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Understanding REIT Risks

Samuels Yoelin Kantor LLP

By Robert Banks, Investor Rights Lawyer

Non-traded REIT (Real Estate Investment Trust) sales are once again in the news. The Financial Industry Regulatory Authority (FINRA) filed an enforcement case against David Lerner & Associates for selling Apple REITs to seniors without disclosing the risks of the investment. Several private class action lawsuits have been filed over the misrepresentation of the Apple REITs. A Cole REIT was in the news when a government pension fund demanded and received a return of its investment because it was too risky for retirement money. Other investors have raised concerns about Wells REITs. Seniors in particular are becoming increasingly worried about their REIT investments when they consider getting out of the volatile real estate market, only to discover that they cannot sell them. Yet other REIT owners say they are satisfied with the returns that their REIT investments have regularly paid. So, what is the story behind REITs? Are they good or bad?

How REITS Find Their Way Into Investment Portfolios

Most REIT owners invest on the recommendation of an investment advisor who touts the fact that REITs allow common investors who don’t have the resources to purchase apartment complexes, shopping centers and hotels to make commercial real estate investments nonetheless. If an advisor recommends a REIT or any other investment, they must believe that it is a suitable investment for your individual risk tolerance, and they must tell you all important facts about the investment, both good and bad. Advisors selling non-traded REITs often tell their clients that the returns are typically above 6% and are reliable to boot. Investors are told that they are safe and offer protection and shelter from the risks of the stock market. But is that really true? What is missing from that story?

REIT Disadvantages

If you purchased a non-traded REIT (one not easily sold on the open market) there is a good chance that you were not told about the downsides of the investment. A significant problem relates to the extraordinarily high fees. The advisor who sold you a REIT may not have mentioned that he or she may have earned a 10% commission from your investment. Consider how long it took the advisor to sell you that REIT, and divide a 10% commission by the time it took to sell you the investment, and you will begin to understand why your advisor recommended it. A 30 minute sales pitch to sell a $100,000 investment yields a commission rate of $20,000 per hour for your advisor and his/her firm! That just may explain why your advisor recommended that REIT over a real estate mutual fund.

In addition commissions, REITs are loaded with other fees. There are typically charges for leasing, managing and acquiring the commercial buildings. Oftentimes there are built in conflicts of interest, with the promoters and principals of the REITS also owning the management, leasing, and acquisition firms. When it is all said and done, the fees can eat up 15% or more of the amount of your investment. In other words, your investment would have to earn 16% for you to realize a 1% return. Oh, you wanted 7%? Then, your investment needs to generate a gross return of 22%. How likely is that in today’ economy?

Yet, many of these REITs have paid investors what seem to be handsome returns of 6-7% or more, and consistently for several years. So, why is that so bad? Here is the problem: If the source of the dividends you receive is simply the uninvested money that the investors paid into the fund, and not revenues generated from real estate owned by the trust, it is a false return. In that case, which reportedly happens frequently, the trust is just paying back part of the money you invested. Every time investor funds are used to pay dividend, the underlying value of the investment goes down by more than the dividends distributed, once the costs of distribution is considered. You think you are winning, but you are actually losing.

Another problem with these REITs is that you never know the true value of the investment. Unlike an open end mutual fund or stock, which is priced and can be sold on the open market every day, non-traded REITs are rarely valued. REITs have been notorious for using outdated values. They continue to report the value as the purchase price, regardless of whether the value of the REIT’s property has decreased. “One common sales tactic we object to is the suggestion that they are eliminating volatility simply because they don’t tell you what the value is,” said Michael McTiernan, a lawyer for the S.E.C.’s corporate finance division. “It’s not that it’s not volatile. It’s just that you don’t know.”1 That is changing now that FINRA and the SEC have begun to scrutinize these funds. New rules will require a new value to be assigned every 18 months, but that is small comfort to investors who are trying to evaluate the worth of their investment this year.

That leads us to the third problem of non-traded REITs, which is that you cannot sell them even if you can determine their worth. Investors have reported to us that their financial advisors often do disclose that these cannot be sold at will, but misrepresent when the can be sold. Most REITs have a life of about seven years, and investors are locked in for the duration of the REIT. There is no opportunity to reposition your investment, or to liquidate it if you need cash.

What Rights Do REIT Owners Have?

If you purchased your REIT from a financial advisor, they are required to tell you the full story about REITs before you invest. And, they cannot offer the investment if the level of risk is of your REIT is greater than you are willing to accept. That is why FINRA filed its enforcement action in May over the Apple REITs against the brokerage firm David Lerner & Associates. The advisors did not tell their investor clients that there were big risks associated with the Apple REIT investments, such as the ones described above. And, that is why the pension fund that was invested in a Cole REIT got its money back.

If you have concerns about your REIT investment, you should speak with an attorney who understand the complexities of the securities laws. They can tell you what the risks are in your particular REIT, and then evaluate with you whether the risks were adequately disclosed. For more than a decade, Banks Law Office has evaluated REIT purchases for our clients.

Class Action or Individual Claim?

Some investors have filed class action lawsuits in court to recover their REIT investments. We caution all investors to carefully evaluate their options before joining one of those cases. In my experience of representing investors for nearly 30 years, individuals with strong claims are almost always better off filing an individual claim rather than participating in a class action. As a class action plaintiff, you have no control over your case. There are no claims that are specific to you, and you have little or no say in whether a settlement offer will be accepted. Most often, you will not participate at all in a class action case. It is run by the lawyers and you won’t know anything about the case until you learn that the case has been dismissed or a settlement was reached. (Class action cases almost never go to trial.) In an individual case, you and your lawyer work together, and the case is about you and your losses. The case is filed where you reside, and you are directly involved in all aspects of the case. The only time that investors are better off in a class action than an individual claim is where the amount of the investment is small, which we define as under $75,000. We urge investors, whether they be individuals, pension funds or other retirement funds, to consult with an attorney and consider your options before concluding that your rights will be adequately protected by a class action lawsuit. I am available to discuss on a confidential basis those options with any REIT investor, including reviewing your REIT paperwork. The Banks Law Office does not charge for our time spent evaluating REIT claims.

1From The New York Times, July 19, 2011 “A Closer and Skeptical Look at Non-Traded REITs” by Terry Pristin.

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