed to be advising. In some cases, if an investor makes an investment of $10,000 in a non-publicly traded REIT, the advisor immediately makes a commission of $1,500 meaning that the next investment is only $8,500. If the advisor is receiving a six percent residual commission, it is nearly impossible for the investment to ever show a positive return regardless of how well it performs. Ultimately, the only people that benefit are the investment advisor and the REIT owners.
Again, this is not to say that all non-publicly traded REITs are bad or that all investment advisors of stockbrokers are fraudulent or corrupt. It is important to understand, however, that issues frequently arise with non-publicly traded REITs. A member of the investing public, however, must be careful before investing in these unique products.
Remedies Available to the Investor.
If a public investor had lost money through a non-publicly traded REIT (or even a publicly traded REIT in some circumstances), the investor may be able to recover the loss from the broker or advisor through the FINRA arbitration process. In many instances, the recommendation will violate the SEC’s Regulation Best Interest (BI).
In addition, broker-dealers engaged in the sale of non-publicly traded REITs are required to provide valuations of the REIT at least annually pursuant to FINRA Rule 2231 and FINRA Regulatory Notice 09-09. It is also important to note that often times, information provided to the investing public concerning non-publicly traded REITs is inaccurate or misleading, violating FINRA Rule 2210. Finally, in many cases, the recommendation of a non-publicly traded REIT will violate the suitability rule, FINRA Rule 2111.
At Boyle & Jasari, LLP, we represent members of the investing public who have lost money through fraud, corruption, and/or mismanagement in many types of investments, including REITs. If you or someone you know has suffered a loss from a REIT or other investment, please let us know. We may be able to recover some or all of the loss.