Amid the recent market fluctuations, non-traded real estate investment trusts have been popular among investors searching for yield and asset classes with low correlations to equities. In fact, non-traded REITs have raised about $10 billion in new money so far this year, the highest inflows seen since 2007, according to the Investment Program Association. But given the risks, the recent regulatory crackdowns on this investment and new efforts by lawyers to target them, non-traded REITs are raising red flags in the industry, and many are re-evaluating their exposure.

“It may be the best thing since sliced bread, but if I can’t sit down face-to-face with a client and explain the fees, how the investment works, it’s something I’m not comfortable doing,” said William Muller of Common Cents Planning Inc. in Glen Mills, Pa. Muller has decided not to use non-traded REITs in his practice altogether because of their illiquidity, lack of transparency, high fees and the way they’re valued. Recent FINRA scrutiny is also raising red flags for Muller.

Increased Scrutiny
In May, FINRA filed a complaint against independent broker/dealer David Lerner & Associates, claiming the firm failed to do adequate due diligence into “valuations and distribution irregularities” of Apple REIT Ten. Since then, the industry has become increasingly concerned about non-traded REITs in general.

FINRA is cracking down on this issue in other ways, working on a proposal to shorten the amount of time b/ds have to come up with estimated valuations for non-traded REITs. And most recently in October, FINRA issued an investor warning about non-traded REITs, saying that these investments can be heavily subsidized by borrowed funds, early redemption is often limited, and fees can be high. In fact, on Tuesday FINRA fined Wells Investment Securities $300,000, claiming the firm used misleading marketing materials in the sale of its Wells Timberland REIT, a non-traded REIT.

“Confronted with a volatile stock market and an extended period of low interest rates, many investors are looking for products that offer higher returns in turbulent times,” said Gerri Walsh, FINRA’s vice president for investor education, in a statement. “However, investors should be wary of sales pitches that might play up non-traded REITs' high yields and stability, while glossing over the lack of liquidity, fees and other risks.”

After the SEC went after private placements from Medical Capital and Provident Royalties, broker/dealers with exposure to them faced arbitrations and litigation from investors to whom they recommended the securities. Since then, many of these firms have imploded. No one wants to see the same thing happen with REITs, although there have been no allegations of fraud.

That said, lawyers are already starting to mobilize around non-traded REITs, including Andrew Stoltmann in Chicago. On his website, www.reitfraudrecovery.com, it says the firm are only suing the brokerage firms and banks with FAs who recommended the REITs, not the individual FAs themselves or the REIT sponsor.

Other law firms targeting broker/dealers who sold non-traded REITs include San Francisco-based Girard Gibbs, the firm that filed against David Lerner; Vernon Healy in Naples, Fla.; and Shepherd Smith Edwards & Kantas in Houston, Texas.

Broker/Dealers Cut Back
Broker/dealers and advisors who sell these products are often the first to be targeted by regulators and investors, and FINRA never goes after the sponsor, says Tony Chereso, president and CEO of FactRight. And no one wants to be the next David Lerner.

“If something goes wrong at the sponsor level or at the offering level, FINRA goes after the broker/dealer; investors go after the broker/dealer,” Chereso says. “The broker/dealer is caught between a rock and a hard spot.”

Chereso, who provides due diligence on alternative investments for b/ds and advisors, says the 18 broker/dealers he works with are looking closely at which non-traded REITs are on their platforms and evaluating which to get rid of. They’re also more closely vetting new programs, he says.

“What’s daunting for the broker/dealer community, and the reason we’re seeing some of them sort of pare back their portfolios, is they’re having a hard time really managing them once they put them on their platform,” Chereso says. “There’s a keener eye on vetting the new programs, especially in light of FINRA’s increased scrutiny and oversight.”

Mark Lamkin, a hybrid advisor who runs his brokerage business through LPL Financial, says LPL has removed 20 percent of the non-traded REITs on its platform, stepping up its due diligence on these products in the last year.

“It creates great litigation,” says Todd Pack, president of IBD Financial Advisers of America, of non-traded REITs. “It is one of the big shoes to drop.”

FAA has been very picky with the investment products it approves for the platform, rejecting 80 percent of the products it reviews. Pack says of all the REIT offerings out there on the market, he would only feel comfortable with five or six. “I think they have a place, but as an industry, we need to do a much better job vetting these things.”

