Stay away from these REITs

Why you need to Avoid Buying Non-Traded REITs

Are you looking for an investment product guaranteed to create big returns?

Well, step right over here, folks. I have just the one thing.

This is probably the best investment opportunity you’ve ever run into, so pay close attention.

First, let me say that I fully understand your struggle to obtain the additional investment income you need. You’ve got money in cost savings and checking accounts and CDs, earning next to nothing. You’re getting near-zero returns from money markets and a bit more from Treasuries – yet your money is there because you don’t wish to risk it in the stock market.

I understand your situation, and I sympathize. I truly do.

So here’s what I must offer: How would you like an investment where you spend just $10 a share, and I’ll promise you a distribution each year equal to 7% of your investment? In other words, should you invest $100, 000, you’re going to get $7, 000 within annual income. Compare that to your bank CD, savings accounts, money market and the like – where you’ll get perhaps a hundred bucks a year for your hundred grand. But rather than $100, I’m offering you $7, 000!

And get this: I’ll send a monthly statement too, and it will show you – each month for the next seven to 10 years – that your own $10 share price will always remain $10. In fact, it may even go higher than $10 a share!

How does which sound? Fabulous? Well, just sign here.

OK, enough of which.

What you’ve just read is the kind of sales pitch that the promoter of a non-traded investment trust might make – perhaps in a seminar he or she enticed you to definitely attend by offering you a free steak dinner.

A non-traded REIT is really a product that takes your money and invests it in property. The rental income is given to you. Promoters say the rent will be sufficient to get 7% in annual income. And after seven to 10 many years, the property will be sold and you’ll get your money-back. You might even get more if the property is sold for any profit.

Some REITs are traded on the New York Stock market and thus have daily liquidity. If you want to buy this type of REIT, you’ll pay normal brokerage commissions (as low because $7. 95). And you can sell at any time too – susceptible to current market values.

But non-traded REITs offer no such liquidity. To purchase them, you have to pay commissions and fees that often total 15% of the investment and can be difficult to identify. And if you need to sell, well, you can’t. These things are non-traded. That means you need to wait for the promoter to sell the underlying real estate and return your hard earned money to you. It can take a decade before you observe your investment again.

Despite the lack of liquidity, the promise of the 7% annual return has enticed many people to invest. The very best 20 non-traded REITs, according to MTS Research Advisors, held $67 billion by the second quarter last year. In those three months on it’s own, investors put $4 billion more into them

No wonder brokers like to sell these products. That $4 billion generated some $600 million in fees and commissions for that brokers and their brokerage firms.

It also means that only 85 cents of each and every dollar you invest is actually used to buy real property. Thus, when you invest $100, 000, you own only $85, 000 really worth of property. That property has to rise 18% in value in order for you every single child get back the original $100, 000 you invested.

So how is it feasible that those monthly statements are able to claim that your investment continues to be worth $10 a share if the REIT is buying just $8. 50 worth of real estate? Common sense says how the statements should reflect the true value of the underlying resource. But when it comes to securities regulations, common sense doesn’t usually prevail. Instead, lobbying by the REIT promoters and brokerage companies does. And they don’t want you to know the reality. It’d be bad for business.

Here’s an example of this deception at the office: The Inland American Real Estate Trust has been telling its investors each month that its shares are worth $10, but MTS Research Advisors present in June 2013 that they were really worth just $6. 94 — a 30% drop. Do those investors know this?

Oh nicely, you might think. At least you’re getting 7% from the actual rental income. Unless…

One particular non-traded REIT, according to MTS, reportedly sends its investors 241% from the rent it receives. How is that possible? If the believe in is earning a dollar in rent, how can it deliver you $2. 41? Where are they getting the extra $1. 41?

Based on the Wall Street Journal, they cheat. Well, OK, that’s not actually what the Journal said. But what else could you call it when someone provides you with money that you think is from rental income when it’s really from the pockets of other investors?

Oh, right. You call it the Ponzi scheme.

Yep, paying some investors with the money supplied by other investors – which is what some do, according to the Journal – is generally a crime. But not so with non-traded REITs, for some cause. Maybe it’s because they use accounting gimmicks, rather than scams, to make it happen.

And one of those gimmicks is actually leverage. That’s a fancy word for what you and I’d call debt.

Yep, if a non-traded REIT has promised you 7% and contains produced only 5% in rental income, it goes to a bank and borrows another 2%. You’re none the wiser, but a problem ensues: The REIT now includes a loan it must repay – with interest. Those payments force the promoters to provide some of its future rental income to the bank rather than to their investors. This further reduces the amount of earnings available, further increasing the amount they must again borrow as well as digging the hole deeper. Maybe this is why the Inland American Real Estate Trust is considered worth only $6. 94 a share.

Promoters will say this issue of borrowing money goes away when they sell the property. They’ll use the profits to pay off the loans. But that assumes the properties can indeed be sold for any profit, and the Journal headline said, “Report Finds Non-Traded REITs Path Publicly Traded Peers, ” suggesting they aren’t producing the earnings they expect. Uh-oh.

