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There are REITs, and then there are REITs. And some of the latter are the kind you will want to keep at arm's length. I'm referring to the non-traded kind of REIT. You may not have heard of non-traded REITs. I hadn't until recently, but when I did, alarm bells started going off.
REIT stands for real estate investment trust. It is a form of equity that allows investors to own shares in a group of real estate investments. A big draw for investors is that REITs must, by law, return at least 90% of their earnings (if any) to investors in the form of dividends.
That structure can make for some healthy dividends, such as Annaly Capital Management (NYSE: NLY ) , a government agency mortgage-bond-buying REIT that presently yields 14.4%; or Health Care REIT (NYSE: HCN ) , which develops health-care properties and has a yield of 5.3%; or Government Properties Income Trust (NYSE: GOV ) , which buys office space and yields 6.6%.
REITs like those list on a stock exchange and trade like any other equity. Their share prices go up and down with the vagaries of the market. They may make money (hooray!); they may lose money (darn!); but whether they gain or lose, the investor will always know their market values.
Not so with non-traded REITs. Those prices are set at their initial offerings, and that's pretty much where they stay. Non-traded REIT marketers tout that price stability as a great advantage for volatility-wary investors. The reality, however, is much different.
The problem is illiquidity. What if the non-traded REIT has no cash to buy back shares? A stable price means zilch if investors can't sell. Since the shares aren't listed on an exchange, you're out of luck there, too. I guess one could try eBay or Craigslist.
High dividend rates are another dubious selling point for non-traded REITs. When an investor considers total returns, those non-traded REIT dividends could just disappear. Upfront fees of 9%-10% -- sometimes as high as 17% -- can wipe out most of those dividend returns. Also, consider that of the 90 non-traded REITs approved by the SEC since 1990, only 13 have returned investors' capital.
There are also problems of transparency. Michael McTiernan, a lawyer with the SEC, told The Wall Street Journal, "We believe investors would benefit from more information how [non-traded REITs] reach their valuations." If they don't get that information, he said, "[The industry] ... should expect to hear from us."
And then there is the question of overaggressive marketing. The Financial Industry Regulatory Authority, or Finra, accused David Lerner Associates of misleading investors in its marketing of its non-traded Apple REIT.
The lure of high yields combined with low volatility has helped sales of non-traded REITs proliferate, with $73 billion worth in the last decade alone. But like anything that looks too good to be true, one should take several hard looks before jumping in. But I just can't find one good reason to buy into a non-traded REIT -- especially when there are plenty of traded ones to choose from.