You may be quite familiar with REITs, or real estate investment trusts, but there's a good chance you've never heard of "non-traded REITs." That's dangerous, though, because they could hurt you if you don't know enough about them.
Let's back up first and define our terms. A run-of-the-mill REIT is a company that invests in real estate, typically by owning lots of properties, but also sometimes by owning mortgages or mortgage-related securities. There are a wide variety of REITs, often focused on particular sectors, such as retail, apartments, offices, hotels, and medical properties. REITs must pay out at least 90% of their income in the form of dividends. Typical REITs trade on the markets as ordinary public stock does, and you can buy or sell your shares whenever the market is open.
A non-traded REIT, though, isn't present in the stock market. It's a real estate investment, but one that's far less liquid, meaning it's not as easy to get in and out of. It, too, is required to pay out at least 90% of its income in dividends, but it's quite different from its traditional REIT brethren in a variety of ways.
Pros and cons
A main advantage of investing in non-traded REITs is its dividend, which is often higher than those of regular, publicly traded REITs. Those selling non-traded REITs -- and they're often bought by people who succumbed to hard-sell pressure -- have been known to present them as wonderful, and low-risk. This is especially appealing to older investors, who are frequent buyers.
The drawbacks of non-traded REITs include steep front-end fees. These can amount to a whopping 15% of the original investment, with 6% to 7% sometimes going to the person who sold the shares. (Can you see now why a financial salesperson might be eager to sell you on these investments?) Imagine investing $10,000 in one and having to fork over $1,500 in fees from the outset! You'll immediately be down 15% and will have to earn a lot to just break even. Ugh.
Worse, shares are often locked up for eight years, and if you want to get your money out earlier and are able to, there are often hefty early redemption fees levied. Thus even if you were thinking you'd break even when selling, you might get socked with a big fee, giving you a net loss. Also undesirable is the fact that the shares, which are frequently sold at about $10 per stub, are often redeemed for less than that.
Can it get any worse than all that? Yup, it can. Sometimes the expected dividend payouts are reduced. A Bloomberg story from 2010 recounts the tale of a couple who spent $100,000 on a non-traded REIT only to have its dividend slashed by 70% five years later. By the time they wanted to sell, the company would no longer buy shares back at the original $10-per-share price, but at $6.85. The couple ended up with a $45,000 loss.
So many people have suffered with non-traded REITs that regulators have been looking closely at them. The Financial Industry Regulatory Authority has issued a lengthy warning about them, too, urging a "careful review" before investing. Among its many tips, it says, "Be wary of claims that a non-traded REIT 'is about to go public.' The public offering process is often lengthy and may never come to fruition; and if it does, the REIT may trade at a price that is lower than its current valuation." They're also referred to as non-volatile sometimes, which is sort of true only because they don't trade regularly on the open market.
Not every non-traded REIT is necessarily a terrible investment, but many have been, and many still are. Don't invest in one without doing a lot of research and asking a lot of questions, don't let anyone pressure you to invest in one, and remember that there are plenty of other ways to collect dividend income -- such as via regular, traded REITs and dividend-paying common stocks.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.