“The Big Short”, Brad Pitt’s recent movie, tells the story of the recent financial crisis caused by the securitization of housing mortgages. The business practices of the financial
industry, which almost caused the world’s economy to crumble, remain in place today.
Securities lawyers, like myself, have routinely warned about the over-marketing of tech stocks,variable annuities, TIC private securities, and other financial products that proved damaging to retail customers.
In the May-June, 2008 edition of The Missouri Bar Journal, I published an article titled, “The Subprime Mess-A Primer to Assist Investors”. Another article, published on this website, warned investors of private securities. See Marketing Of Private Securities by Brokers Is a Persistent Problem Within The Brokerage Industry.
Similar red flags apply to the marketing of private REITs today.
The simple truth is that the financial services’ profit motive has caused the credit and housing bubble, the tech bubble, and other abuses. The financial industry continues to probe and search for weaknesses in the regulatory system. In so doing, consideration of the suitability of such investments for private investors falls by the wayside. The financial industry’s priority is in generating more fees and commissions. Retail investors’ ability to realize any gain is at best incidental.
What are private REITS? They are baskets of primarily commercial real estate that were not marketable to equity and/or hedge funds. They are assets of lessor quality that did not appeal to more sophisticated buyers. Private REITS are structured as private placement limited partnerships sold to retail customers. They are not publicly traded REITS which can be bought and sold on an exchange and can be quickly monetized.
It is common for advisors selling private REITs to receive a 6-7% commission. Additional fees and commissions charged by private REIT promoters can be 11-12% of the original investment. None of these fees and commissions, however, are disclosed in the investor’s account statement or the private REIT”s prospectus. If you carefully read the prospectus, however, most characterize the private REITs as speculative and warn that you might lose all of your investment.
In 2013 the sales of private REITs hit an annual high of $20 billion. In 2015 sales were less than $10 billion. During that time, government regulators began closely looking at this cottage industry and proposed reforms. The Financial Industry Regulatory Authority (FINRA) sanctioned some independent broker-dealers for not adequately supervising their brokers’ sale of private REITs. An initial draft of the new fiduciary rule promulgated by DOL applicable to retirement accounts held by brokerage houses would outlaw the selling of private REITS. The financial industry vigorously fought this rule proposal, forcing the DOL to retreat.
Following are some of the red flags of systemic abuses in the marketing of private REITs:
1. Commercial properties, packaged into private REITs, are marketed as conservative and safe income producing investments with better returns than other income producing investments. The opposite is true—they are speculative with little upside and much greater downside risk.
2. It is impossible to understand the quality of the properties inside a private REIT, because the properties and their financials are not disclosed. The investor must rely totally upon the representations of his/her advisor, who in turn relies exclusively on the firm that is doing the marketing. Your advisor is acting as little more than a salesman.
3. Private REITs are driven by fees and commissions. Any advisor that tells you that you are not paying any fees and that 100% of your investment is working for you is flatly false. If you invest $100 your investment is immediately worth about $85, notwithstanding what the marked-up price says. Try to sell your investment the next day and you will be unpleasantly surprised.
4. Private REITs are not publicly traded. They are illiquid. They can only be sold back to the promoters at their discretion at a steep discount. In addition, most private REITs have redemption penalties unless the investment has been held a certain period of time.
5. Conflicts of interest in promoting private REITs are not disclosed to retail customers. The promoters often have a financial agreement with your advisor, not disclosed to you.
6. It is likely that most of the commercial properties that end up in private REITs are properties that did not meet the underwriting requirements to be included in publicly REITs. The safest real estate never reach the market of retail customers. If the investments are truly attractive, hedge and/or equity funds quickly gobble them up leaving only the crumbs for retail customers.
7. The return from a private REIT can often be deceptive. The return can be return of principal or even money from new investors- a Ponzi scheme. It is unlikely you will get a straight answer from your advisor.
If your advisor is recommending a private REIT, consider asking a few obvious questions (before you reconsider continuing using the firm):
–> Why is the firm’s private REIT recommendation is a better investment than a publicly traded REIT?
–> What are the total fees and commissions?
–> How can I sell my private REIT?
Private REITs are unsuitable for most individuals. Financial advisors violate their fiduciary duty to customers in the selling of these financial products.