Bates Research - 01-03-14
FINRA and Non-Traded REITs
Guest Post by Expert Terry Long
FINRA is in the process of rolling out new regulations which will govern non-traded REITs, one of the fastest growing investment vehicles in the last few years for retail investors. REITs attract investors looking for yield, which in some products can run 7% or higher - but the real advantage is that these products qualify for a 1031 "like kind" exchange, allowing retail investors to sell real property and re-invest the proceeds without incurring capital gains on the transaction (for more detailed information on REITs please see our white paper on the topic).
While an argument can be made that investors are confusing an investment decision with a tax decision, REITs have nevertheless continued to be marketed at an ever-increasing pace to an audience of investors that, some argue, lack the necessary sophistication to properly evaluate and/or understand the product prior to making an investment.
In response to this perception, FINRA has proposed changes to non-traded REITs' valuation and reporting practices. These changes are currently awaiting adoption by the SEC. FINRA had previously issued an Investor Alert on the issue of non-traded REITs, and the most recent proposed rule changes are the result of a two year review.
At the heart of the new FINRA regulations are the fees (which in some offerings can approach 12%) that are charged by non-traded REITs and the methods by which the initial and ongoing fees are disclosed to investors. Of particular concern is the oft-utilized practice of reflecting the value of a REIT investment on monthly or quarterly statements at the original purchase amount, not the current NAV, which would reflect initial offering fees and the change in value of the REIT holdings due to market fluctuation. In the absence of accurate NAV statement reporting, less sophisticated investors are sometimes tempted to assume there has been no change in the value of underlying properties and often are unaware of the total fees that have been subtracted from their initial investment. The issue is further compounded by the fact that REITs enjoy an 18 month grace period after their offering period before they must disclose their net asset values. Since many REITs will extend their offering periods for years, this can mean that an investor would not see a current market value on his or her statements for as many as four to five years. Because these securities do not trade on a central exchange and lack the liquid pricing that accompanies it, investors are more reliant on these statement values.
In April of 2013 FINRA concluded its review and made its final recommendation. FINRA proposed changes that would impact NASD Rule 2340 and FINRA Rule 2310, requiring brokerage firms to choose one of three valuation methodologies for reporting non-traded REIT values:
- for two years after breaking escrow, "net investment," consisting of gross offering price less any cash distributions to investors and "organization and offering expenses" (as defined by Rule 2310) that are funded through borrowing or offering proceeds (a firm may rely on the issuer's periodic reports for this information);
- at any time, a valuation performed by an independent valuation service, which (under a proposed amendment to Rule 2310) the issuer must commit to provide and must perform at least once every three years; and
- a periodic valuation by any program that provides them according to a methodology disclosed in the prospectus.
Some industry insiders have shown concerns relating to option one, namely that the high upfront costs of the REITs must be deducted at once, rather than being amortized over the life of the investment. Others have indicated that the presence of option three gives REITs an 'out' to continue their current practices in regards to valuation, as long as they are disclosed. The net impact of these changes will be unknown until we have seen more funds required to adopt them.
While the intent of the proposed FINRA rules has merit, it is important to note that it is not always easy to value the holdings of a non-traded REIT. At times, the only accurate valuation that can be obtained is through a sale of the property/properties in the REIT, which may only occur after the investor has held the security for many years. Interim valuations are problematic and can change quickly - a REIT which has lost value might, in a period of just few months, recover that lost value and go on to show a substantial profit. In this regard, non-traded REITs are not unlike any other real estate holding which an investor might possess. For example, few people ask for a monthly or quarterly valuation of their primary residence, vacation home or other investment property.
FINRA is not saying at this point what an appropriate fee level should be for non-traded REITs, only that the fees should be disclosed as part of an NAV determination. Investors will still be left to their own devices in determining the level of fees they are willing to pay versus the benefits they expect to receive from the product. However, now that FINRA has placed the spotlight on fee disclosure, it could be expected that the next step might be to suggest or mandate maximum fees which could be charged by sponsors. This type of regulation would not be unlike the progression of the mutual fund industry where a heightened awareness of fees has led to an overall decline in fee levels. But as more focus is directed at fees it will be important for regulators and investors alike to remain aware that a real estate investment, by its nature, involves higher fees than stocks, bonds and mutual funds. At the retail level, commissions can approach 6%, with another 6% due when the property is sold. While commercial transaction costs are almost always lower, they are still higher than traditional brokerage fees. However, because of the expertise offered to the retail investor by a quality REIT sponsor, the sum of these fees on a fully disclosed basis, might still be an excellent value.
In any case, non-Traded REITs have been a hot-button issue for FINRA this past year. In May of 2013 they warned brokers about communication regarding non-traded REITs with the public. They provided guidance on a number of aspects, including disclosures, liquidity, prior performance and specifically called out distribution rates - stating "Nor may firms state or imply that a distribution rate is a 'yield' or 'current yield' or that investment in the program is comparable to a fixed income investment such as a bond or note". This is an attempt to resolve concerns that investors may mistakenly believe that they have invested in a fixed income type security when they are actually purchasing a REIT.
This past year also saw a high profile settlement in the state of Massachusetts, where LPL Financial agreed to pay a half-million dollar fine in connection with the sale of non-traded REITs. The settlement terms also included two million dollars in restitution. This action was brought after FINRA settled with David Lerner Associates for $12 million in restitution and $2.3 million in fines in October of 2012.
Investors can expect the new changes to come into effect in the first quarter of this year, with the SEC bringing them into full effect late in the third or early fourth quarter, according to industry insiders.