Investors and wealth managers are placing some pretty big bets on an alternative asset class that is giving fixed income yields a run for their money.
Indeed, capital inflows into nontraded real estate investment trusts (REITs) for the first six months of the year reached a record $10.7 billion, nearly matching the total inflows for all of 2012, according to Robert A. Stanger & Co., an investment bank that specializes in direct investment securities. The firm projects nontraded REITs will raise up to $20 billion for 2013.
"One of the reasons these investments are raising so much money is that real estate can provide a higher yield than is currently available from fixed income securities," said Keith Allaire, managing director of Robert A. Stanger. "They are attractive right now, in an environment where you can't get much yield elsewhere."
Like traditional REITS, nontraded REITs are real estate companies that own income-producing real estate, such as apartments, office buildings, shopping malls or hotels. Modeled after mutual funds, such trusts enable small investors to diversify their portfolios by owning shares in commercial real estate.
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Both exchange-traded and nontraded REITs offer a hedge against inflation, since the underlying properties can simply raise rental fees if interest rates begin to rise.
They both also offer tax advantages. By law, all REITs must distribute 90 percent of their taxable income to shareholders each year in the form of dividends but are permitted to deduct those dividends from taxable income, helping boost returns.
But that's where the similarities end, said Adam Markman, managing director, consulting, at Green Street Advisors, which provides real estate and REIT research for investors.
"Traditional REITs and nontraded REITs share the same name, but they are very different," he said, noting nontraded REITs have higher fees, less liquidity and a lack of mark-to-market pricing. (Mark-to-market pricing is an accounting practice that provides investors with an appraisal of a company's assets at the current market price.)
As the name implies, nontraded REITs are not sold on the stock exchange. As such, they are generally illiquid, often for periods of eight years or more, according to the Financial Industry Regulatory Authority (FINRA), which issued an investor alert regarding these REITs on its website last year.
Nontraded REITs, which are sold by broker-dealers, are not intended to exist in perpetuity.They are instead designed to deliver consistent dividends to shareholders until a liquidity event occurs. That event can be a restructuring as a traditional REIT that gets listed on a stock exchange, a merger with an existing company or the outright sale of its portfolio of commercial properties.
Upon liquidation, the return of capital (or principal) may be more or less than the original investment, FINRA noted, depending on the value of the asset.
Investors generally cannot sell their shares in a nontraded REIT until a liquidity event occurs, but a portion of total shares outstanding may be redeemable annually. Share redemption offers, however, may be below the purchase price or current price, according to FINRA.
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The other big drawback of nontraded REITs is their cost structure.
Most take 13 percent to 15 percent off the top in front-end fees, which include sales commission, management expenses and administrative costs, Markman said. FINRA notes that front-end fees for exchange-traded REITs are often half that, at roughly 7 percent of the offering proceeds. Investors who buy REITs on the open market, however, would pay a smaller brokerage fee that is usually less than .25 percent, according to Green Street Advisors.
Securities regulators fear such risks may not be readily apparent to unsophisticated investors, because of poor transparency and questionable marketing tactics by some in the industry.
For its part, the Securities and Exchange Commission notes that nontraded REITs often pay distributions in excess of earnings in the first few years of operation. The SEC's latest disclosure guidance stated in July that "given this practice, we frequently issue comments requesting disclosure that enables investors to evaluate the registrant's ability to maintain or increase the historical distribution yield."
Indeed, some REITs eliminated dividends or suspended redemptions when the market went south in 2008.
Because nontraded REITs are typically sold over a period of years at a fixed price per share, and there is no trading market through which shares are valued, the SEC also warns that investors must make their own assessments of whether offering prices reflect the current value of shares.
Such shares can be diluted over time, it notes, as a result of operating losses, a decrease in the value of the REIT's assets, the sale of equity at below fair value or the payment to shareholders of distributions in excess of earnings. Thus, the SEC urges nontraded REITs conducting continuous offerings to annually update the dilution disclosures in their prospectuses.
With all the risk factors, then, why are nontraded REITs attracting so much money? In a word: income. Nontraded REITs are producing average dividends of 5.5 percent to 6.5 percent per year—after fees are taken out.
Traditional REITs have dividends closer to 3 percent, while other fixed income securities that investors typically rely upon are yielding even less. Currently, the benchmark 10-year Treasury yield is about 2.5 percent.
As an alternative asset class, nontraded REITs also offer a low correlation with traditional asset classes, which can help diversify one's portfolio and limit volatility.
Green Street Advisors states on its website that "publicly traded REITs remain superior for almost all investors." But Allaire at Robert A. Stanger noted that the biggest pension funds own both traded real estate and nontraded real estate.
"Investors can do both, as well, but they should always remember diversification," he said. "Don't put too much of your investment into illiquid products and make sure you don't need that money while it's tied up."
His firm recommends investors limit their exposure to income-producing real estate investments to between 5 percent and 10 percent of their overall portfolio.
Nontraded REITS may offer better returns than fixed income products and even their traditional REIT counterparts, but they also come with some serious downside risks.
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According to FINRA, yield-hungry investors who are willing to bear the risks of illiquidity and higher fees should thoroughly investigate any REIT they plan to buy, including the experience level of the management firm.
"You should consider the front-end cost relative to the sales costs you would incur to buy and sell other securities during the same holding period as the life of the REIT," FINRA stated in its advisory. "You may also want to consider how much share price appreciation and distributions you will need to receive to overcome these front-end charges."
To minimize volatility, Allaire added, average investors should opt for nontraded REITs that encompass multiple property types across a diverse geographic region, rather than those that invest more narrowly in a single segment of the market.
—By Shelly K. Schwartz, Special to CNBC.com