Research demonstrates that excessive expenses, conflicts of interest, and lack of markets cause non-traded REITs to be inferior investments
Research reports clearly show that non-traded real estate investment trust (REIT) securities are lousy investments. They are lousy, because an investor always has the alternative to invest in publicly traded individual REITs and REIT mutual funds and ETFs, which are the best REIts to invest in and they tend to produce higher net returns.
Note that non-traded REITs may be SEC registered REITs that do not trade on an exchange or private-placement REITs that are not registered with the SEC and are sold to accredited investors. Both types of non-traded REITs should be avoided. In this article, “non-traded REITs” refers to both of these types.
Before I dive in and summarize the evidence, understand that most investment comparisons involve some degree of ambiguity. It is usually not so easy to say, “such-and-such classes of investments are lousy investments. Not so with non-traded REITs – whether they are registered with the SEC or unregistered and privately placed.
Keep in mind that any investor considering buying a non-traded REIT always has available the direct alternative of buying a publicly traded REIT. Since there are about 150 publicly traded REITs available, an investor can always find a comparable public REIT with far lower costs, fewer built in conflicts-of-interest, and a readily available market to exit quickly from their investment should they choose to do so.
Furthermore, investors have the additional opportunity to invest in publicly traded index mutual funds and ETFs that hold multiple REITs and thus provide much greater diversification. Such diversification is not available to an investor through the purchase of an individual REIT – whether publicly traded; publicly registered, but not publicly-traded; or privately placed and not traded. Very low cost, passively managed index REIT investment funds become the diversified performance benchmark standard against which the performance of all individual REITs can be measured.
Of course, with publicly traded individual REIT securities, there will be performance variations around the industry average, and some will look better than others will. The same is true with private placement REITs, but their deficiencies are so large and numerous that private REIT “winners” are a vanishing species compared to low cost public REIT index funds.
Furthermore, no studies demonstrate that industry professionals can pick winners over losers beforehand. Investors are just sold whatever non-traded REITs are open at the time. The financial industry takes a big cut up front for promoting the “non-traded REIT du jour.” This leaves the investor to live with a random outcome over the next decade or perhaps more.
A myriad of problems glossed over by highly compensated non-traded REIT sales agents
Non-traded REIT securities are riddled with excessive and hidden sales and promotion expenses to compensate those who push them. Non-traded REIT securities are illiquid and lack transparent markets. There are no guarantees that these non-traded REITs will actually liquidate in a timely manner.
Selling your shares earlier might require accepting a deep discount off the supposed fair market valuations provided by the non-traded REIT manager. Because non-traded REITs lack active aftermarkets for reselling shares, investors are often faced with selling their shares at dramatic discounts, if they want to get out early versus waiting perhaps years go get out.
Non-traded REITs are also subject to significant conflicts of interest where insider incentives are counter to the interests of share or unit holders. Since private REITs are illiquid, shareholders are at the mercy of those who run private REITs. There are numerous and well-documented situations where the decisions of affiliated private REIT managers and agents seem to be counter to the best interests of private REIT unit or share holders.
Compared to publicly traded REITs, which receive greater scrutiny, non-traded REITs tend to pay out more to affiliates. Non-traded REITs are less efficiently managed, and sponsors, managers, advisors, and dealers siphon away relatively more value from non-traded REIT shareholders. In contrast to publicly traded REITs, the vast majority of non-traded REITs actually have no employees. Instead, they are managed by a third party under a management contract. The more these third party managers are paid for their overpriced services, the less remains for nontraded REIT shareholders.
Non-traded REITs are heavily promoted by financial industry middlemen
Excessive investment fees are a huge problem for individual investors. The failure to cut investment costs down to the minimum is one of the main reasons why investors fall behind the market’s return over the long haul. Non-traded REITs are one of the worst investments that individuals can make, because to their excessive and avoidable costs.
