Non-traded REITS

I was recently approached by a friend. They were concerned about some investment options that a family member was involved in. It turns out their loved ones was investing in non-traded REITs.

The person’s advisor recommended this asset and had tied up a significant portion of their cash into these non-traded REITs for who knows how long. We got to talking about these investment strategies and why they are a bad idea.

Edelman Financial has a great mock pitch for this kind of asset. This is taken from their site, but paraphrased.

A fancy broker may say:

Hey buddy, come here. I have a way where you can get $10 per share you invest in. You buy the shares now and I will give you a distribution of 7% of your investment every year. Guaranteed money. For every $100K you put in, you get $7K annual income.  

Your bank is not giving you that kind of return. CDs are at an all time low. Some banks even charge you to keep your money. You may get $100 from them for that $100K. I am offering you a guaranteed return. $7K!

Bonus, your share prices remain the same. The $10 you give me now will remain $10 and may go up if we sell the property for more in the future. Plus, you can work it out to where these distributions are not seen as income, but capital gains. You will save loads on taxes.

Sounds good to me. Sign me up.

What is a non-traded REIT?

Non-traded REITs are another form of real estate investments (such as traded REITs or owning your own property) but that are very very illiquid. A person “invests” in a non-traded REIT and becomes part of a real estate portfolio. This is a pooled portfolio with other investors.

The brokers take investors’ dollars and buy properties. As time goes on, they buy more properties while still having to pay back the investor. They may be short on cash and borrow some of it from the bank. Now they have to pay out to both the investors and the banks, but of course the banks come first. The cycle continues and over time there is less and less cash on hand to pay investors. In many ways it is a legal Ponzi scheme.

Fees, fees, and more fees

A big negative of non-traded REITs  are the up front fees. Typically these are arbitrarily set by the broker in the range of 10% to 15%. This means for every dollar you invest, only $0.85 to 0.9 is actually invested.

Compare this to a traded REIT such as Vanguard’s REIT index fund institutional shares (VGSNX) which has an expense ratio of 0.10%. That is 150 x lower than the non-traded REIT! Crazy. Imagine someone telling you to pay $900 for a Big Mac instead of $6. That is basically what is happening.

This is big business. Per Edelman Financial the top 20 non-traded REITs had $67 billion in assets last year. Of that, $600 million were in fees and commissions!!!!! A subset of that, something like $0.85 per dollar went to buy real estate. That is a whopping 15% commission. This is a huge business and one that is not talked about much on personal finance sites.

So how do non-traded REITs earn you cash?

There are 2 ways it brings cash flow:

1) Every year there is a pay out to investors based on cash flow of the operations and other sources (such as borrowing money from banks for example). You could consider this similar to rental income if you physically owned the properties. However, the distributions are not guaranteed and can be reduced at any time by the owner. 

2) There is a payment to investors when the property is sold. But guess what, if the property is sold at a loss, then you get nothing. Also if their are bank loans on the property, the bank is paid before you. 

Time to get out?

What if you want to take your cash out. Well they make this quite difficult to do. First, they choose when to sell the properties. If you decide to withdraw your investment before the properties are sold then there are high fees. Double whammy. High fees to enter and high fees to leave. 

So in many way, these non-traded REITs are more like direct real estate investments (with high fees to finalize a transaction) and less like traded REITS. They are worse then direct real estate investments because you are not in control of the properties. The returns are impacted by numerous things such as the economy (think of the Great Recession), demographics (where are the properties located), and other market conditions.

How do they convince anyone to buy this stuff?

So why would anyone go with this form of investment. Well the only positive I can see is that it is a way to reduce or eliminate tax while obtaining a real estate investment return. You can take your distributions from the non-traded REIT and tax defer it at a capital gains rate. So instead of paying an ordinary income tax rate (which for high earners can be upwards of 40%) you pay the capitals gains rate of approximately 15%. 

So back to the spiel

We already heard how the broker may convince us to buy the non-traded REIT above, but what they don’t tell you is: 

So your money will be tied up for decades. If you want to get it out, I will take back some high fees. Oh, and that $100K you are investing. Actually $15,000 goes to me for fees and commissions upfront. We will buy shares with the remaining $85,000.

And don’t worry, there will always be money to pay you distributions. We will get what we can in rental income (let’s say $5,000) and we will just get more investors or borrow some money from the bank on the equity of our properties for the other $2,000 we owe you (total of $7,000 annual pay out that was guaranteed when joining the investment.).

Since we now owe both you and the bank, we will always pay the bank first (and with interest). So they will get a chunk of that rental income we were giving you which means next time we have to borrow more money. And actually, when we sell the property the banks get paid first. So, in hindsight, there may not be any money at the end once we sell the property (so no return of that $85,000), but you will get that $7,000 annually for as long as we hold onto the properties. (At best, in 14 years you have recouped the initial $100,000 investment if they have not sold the properties.).

