A friend recently approached me. They were concerned about some investment options that a family member was involved in.
It turns out their loved ones were 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 terrible idea.
Edelman Financial has a tremendous 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 investment (such as traded REITs or owning your own property), but that is 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 significant negative of non-traded REITs is the upfront 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 a 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 two ways it brings cash flow:
1) Every year there is a payout to investors based on the 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 there 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 their properties. If you decide to withdraw your investment before the properties are sold, then there are high fees—a double whammy. High costs to enter and high fees for leaving.
So in many ways, 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 than 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 might 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 for your 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 payout 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.).
Wow! So this is some serious Bull $###, and the fact that a friend's family is involved in one makes it frustrating. The tricky 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
- 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 upfront.
- 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.
- 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?