At the front end, non-traded REIT selling commissions, dealer manager fees, marketing allowances, and organizing and offering expenses are very high – usually totaling 12% to 15% of your initial non-traded REIT investment. That is only 85 cents on the dollar going into your non-traded REIT investment, while the other 15 cents on the dollar vanishes at the outset into the pockets of those telling you that you are making a good investment. Due to very weak disclosure regulations, most investors in non-traded real estate private placements have no clue that they are paying so much in sales and distribution fees.
Most experienced investors figure out (eventually) that they do not have to pay a financial adviser a 5% front-end load on a mutual fund. Experienced investors often decide only to buy no-load mutual funds, so that their full dollar is put to work in the investment. However, with non-traded and privately placed REITs, unwitting investor actually pay a front end load that is two to three times higher than they used to (or still) pay to buy mutual funds through a financial broker!
Individual commissioned financial advisers push non-traded REITs hard, because the commissions they earn are higher than most other financial products. Individual representatives typically pocket about 7% to 8% of the offering price. In effect, they are taking about half of the total front-end non-traded REIT expenses. These sales people are not fiduciaries and they are not acting in investor’s best interests.
Commissioned non-traded REIT and private placement REIT agents have absolutely no incentive to tell you that you could do better buying a publicly traded REIT or REIT fund. In fact, they may not even understand the research. They have no incentive to become better informed. They are just sales agents pushing a financial product, although they might suggest that they are “financial advisers” helping you to make a good decision.
Instead, they follow the age-old securities broker sales formula. They cherry pick and push non-traded REIT families that appear to have performed well in the past. Even though the performance history of prior non-traded REITs in a series is not a predictor of subsequent success, why let that get in the way? If a non-traded REIT or private placement REIT is new and not part of a series, they may sell the pro forma financials as if they are real and may significantly downplay the risks.
Blue Vault Partners/ U Texas McCombs study demonstrates non-traded REIT under performance
In 2012, Blue Vault Partners together with the real estate studies center at the University of Texas Austin’s McCombs School of Business announced a study of non-traded REIT performance. Entitled the “Non-traded REIT Industry Full-Cycle Performance Study,” this research was a systematic evaluation of the net returns to investors over the life of 17 large non-traded REITs.
This study provided a full lifecycle analysis of the internal rate of return on the capital investment of each REIT from the beginning through final liquidation. Returns include payments during the active life of the REIT and funds received in the final liquidation event, which could include an IPO, a merger, or a sale of all assets.
In summary, of these 17 large REITs, 71% underperformed passive benchmarks across their full lifecycle. The average benchmark return was 11.67% annually versus and average annual compounded return of 10.33% for these non-traded REITs. Therefore, in relative terms the average investor in these 17 non-traded REITs lost about 1 and 1/3 percent annually versus the benchmark return.
This study’s researchers concluded that the primary cause of under performance was excessive front-end sales charges and fees. When they restored an assumed total front-end sales charge of 12% to non-traded REIT performance, the study authors concluded that publicly traded and non-traded REITs had similar performance. (Note: Given that there are over 1,000 publicly traded and non-traded REITs, the 17 REIT sample size of this study is far too small to support any valid statistical tests, even if they do represent many of the largest non-traded REITs by originally invested capital.)
A larger Green Street Advisors study finds even greater non-traded REIT under performance
In 2014, Green Street Advisors published a similar full-lifecycle non-traded REIT study – this time covering 34 nontraded REITs over the period 1990 to 2014. In the report, it was stated that these 34 full-cycle non-traded REITs accounted for about one-half of total amount of capital raised from non-traded REIT sales over this period.
Green Street calculated that with twice as many full cycle REITs analyzed as the 2012 Blue Vault/McCombs study, these 34 nontraded REITs achieved an average compounded dollar-weighted internal rate of return of 10.9%. While this might sound like a great return, unfortunately over the same 24-year period, the benchmark composed of similar publicly traded REITs of similar duration and property type achieved a much greater 14.5% return.