The relatives

Wow! So this is some serious Bull $### and the fact that a friend’s family is involved in one makes it frustrating. The difficult part is that I do not see an easy way out for them. It is like a bad marriage, if you are already married, breaking up is hard to do. So I suspect they may have to ride this non-traded REIT trip out until it is done.

One thing they should seriously consider doing is firing their financial advisor. How much money have they already put in his/her pocket? What other bad investment suggestions are they making?

So here is a recap of non-traded REITs

Negatives:

  • No direct ownership of a property. You own nothing. This is worse than a timeshare.
  • Not liquid. You can not trade these assets for another asset. You are stuck with the non-traded REIT for as  long as the term. This may be decades.
  • High fees. These are paid up front.
  • High fees if you want to get out early.
  • Returns are often low and variable. The non-traded REIT group may borrow money from the bank to pay your distributions which further reduces the value of your share.
  • You may not get your initial investment back.

Positives

  • Really not many, so don’t do it! But for fairness sake here you go.
  • You can take distributions at a lower capital gains tax rate instead of ordinary income rates. This may save you some on taxes.
  • You can get regular distributions, though I would argue there are many more efficient ways to do this.
  • It will help you determine if a personal finance advisor is good or not.

So what do you guys think? Ever thought about these investment tools? Ever invested in a non-traded REIT and have some experience to share?

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Also published on Medium.

DadsDollarsDebts

I am a Dad and Doctor trying to find financial freedom by owning my dollars and debts. Helping dads with their finances so they can focus on the family.

11 thoughts on “Non-traded REITS

  • August 9, 2017 at 4:53 am
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    Yes i agree with your post, a non-traded REIT does not trade on a securities exchange, and because of this it is quite liquid for long periods of time and there is so many positive as well as negative points. Thanks for sharing this post.

    Reply
  • August 1, 2017 at 8:19 am
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    Sounds like a raw deal. It’d be better to lend directly and have a solid contract. I think it’s called hard lending or something like that. Even real estate crowdfunding is better. Why invest in non traded REIT when there so many more options? How about just REITs? 🙂

    Reply
    • August 1, 2017 at 8:15 pm
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      I wonder if it is a relic of the past. Back prior to the internet era and crowdfunding. It was like crowdfunding prior to the internet…it definitely is a raw deal. Better to put that money it a good old fashioned TRADED Reit.

      Reply
  • July 31, 2017 at 6:17 am
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    Thanks for sharing your good article. I really appreciated for your good topic about REITS.

    Reply
    • July 31, 2017 at 6:50 am
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      Thanks Jenny. I just want to make a distinction. This article is about “non-traded” REITS which I think are a bad investment vehicle. “Traded” REITS like you can buy through Vanguard, Fidelity, or another broker are fine assets. Those are typically low cost to enter and you can sale your shares easily. I do invest in “traded” REITS.

      Reply
  • July 29, 2017 at 8:24 pm
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    Okay, as an investor in this sort of stuff (in a BIG way I might add, $425k worth!) allow me to comment. I agree with the author on non-traded REIT’s, but I don’t agree when it comes to Real Estate Crowdfunding overall. There are many types of R.E. crowdfunding investments; some equity deals, core-plus deals, debt deals, etc.
    Take a look at http://www.crowdstreet.com or http://www.realtyshares.com or even http://www.virtuapartners.com

    These online platforms allow accredited investors to become limited partners and earn preferred rates of 8% (name any other asset class that pays its well!), plus appreciation which translates into very high I.R.R. over the term of the investment.
    I’m invested in six of these deals all with varying maturities. I am “laddering” so to speak. Some deals mature in only 2 years, others in 3-4 years, a coup,e at 5 years. Most of these deals are not leveraged, or if leveraged with debt, not a great deal of debt. They usually enter deals at a very low LTV and very high cap rates.
    All of the properties purchased are institutional-grade properties. I’m investing in the same space as KKR, Blackstone and the like.

    I agree non-traded REIT’s are bad investments, but not private, individual deals. Based on proforma, I choose my investments. I choose whether I invest in commercial office buildings, hotels, multi-family, etc. Meanwhile I earn 8% returns based on the rent rolls, not on return of capital. Once underlying properties are sold OR refinanced, I receive my original Capital back along with appreciation/profit.

    I’ve literally invested over $400k in these type deals and my monthly cash flow is terrific. Fees? I’m paying 3% fees and that s in,one with what I’d be paying a mgmt. company to oversee a rental property.

    Reply
    • July 29, 2017 at 10:00 pm
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      Thanks for chiming in Mr Kirk. I agree with you. Realestate investment (crowd funding) can be a good way to invest funds. Just as owning real estate and renting it can be quite profitable. Both of these if done well can be very lucrative.

      These are different than non-traded REITs which are a less liquid asset with no real guaranteed returns.

      Thanks again!

      Reply
  • July 29, 2017 at 8:30 am
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    That sounds awful! It is always hard to see family and friends make terrible decisions with their money when you know straight away that it is a bad idea. I know there’s not much you can do since it is their money, but still it doesn’t sit well.

    Reply

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