After a year in which securities regulators cracked down on nontraded real estate investment trusts, REIT sponsors and the broker-dealers who sell them are focusing on compliance and whether sales of the products to investors are suitable.
After a year in which securities regulators cracked down on nontraded real estate investment trusts, REIT sponsors and the broker-dealers who sell them are focusing on compliance and whether sales of the products to investors are suitable.
“We had a very disruptive but also a very innovative year,” said Nicholas Schorsch, chief executive of American Realty Capital, a sponsor of nontraded REITs. “This is the transformative time. We just had a due-diligence meeting with [broker-dealer] executives, and a lot of those guys are looking to clean up and clear up their systems. The industry is prepared for change, and the products will be much better, and therefore get bigger.”
Another REIT executive agrees.
“To me, the industry is one that's evolving,” said Jeff Holland, executive vice president and head of capital markets at Cole Real Estate Investments, another sponsor of nontraded REITs. Changes are being driven from within the industry, but also by external factors, he said, citing a rule proposed last year by the Financial Industry Regulatory Authority Inc. that would require valuations on REIT account statements be kept more up-to-date.
Noting that Cole and others in the industry recently have launched nontraded REITs that calculate a daily valuation, Mr. Holland said: “That's indicative that Finra wants changes, and the industry is moving in that direction, as well.”
BEGINNING OF EVOLUTION
He compared the nontraded-REIT industry to mutual funds of 30 years ago, when funds typically carried sales loads of 7%. “That changed. Mutual funds created options, such as different share classes. The nonlisted-REIT industry is at the beginning stage of that evolution.” Mr. Holland said.
The present state of evolution in the industry came after a year of both good and bad news for nontraded REITs.
Registered representatives and advisers continued to tout nontraded REITs as an instrument for portfolio diversification into real estate, as well as steady returns of 6% to 7% income.
“Traded and nontraded REITs “are truly different animals, and both have a place in someone's portfolio,” said Kevin Hogan, executive director of the Investment Program Association, a trade group for nontraded REITs and other private investments. “Traded REITs truly perform and respond to the nuance of the stock market, like the rest of the portfolio. The nonlisted REIT is not going to respond to the ebbs and flows of the stock market. Look at endowments that invest in real estate. They're looking for an asset that does not respond to the stock market.”
The lack of liquidity of a nontraded REIT also may prevent people from selling the asset at the bottom of the market — exactly the wrong time to sell an investment based on the value of real estate, he said.
Indeed, the industry raised about $9 billion last year from investors, making it a strong — if not record-setting — year for sales.
But the industry also came under intense scrutiny from securities regulators, who are keeping a close eye on how the products are sold and whether reps, advisers and their broker-dealers are making misrepresentations to clients about the investments.
Reps and advisers must focus on several issues when selling the product to investors, said Tony Chereso, president of due-diligence firm FactRight LLC:
• The REIT manager sponsor's ability and strength to raise capital.
• The ability to deploy it in the appropriate sector of real estate, from net-lease properties to apartment houses.
• Whether there is still room for the sponsor to acquire properties in that sector.
Reps and advisers also must focus on the REIT's management team and its ability to manage the real estate portfolio, Mr. Chereso said.
“If they can do all that — earn back the front-end load down the road — they will create value to recoup the investment for the investor,” he said.
The industry also could help itself if wholesalers from various industry sponsors would stop rumormongering and spreading gossip about their competitors, Mr. Chereso said.
“Most of what we hear from our broker-dealer clients is about rumors that they heard and want us to check out,” he said. “I've had conversations with broker-dealers that have suspended sales agreements with sponsors based on rumors being spread. There's such a need to differentiate yourself in the marketplace because it's so crowded [with REIT sponsors], and therefore rumors are more rampant. It's not just about one firm; it's about sponsors across the spectrum.”
Finra drew attention to the product throughout the year, with Finra officials routinely citing nontraded REITs as an area of concern when speaking at industry meetings.
Finra backed up those remarks by issuing an investor alert about the products in October, warning of complexities, including the fact that returns, or dividends, aren't guaranteed and may exceed the REIT's operating cash flow. The alert also highlighted nontraded REITs' lack of a public market and how that creates illiquidity and valuation problems.
Brokerage firm executives cringe at such alerts, which routinely cause anxiety and concern because of Finra's emphasis on what are perceived to be negative qualities about a certain product or investment strategy.
But according to industry executives and due-diligence consultants, the bombshell moment last year for the industry came in May when Finra filed a complaint against broker-dealer David Lerner & Associates Inc.
The complaint alleged that brokers there pushed REITs without fully investigating if the investments were suitable. Finra also alleged that the firm marketed the REITs on its website with misleading returns.
Industry executives with other REITs noted that the firm was an industry outlier. It sold just one line of REITs, the Apple REITs, and no other broker-dealer sold those REITs.
Regulators, however, are quick to note that they are looking at broker-dealers for problems in compliance and suitability for clients.
“In 2011, we were actively looking in this space, and that resulted in the complaint against David Lerner,” said Susan Axelrod, executive vice president and head of the Finra unit that regulates member sales practice. “We will do vigorous exams [of broker-dealers] looking at these issues, and where appropriate, there will be vigorous enforcement actions.”
Ms. Axelrod emphasized that Finra's focus doesn't “mean that every REIT is bad or that every firm that sells them is bad.”
Finra, however, has three main areas of concern for broker-dealers and reps: the suitability of the REIT for investors, inadequate due diligence by broker-dealers selling the product, and representations made by the sellers at the point of sale.
Ms. Axelrod offered advice to reps and advisers who sell the REITs, which also have come under scrutiny for their high sales commissions, lack of liquidity and questions about valuations.
“Understand the product you are selling, do the due diligence, particularly about things you discussed with the clients,” she said.
“Be upfront with customers and discuss the risks associated with it, such as the lack of liquidity. And, especially for new clients, recognize the need to spend extra time” talking about the product, Ms. Axelrod said.
bkelly@investmentnews.com