Brian Kovack, president of Kovack Securities, says his firm is also very selective about which non-traded REITs it puts on the platform and has passed on certain REIT sponsors. Kovack says the investment has become much more of a potential issue than in the past, especially because it has become a crowded space. According to IPA, there are approximately 73 REITs in the market from 50 different sponsors. This is up from 38 REITs from 28 sponsors in 2008.

Risks
In addition to regulatory scrutiny, non-traded REITs have risks that are often not associated with the listed REIT structure.

Bryan Hopkins of Hopkins Wealth Management Group in Anaheim Hills, Calif., says now is a great time to buy commercial real estate, because of great capitalization rates and interest rates. But longer-term, he’s concerned that there’s so much capital that needs to be deployed by new REIT players. They’re sitting on a bunch of cash they’ve raised, and they’re all competing to buy the same buildings, which could put upward pressure on pricing, he adds.

Also, with small start-ups, those that have $1 million a month coming in, it will take at least a year until they have enough capital to buy a building, Hopkins says. “It’s going to be years before you provide investors any real diversification.”

Philip Martin, REIT strategist at Morningstar, believes publicly traded REITs, which are “listed” on the major exchanges, are more appropriate for investors looking to get real estate exposure because they are more shareholder-friendly. Non-traded REITs, he says, have many drawbacks and risks, such as costs and fees. Typically, non-listed REITs charge 7 to 10 percent to the brokers and affiliated b/d; fees to the affiliated advisor of 1 to 2 percent; asset management fees of 1 to 2 percent of gross real estate assets; acquisition and disposition fees of 1 to 3 percent of acquisition or sale price; and debt financing fees of about 1 percent. For every $1 invested, this leaves about 82 to 85 cents in net investment.

But Nethea Rhinehardt, director of financial services research at Fact Right, says REIT companies are actually lowering fees because of the increased scrutiny. Up-front loads probably aren’t going to budge, she says, but Fact Right does expect third quarter 2011 fees to come down incrementally on asset management or acquisition fees.

While they are SEC-registered, non-listed REITs don’t provide a lot of supplemental disclosures, such as quarterly conference calls and property tours, as listed REITs do, Martin says. Also, because they’re not listed on an exchange, non-listed REITs are illiquid, he adds.

Because they’re not traded, they don’t mark to market on a daily basis, and net asset value is determined very infrequently, Martin says. So the REIT’s pricing often doesn’t reflect the wild market swings. “It would be naive to think, however, that underlying non-listed REIT portfolios and business models are not affected, both positively and negatively, by many of the same factors that contribute to stock market volatility.”

Another risk involves how non-traded REITs pay out distributions, something we covered in September. REIT sponsors are taking a big bet that they can generate a 6.5 percent or 7 percent return, since they only have 85 cents of the investor’s dollar to work with, says Chereso. FAA’s Pack says when some REITs first start out, a large percentage of their distributions are paid out as return of capital.

“If they’re not buying assets that are going to be able to effectively cover the distributions, what they’re doing is paying distributions without earning proceeds from the investment and essentially, what’s happening is the next investor is paying the previous investor’s dividends,” Chereso says.

One Bad Apple?
But some say the bad apples, such as Lerner, have painted a bad picture of the entire non-traded REIT industry, and inappropriately so. The Lerner headlines caused a significant amount of anxiety, and regulators responded, says Kevin Hogan, executive director of the IPA. Hogan says non-traded REITs just need to be better understood by FAs and investors, especially in terms of their fee structure and valuation. “Are they for every investor? No.”

“I think that what’s happening is that there is an overreaction on the regulatory side to some of the things that have happened in the non-traded REIT space,” Chereso says. “Instead of sort of dissecting what the core issues were that resulted in some of these Apple REIT issues, instead figuring out the appropriate ways of addressing them, they are taking some shotgun approaches to the industry.”

But some REIT sponsors are trying to address industry concerns, offering more transparency and liquidity. For example, according to an SEC filing, Cole Real Estate Investments, plans to launch a new non-traded REIT that would eliminate upfront commissions, charge an asset-based fee, and offer daily NAV and daily liquidity. Clarion Partners and American Realty Capital have already launched non-traded REITs that offer daily NAV.

“There are good actors and bad actors,” says Jeff Holland, executive vice president and head of capital markets at Cole. “Bad actors lead to the entire industry being tarred with the same brush, and that’s frustrating for us.”