Reps react to Finra's proposed rule changes on nontraded REIT costs

Some optimistic, others skeptical about plan to scrap the automatic per-share value of $10

Feb 4, 2014 @ 12:34 pm

By Bruce Kelly

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Registered representatives who sell nontraded real estate investment trusts and industry insiders greeted proposed Finra rule changes that would give investors a truer picture of what it costs to buy shares of such REITs with varying degrees of muted optimism and skepticism.

If approved by the Securities and Exchange Commission, the rule change, which was posted on Finra's website on Monday, would do away with the practice of broker-dealers listing the per-share value of nontraded REITs at $10, the price at which brokers commonly sell them to clients.

Instead, the Financial Industry Regulatory Authority Inc.'s potential rule change would take into consideration the various fees and commissions paid to brokers and dealer managers, reducing the share price on each customer account.

“I don't think this will hurt my business, and for my clients, this isn't an issue,” said James Ehrenkrook, who is affiliated with Independent Financial Group.

He said that he explains to clients how he gets paid for different services and products, emphasizing the difference between fees for assets under management and a commission for a product such as a nontraded REIT.

“The key is how much the clients will make, not the adviser,” Mr. Ehrenkrook said.

“I have mixed feelings on this,” said Eric Reinhold, an adviser with Ameriprise Financial Services Inc. “I never thought it made sense to show $10 per share from beginning, because it gave the impression that the valuation was always the same.”

Investing in different asset classes such as stocks, which are liquid, and real estate, which isn't liquid, will give rise to differences in valuations, Mr. Reinhold and other advisers said.

“I think trying to make both of these very different assets the same is a mistake,” he said.

“In a rising real estate market, REITs have appraised to the upside, which in some ways works against clients,” particularly when a nontraded REIT is still in the phase of raising money, Mr. Reinhold said.

In a statement, the Investment Program Association, which represents the interests of nontraded REIT companies and other direct investment products, stressed that it had worked closely with Finra on the rule proposal.

The IPA worked with Finra “to create an account statement rule that is fair to investors and presents a clear picture of nonlisted REITs and direct participation programs as they evolve,” the IPA said.

Monday's Finra proposal to the SEC takes steps in this direction, the IPA said.

“Deducting commissions and direct marketing fees on the account statement represent steps forward for these increasingly popular products, and the IPA supports this part of the proposal,” the association's statement said.

Because of the proposal's complexity, the IPA said that it would like to see a 90-day comment period after the rule is published in the Federal Register rather than the proposed 21 days.

The nontraded REIT industry, which saw sales double last year to $20 billion, from 2012, has been anxiously waiting for the Finra rule proposal. Whether a change in per-share valuation disclosure would hurt or slow nontraded REIT sales has been hanging over REIT sponsors and the independent broker-dealers that sell the product.

Many broker-dealers had record revenue from nontraded REIT sales last year as a number of REITs had “liquidity events,” meaning that they merged with another company or were listed on an exchange.

The proposed rule has two methodologies that broker-dealers can use when an estimated value is presumed reliable, according to the 268-page Finra proposal.

Those methodologies are net investment and independent valuation.

For example, the net investment methodology could be used for two years following the nontraded breaking of escrow, or when the issuer is permitted to access the offering proceeds to buy real estate.

“For example, if the prospectus for an offering with a $10 offering price per share disclosed the selling commissions totaling 10% of the offering proceeds, and organizational and offering expenses of 2%, the amount available for investment would be 88%, or $8.80 per share,” according to the Finra rule proposal.

Nontraded REITs now don't have to show an estimated per-share valuation until 18 months after the sponsors stops raising funds, which in many cases can take two or three years. The Finra proposal drastically speeds up the process by which investors would see a valuation of less than $10 a share.

The second method is independent valuation and could be used at any time, according to the Finra proposal.

It would consist of the most recent valuation disclosed in the issuer's periodic or current reports and would require a third-party-value expert's or experts' determination.

The proposed rule changes, which have been in the works at Finra since 2011, is now in the lap of the SEC. The effective date of the proposed rule change will be announced no later than 90 days following the SEC's approval.

The specific rule that Finra is proposing to change is NASD Rule 2340, regarding customer account statements.

It relates to the per-share valuation for nontraded REITs and other “direct participation program” investments such as oil and gas partnerships.

Finra has shifted its stance on nontraded REIT valuations since its initial rule proposal was published in September 2011.

In that proposal, Finra considered requiring that every customer account statement present a valuation of a nontraded REIT or “direct participation program” security.

In the proposal that is heading to the SEC, Finra isn't requiring broker-dealers to list an estimated value per share for each security.

Finra has doubts about “reliable” valuation, it said in its proposal.

“Finra has determined not to explicitly require the presentation of a valuation in customer account statements because it could interfere with the objective of ensuring that valuations are reliable,” according to the rule proposal.

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