by Josh Azan

Real Estate Investment Trusts (“REITs”) are a popular option for investors seeking stable investments that offer higher than average returns. However, piggybacking on the popularity of REITs, the non-traded REIT market has become a very desirable alternative for elderly investors, and investors who are looking for attractive yields without high risk.

REITs are companies that operate in real estate. Investors buy into the REIT program by purchasing shares or units, entitling them to their proportionate share of the income of the REIT. The REIT is not taxed if it distributes at least 90% of its taxable income back to investors. Therefore, because REITs, unlike a normal corporation, must distribute such a high proportion of its income, the returns on REITs are often much higher.

Investors looking to invest in REITs have the option to invest in traded or non-traded REITs. Traded REITs are those REITs whose shares are publicly traded on a stock market. The market determines the prices for the shares of these REITs. The shares are very liquid, and buyers and sellers can change their positions easily and reliably.

Conversely, non-traded REITs’ shares are not traded publicly on the stock market. The prices for these REITs are set by the REIT itself or the underwriter. These shares are not very liquid. Often the only way for buyers and sellers to change their positions in these REITs is to explore the secondary markets. These transactions can often take weeks, and there is no guarantee that a deal will be struck, or that an auction will succeed.

Increasingly, non-traded REITs are also coming under fire for their pricing and disclosure practices. The non-traded REIT market is very competitive. Further, the REITs themselves need to raise high levels of capital to invest in real estate, which must be accomplished by selling their shares at a certain share price. In order for an individual REIT to be able to justify its share price, it must offer distributions, or dividends to allow potential investors to recognize a certain “yield,” often 8% or greater. “Yield” is in quotations because an increasingly popular practice among non-traded REITs is to offer distributions to investors that are not only funds from operations, but funded by loans, or worse, subsequent investors’ capital. This practice, while creating the desired distribution rates, effectively undercuts the REITs’ capital base, and therefore its ability to both secure loans, but also to generate funds from operations. The distributions can become unsustainable.

Many non-traded REITs have taken part in this practice, and many investors have been damaged when the REITs have been forced to suspend dividends, and the value of the REITs on the secondary market plummets. In fact, this practice has become so widespread that FINRA recently issued a notice outlining the disclosures that these REITs must make to investors.

However, a corollary of this practice, which given recent times has not been a significant issue but promises to become one, is the disastrous effects of interest rates. Since the economic downturn of the late 2000s, interest rates have been at historic lows. This has allowed REITs to leverage their capital acquisitions and fund their distributions with little cost. However, as interest rates increase, both the mortgage costs underlying the assets of the REITs, and the working capital loans for the REITs, will increase. Given the practice of non-traded REITs to fund a healthy portion of their dividends with debt, many of the REITs’ business costs will increase.

Of course that leaves less funds available to investors for distributions. As these business costs increase, in order for a REIT to satisfy the demands of investors, distributions may need to be funded either with increasingly more funds from subsequent investors (essentially turning the REITs into a Ponzi scheme), or the share price will have to adjust downward, affecting the portfolios of investors in the REIT.

Existing and potential investors should be wary of these possible deleterious effects of a pending increase in interest rates. Investors would be wise to inquire about the composition of a targeted REIT’s distributions, the REIT’s overall financial position, and any plans that the REIT may have to change dividends or REIT share prices. Quite unlike what many investors are expecting when they invest in them, non-traded REITs have started to show their true characteristics as an investment that offers high current income, but with many risks to the initial principle. An interest rate increase is yet another risk of non-traded REITs.