Compared to the Blue Vault study, two years later with double the sample size, Green Street found that non-traded REIT investors lost 3.6% annually versus the publicly investable benchmark alternative. To put this in perspective, one dollar earning 14.5% annually for 24 years grows to $22.52. In contrast, one dollar earning 10.9% for 23 years grows to only $10.80.
With this Green Street data, the non-traded REIT investor probably feels pretty darn good turning one dollar into over ten dollars. Performance of these non-traded REITs would have seemed great, until an investor realized he or she could have earned twice as much with a publicly traded REIT fund!
Lack of this comparative knowledge is a phenomenon that I have found with many clients who come to me. Having purchased a non-traded REIT from some broker in the past that had paid out cash, many of these people are happy with these investments and the cash flow. Most of them think that it would be a good idea to keep buying more non-traded REIT shares. Only after I show them the research and tell them that they can invest directly in low cost publicly traded REIT mutual funds and ETFs do they change their attitudes and behavior.
SLCG study finds that 27 large non-traded REITs averaged one billion dollars of under performance each
Finally, in 2014 a third non-traded REIT analysis was reported by the Securities Litigation and Consulting Group (SLCG). This study looked in detail at 27 full-cycle REITs over the same 1990 to 2014 period. SLCG concluded that in aggregate investors in these non-traded REITs had lost at least $27.7 billion versus the publicly traded benchmark.
Since the 27 full cycle non-traded REIT funds in the SLCG study overlapped but were not the same as the other two studies discussed above, the non-traded and publicly traded annual internal rates of return were not the same. However, the spread between the traded and non-traded IRRs was an even larger 5.6% per year. In this case, SLCG used the very low cost Vanguard REIT Index Mutual Fund (VGSIX) as the benchmark for most of the period, since VGSIX has been open to investors since mid-1996.
Survivorship bias in non-traded REIT performance data is likely to be very large
The three non-traded REIT studies above all complement each other. They use overlapping but dissimilar data sets of full-cycle non-traded REITs that had a liquidation event. All three studies demonstrate clearly that non-traded REITs are inferior investments – particularly the larger Green Street and SLCG studies that showed annual performance deficits of 3.6% and 5.6%, respectively. While the 2012 Blue Vault/McCombs study had a smaller data set, even that study showed a non-traded versus public REIT annualized performance deficit of 1.3%.
However, there is a major deficiency in all three of these studies, which is beyond the control of any of these firms. That deficiency is that these studies looked only at full-cycle non-traded REIT performance. For example, the largest study is Green Street’s at 34 fully cycle non-traded REITs, but these thirty-four non-traded REITs only represented about half of the total non-traded REIT capital raised during the study period.
What would the impact have been, if the performance of all other non-traded REITS representing the other half of the capital raised over twenty + years could be included? The answer to this question is entirely speculative, because the other hundreds of non-traded REITs have not liquidated and valuing them mid-cycle is fraught with problems.
Nevertheless, my personal opinion is that including objective “fair market value” data for the non-full-cycle non-traded REITs would make the comparison with publicly traded REIT benchmarks much more negative. My reasoning is that it is much more likely that better performing non-traded REITs were able to achieve a liquidation event compared to those that did not.
- First, this is undoubtedly true of those with IPOs, because stronger performing non-traded REITs are more likely to be accepted by the public markets. Note that the relative performance studies in this article use publicly traded REITs as the benchmark comparison, publicly traded REITs have performed better, and at some point, these public REITs would have needed to be strong enough to achieve an IPO.
- Second, those non-traded REITs that merged to reach a liquidation event are not necessarily stronger. However, it is still more likely that a better performing non-traded REIT will find a merger partner than a weaker one.
- Third, some of these non-traded REITs may have been simply too early in their multi-year development lifecycles to have reached a liquidation event. The eventual relative performance of such immature non-traded REITs would be a toss-up after costs were taken into account. However, this is only true of those non-traded REITs that are on a track to achieve a financially attractive liquidation event. Many non-traded REITs are not on such a track and could be referred to as the living dead.
How many living-dead non-traded REITs are there?
