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Stock market volatility and low interest rates these days have caused more than a few investors to contemplate alternative investments, and one possibility is the Real Estate Investment Trust (REIT).
Concern over the clarity of these investments has led the Office of Investor Education and Advocacy of the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) to issue alerts recently explaining the ins-and-outs of REITS, especially those REITS that are not publicly traded. Investors need to take care with these kinds of products and make sure they are well informed.
According to an investor bulletin issued by the SEC in December, REITs were established by Congress in 1960 to allow individuals to invest in income-producing real estate of a scale beyond the reach of ordinary investors. They provide a way for individuals to share in the income produced through commercial real estate ownership without actually having to pony up the millions required to buy it. In fact, the typical investment in a non-publicly traded REIT is $1,000 to $2,500.
Typically, a REIT owns and operates income-producing real estate or real estate-related assets. These assets may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities and warehouses, as well as mortgages and loans. REITs often specialize in a single type of real estate such apartment communities, and retail, office or industrial space.
REITs differ from other real estate companies in that they typically must acquire and develop real estate properties and operate them as part of their own investment portfolio. They usually do not resell the properties after they have been developed.
To qualify as a REIT, most of a company’s assets and income must be connected to real estate investment and the company must annually distribute at least 90 percent of its taxable income to shareholders as dividends.
The REIT may then deduct the dividends it pays out to shareholders from its corporate taxable income. Because of this, most REITs pay out all of their taxable income to their shareholders and pay no corporate tax.
Other qualifications for a REIT include that the entity: would be taxed as a corporation if not for its REIT status; is managed by a board of directors or trustees; has shares that are fully transferable; has at least 100 shareholders after its first year; has no more than 50 percent of its shares held by five or fewer individuals during the last half of the tax year; and derives at least 75 percent of its gross income from real estate related sources.
According to the SEC alert, there are three categories of REITs: equity, mortgage, and hybrid, the most common being equity. These REITs typically own and operate income-producing real estate.
Mortgage REITs provide capital to real estate owners and operators as mortgages or other types of real estate loans. They can also provide funds indirectly through the purchase of mortgage-backed securities. These REITs are generally more highly leveraged than their equity counterparts. Moreover, mortgage REITs often use derivatives and other hedging techniques to manage interest rate and credit risk. These strategies come with risks of their own, and the SEC cautions investors to work to fully understand these risks before investing in a mortgage REIT.
One thing that has made REITs attractive is their exemption from rules that govern investment companies like mutual funds. The exemption generally applies to companies that have most of their assets in real estate. The SEC said in its alert that it is reviewing whether certain kinds of mortgage REITs should continue to be exempt from these regulations that limit how much a fund can be leveraged, as well as the fees that investors can be required to pay.
Hybrid REITs use the investment strategies of both equity REITs and mortgage REITs.
The three categories of REITs also break down into two broad types: those that are registered with the SEC and publicly traded on a stock exchange and those that are not. The former are known as publicly traded REITs.
The other type – commonly called non-traded REITs -- are registered with the SEC, but are not publicly traded. They may also be called non-exchange traded REITs.
An investor alert issued by FINRA in October noted that turbulence in the stock market and persistent low interest rates have made investors seek products offering attractive yields, including non-traded REITs.
While the two-types have much in common, investors would be well advised to know the key ways in which they differ, FINRA said. Most significantly, shares of non-traded REITs do not trade on a national securities exchange and are generally illiquid, often for several years.
The possibility of early redemption of shares is often severely restricted in a non-traded REIT, and the fees and commissions paid by investors can be high, eroding total return. In addition, the attractive high yields periodically distributed by these REITs might be heavily subsidized by borrowed funds and include a return of investor principal, unlike a corporate dividend, which is typically derived solely from earnings.
FINRA urged investors considering non-traded REITs to be prepared to ask questions about the benefits, risks, features and fees.
The SEC’s alert also cautioned investors to know what they are getting with a non-traded REIT. They are illiquid investments, the SEC said, and cannot usually be sold on the open market, so that investors who need to sell to raise money quickly cannot turn to their non-traded REIT. Moreover, redemption programs are typically limited and can be discontinued at the company’s discretion.
Returns on capital may also be a long time coming. The company may have to list the shares on an exchange or liquidate the company’s assets, and the timing is at its discretion. An event like this may not occur until more than 10 years after the investment is made.
The SEC also noted difficulty in valuing the shares of non-traded REITs. No market price is available and these REITs do not typically provide an estimate of their value per share until 18 months after the offering closes. This could be years after early investors bought in. As a result, the value -- and the volatility -- of a non-traded REIT may be impossible to asses for years.
Significant up-front fees are another area of concern. Non-traded REITs are typically sold by financial advisers and often have steep upfront fees that lower the value of the investment. Sales commissions of 9 percent to 10 percent are common. Investors should be well aware that a portion of the share purchase price is a commission, and that the amount actually invested is therefore reduced.
The SEC alert also notes that though investors may be attracted by the relatively high dividend yields of non-traded REITs compared to publicly traded REITs, they need to consider the total return -- capital appreciation plus dividends – rather than focusing on the high dividends.
Also, unlike publicly traded REITs, non-traded REITs frequently pay distributions beyond the funds generated by operations. This means they might use proceeds from share offerings and borrowed money, something publicly traded REITs generally do not do. This practice reduces the value of the shares and reduces the cash available to the company to purchase additional assets. Investors need to assess how much of the distributions of a REIT have been paid from sources other operating funds.
Investors must also bear in mind that non-traded REITs usually do not have their own employees and are externally managed by contract. The external manager might collect fees for activities not aligned with the interests of shareholders, such as fees based on the number of acquisitions or assets under management, with no regard as to whether the property or asset acquired has the prospect for a good long-term return. The external manager may also manage other companies competing directly with the REIT.
Given all the areas of concern noted above, investors should assess their own financial situation, consult their financial adviser and thoroughly research REITs before making any decisions. Disclosure filings of REITs, including annual and quarterly reports and any offering prospectus, can be reviewed at www.sec.gov.
Shares in publicly traded REITs can be purchased through a broker. Usually investors can purchase common stock, preferred stock or debt securities of a publicly traded REIT. Non-traded REITs are handled by brokers engaged to participate in the offering. There are also REIT mutual funds, both indexed and actively managed.
The SEC shared a final word of caution about tax consequence. Shareholders of REITs must pay taxes on the dividends they receive and on any capital gains associated with their investment. Moreover, REIT dividends are usually treated as ordinary income and are not entitled to the reduced tax rates that apply to other kinds of corporate dividends. This is why investors often prefer to invest in REITs inside a tax-deferred account like a retirement account. Also, a REIT is not a pass-through entity, meaning that its tax losses are not passed through to investors, as they are with a partnership.
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