A lot of these shenanigans can be eliminated effortlessly: Simply require non-traded REITs to improve their transparency. Starting within 2016, those monthly statements will be required to show the actual investments’ true value, not the original $10 share. That’s an excellent start – but it’s a year away.

And this change won’t address the problem of promoters borrowing money to artificially (and temporarily) increase the income that investors receive. Nor will it address the problem of high fees and commissions or the possible lack of liquidity.

So we think NASAA will be unmoved. Yep, the United states Security Administrators Association includes non-traded REITs on its list from the nation’s top 10 investment scams. We expect that to stay this way.

Before you buy shares of a non-traded REIT, remember that it’s sold with a product-pushing, commission-based broker. So, do yourself a favor: Talk for an independent, objective, fee-based financial advisor instead.

Mortgage REITs: Stay Aside

Mortgage REITs have been maintaining abnormally high dividend yields more than last 5 years but surprise, surprise, investors have seen razor-sharp depreciation in capital and decline in current income. Maybe, it’s time for yield-hungry investors to open their eyes and recognize a fundamental fact: All REITs are not same. Mortgage REITs are a very leveraged exposure on interest rate spread, which is more ideal for a speculative investor, not an income investor.

Real estate is definitely an integral asset class in most investor portfolios. Besides being a supply of enormous wealth, real estate has a low correlation with conventional asset classes like equities and debt, and can therefore serve being an important and attractive diversifying asset. However, with an illiquid, opaque market which involves high initial investment and transaction costs, physical real estate leaves much to become desired. Some of these problems are addressed by Real Property Investment Trusts (REITs); investment entities that provide an important link between real estate and financial markets.

A REIT is really a trust company that accumulates a pool of money through a preliminary public offering (IPO), which it uses to purchase, develop and manage real estate. REITs are traded like conventional equities on major stock exchanges, and allow retail investors to efficiently gain property exposure through transparent, liquid and regulated securities. REITs also offer tax advantages to investors as they tend to be tax pass-through entities that avoid taxation at the corporate level so long as they distribute a majority of their earnings. This feature makes them much more attractive as they generally pay out dividends far above those on most other types of stocks.

The market for REITs in the united states is over $650 billion in size and, depending on the kind of real estate exposure, appear in various shapes and sizes. You will find REITs which operate hospitals, shopping malls, office space, residential flats and warehouses, to name a few. These REITs have a well balanced, toll-road like revenue model as they earn rental income. There also exists another class of REITs, called Mortgage REITs, which borrow money and get mortgage loans (or mortgage-backed securities), thus benefitting from the difference in interest rates (also called the “spread”). Retail, Industrial/Office, Residential and Mortgage REITs together comprise 64% from the entire space. (Specialty REITsarea collection of different REIT kinds like hospitals, hotels, etc)

As touched upon earlier, a significant attraction of REITs is the dividend income they provide. For example, the dividend yield of REITs in 2013 was 4. 06%, when compared with 1. 95% for the S&P 500. REITs’dividends are assumed to be fairly stable since they’re required to distribute at least 90% of their earnings to be eligible for a favorable tax treatment. Due totheir extremely high yields, mortgage REITs have discovered their way into the portfolios of various income seeking traders.

But are these abnormally high yields concealing any shakiness within their business models? A quick comparison of the total returns associated with representative indices* for Industrial/Office, Mortgage, Retail, and Residential REITs, as well as their dividend yields presents a stark contrast. From 2006-2013 (YTD), Mortgage REITs have provided the greatest dividend yields of all types of REITs, and the quantity of excess is substantial. However, they have also been the worst performing category among REITson a cost basis between 2006 and 2013, losing nearly 6% of their value every yearduring this era. It’s worth mentioning that despite a significant drop in returns per share, Mortgage REITs saw an increase in their dividend produces, which was not the case for any other REIT kind. This significant price erosion indicates the presence of a dividend snare with Mortgage REITs.

Mortgage REITs are fundamentally different from another REIT types. They don’t have any real assets, and rather take highly leveraged positions in mortgage backed securities. If these mortgages wind up performing poorly (turn to junk) they are almost entirely destroyed. Their debt to equity ratio is nearly 5x, compared in order to 1x-1. 5x for all the other REIT types as well since the S&P 500. These high levels of leverage have rendered them extremely sensitive to rate of interest fluctuations. When the US Federal Reserve announced its third circular of Quantitative Easing (QE3) program in September 2012, rates of interest started falling to near zero values. Mortgage REITs benefitted due to this interest rate fall, as they could now borrow at inexpensive rates. In the period following the announcement (between Sept 2012 and April 2013) they increased in value through 11%. However, as soon as the subsequent announcement of tapering was launched, leading to an increase in interest rates, these REITs dropped by 18%.

Clearly, Mortgage REITs are a unique and dangerous asset class. Investing in them involves not only a wide range of research, but also heavy speculation, and it becomes imperative to time the marketplace. As an investment for income seeking investors, they are certainly not the best option.