There are living dead among non-traded REITs. When a REIT is not able to achieve a liquidation event that does not mean that assets will sold and the REIT will be shut down. Short of bankruptcy and complete insolvency, no matter how poorly the underlying real estate might have performed for investors, the REIT manager may still keep it going to collect management fees.
Non-traded REIT operators can collect fees, as long as the properties are cash flow positive and investors are locked in with low valuations and no place to sell their non-traded REIT securities except to private market sharks offering pennies on the original dollar. It is likely that there are numerous situations like this out in the non-traded REIT “market.” If such living dead non-traded REITs have delivered inferior dividends and have a liquidation value that is perhaps pennies on the dollar, then including them in the performance analysis would inevitably have widened dramatically the negative performance gap between non-traded and publicly traded REITs.
The crux of the problem is potentially huge survivorship bias in the data set. SLCG’s 2012 “A Non-Traded REIT Primer” stated that about 1,100 REITs filed tax returns according to the IRS, but there were only 153 publicly traded REITs at the beginning of 2011. This leaves over 800 non-traded REITs in existence. In contrast, the largest of the three studies discussed above looked at only 34 full cycle non-traded REITs that had achieved an IPO, liquidation, or merger. Thus, hundreds of non-traded REITs were excluded from these studies.
You should note that survivorship bias can be extremely important in investment performance analysis, Mark Carhart’s classic 1997 mutual fund study; “On Persistence in Mutual Fund Performance” corrected for survivorship bias and overturned many prior research conclusions. In this situation, correcting for non-traded REIT survivorship bias in these studies is unlikely to change the conclusion that investors should stay away from non-traded REITs pushed by brokers. However the lousy non-traded REIT performance measured by the three studies above would most likely become far worse, if the performance of living dead non-traded REITs were to be added to the analysis.
Questionable non-traded REIT pricing and secondary market sales
Individual investors can only buy non-traded REITs through a financial adviser. There is not data indicating that financial advisors have any real clue whether the non-traded REITs they are pushing are good or bad. The energy behind the sales push comes from extraordinarily high non-traded REITs commissions, and not the desire to put the best interests of the client first. Once the clients buy into a non-traded REIT, they are on their own.
You should understand that weak regulations allow non-traded REITs to maintain their original sales price (usually $10/share) as the current market value of shares for up to 18 months after the sales offer period has ended. If the sales period itself lasts 18 months, and you buy at the beginning, it might be three years before the REIT is required to restate the share value. Recently, numerous nontraded REITs have slashed valuations. Voluminous articles have been published about this problem and can be found via Google.
Many investors have been very surprised about the fall in the “per share value” of the non-traded REITs that were sold to them. In reality, all along these investors had been looking at the original sales price per share that was not necessarily tied to any market value per share for the underlying assets. At least with a public REIT, an investor has a much better understanding of the current fair market value of their shares.
Furthermore, if they want to sell, public REIT investors have a place to sell their shares without being surprised about share values. If the investor has invested in a low cost REIT mutual fund or ETF, market volume tends to be high and spreads tend to be narrow. Over time, you know what you can get for your publicly traded REIT and REIT fund shares.
Non-traded REITs – not so much. When investors want to cash out of non-traded REITs, they are often very surprised how much they have to discount their holdings to attract a private buyer. Often they have few private market sales avenues available. They might be able to sell their shares back to the REIT manager, but only at a significant discount to stated fair market value. Alternatively, they might have to sell to a more knowledgeable third party that has made a discounted tender offer.
The bottom line
You can always buy a publicly traded individual REIT, REIT mutual fund, or REIT ETF and avoid the problems associated with non-traded REITs. Just walk away from anyone pushing a non-traded REIT. Just say no and give yourself a raise.
Larry Russell researched and wrote this article. Over the past fifteen years, Larry has published hundreds of financial articles to educate the public about best practices in personal financial management. His fee-only registered investment adviser firm provides independent financial planning services to clients across the United States. In addition, Larry has personally developed the VeriPlan home retirement financial planning software application that individuals use to make their own lifetime financial plans for their families.
