"Life is filigree work. What is written clearly is not worth much, it's the transparency that counts."
-Louis Ferdinand Celine
If you’ve ever read through a prospectus, you know that they are written by a team of financial professionals and attorneys and the document can be quite lengthy and very obtuse. The intention of the prospectus is to provide the potential investor with a description of the security for sale along with the fee structure and other pertinent information needed to make an informed decision. Unfortunately, too many investors over the last decade were not clearly informed nor were they provided with transparency on investments related to real estate which resulted in losses and many a headache.
There are many different investments related to real estate and some, if carefully studied and understood, can have a powerful impact on an investment portfolio. A Real Estate Investment Trust (REIT) is a company that buys and operates income-producing real estate. These companies have been around since the 1960s and enjoy tax advantages as long as they pay out 90% of their net earnings to shareholders. Publicly trades REITs have typically been a reliable staple of income-oriented individual investors. Then came the 2000s and financial engineering brought about a new kind of REIT.
Non-publicly-traded REITs (NPTRs) are, as the name implies, not publicly traded. If an investor were to have bought a NPTR there was no way to sell that position unless the sponsor agreed to buy the shares back. In general, no secondary market was provided, thus sticking the investor with a non-liquid asset. Brokers loved to sell this investment because they were paid a very high commission, typically 15%.
Up until this year, brokerage firms were allowed to show NPRT on their client’s statements at par value (purchase price) with no indication of the real value of the holding or of the up-front 15% commission cost which the investor lost on day one. Recent changes by FINRA now force brokers to post the true value of non-traded REITS on customers’ statements and provide more detailed information up front about the actual investment. This new rule will make NPRTs a tough sell going forward and hopefully they will disappear from the investment landscape. Deplorably, some companies are now trying to reengineer this illiquid segment in to a bright and shiny new investment touting, of course, huge potential returns.
The new product being offered is a closed end mutual fund that buys NPTRs at a discount from the original investors that are stuck with them. The original investor is happy because they were finally able to unload the investment they don’t want anymore and this company believes they are buying so cheap that they can generate big returns on eventual real estate appreciation. We view this as a very dangerous strategy for two reasons:
1) Many non-publicly-traded REIT shares were never worth anywhere near the original par value and were so leveraged that there is not much value left if the debt were to be paid off
2) Many non-traded REIT’s are still the subject of massive unresolved lawsuits from the original shareholders and this could continue for many years to come.
In short, a bad idea does not get better if you repackage it and call it something else.
The main goal of investing should be to purchase and own things that are valuable and will increase in value. Owning real estate and REITs can be vital to a successful portfolio, providing both diversification and income. It is paramount, however, to have a full understanding of the underlying asset, the fees involved and the extent of a secondary market for the investment. There is an old and useful adage in investing – Know what you own and own what you know.
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