Although not necessarily high on any institutional investor’s list of investment options, the world of nontraded real estate investment trusts (REITs) has become a more talked-about topic recently, especially given the Financial Industry Regulatory Authority’s spotlight on them.
Early in 2015 FINRA, in its priority letter for the year, highlighted nontraded REITs and identified several concerns with the investment strategy. Among them were issues of liquidity, high fees and valuation difficulties. “These risks remain relevant with respect to customer-specific suitability obligations that firms must perform when recommending non-traded REITs to clients,” said the letter. “FINRA also emphasizes that firms should perform due diligence on an ongoing basis on REITs they allow their representatives to recommend.”
Joseph Price, FINRA senior vice president in charge of corporate financing and advertising regulation, says there are two main issues as they pertain to shareholders. The first is that fees and expenses are not transparent. Fees, he says, can be found in prospectuses, but the way values appear on account statements after a purchase — the so-called par value — do not net out fees and expenses for shareholders. The second concern is “that the underlying value of the portfolio may be changing dramatically in response to the markets, and that investors may not be aware of that,” he notes. In the past, appraisals were required for up to 18 months after the offer period. Now FINRA is requiring an appraised value within two years of breaking escrow. “Investors have that information on a more timely basis, and the appraised values will reflect the underlying value of the portfolio,” says Price.
And whereas investments in nontraded REITs are dropping from a peak of nearly $20 billion in 2013, according to investment bank Robert A. Stanger & Co., levels remain near $15 billion or so — much higher than the bottom in 2009, when they raised about $6 billion.
“It’s been a lengthy process of this industry working with the regulators, primarily FINRA but the SEC as well, in getting a rule change. It’s one we are extremely pleased with,” says Kevin Hogan, CEO of the Investment Program Association (IPA), a direct investment advocacy group. He adds that transparency and fee details will in the long term be a plus for the industry.
“There is a feeling that there could be some price compression around fees and expenses,” says Hogan. “But I think this is an industry where fees have come down over the past number of years, and I think will continue to do so as this rule comes into play.” FINRA’s Price agrees and says that when fees are more transparent, it’s likely they’ll fall.
IPA’s Hogan says the new rules might usher new and innovative products such as daily net asset value products or ones with new share classes and more levelized compensation structures.
The FINRA rules do not take effect until 2016, giving nontraded REITs a bit of time to change their disclosures and structures. However, there is also no grandfathering. Price says once the rules take effect, they do so for everyone at the same time.
