On Advice

Regulators have an uphill battle to bring transparency to illiquid investments

Bringing light and due diligence should be a priority for the investment advice industry

Feb 7, 2014 @ 12:01 am

By Bruce Kelly

Securities regulators and the alternative investment industry are working together to bring more transparency to illiquid investments, including nontraded real estate investment trusts — a positive for financial advisers and their clients.

Last week, the Financial Industry Regulatory Authority Inc. issued a rule proposal that would give investors a clearer look at the cost of buying such REITs.

That's all well and good. But they face an uphill battle in trying to bring clarity and understanding to an industry that has been riddled with confusing disclosures and related-party transactions.

Bringing light and top-notch due diligence to illiquid investments, whether sold by a Goldman Sachs banker or LPL Financial registered representative, should be a priority for the investment advice industry. Sales of such investments are becoming more and more common, with nontraded-REIT sales reaching $20 billion last year, double the amount in 2012.

But even greater evidence of the dire need for transparency when investors buy alternatives is in the details of individual deals and partnerships. The twisted history of one such illiquid investment, American Spectrum REIT I Inc., shows the potential for pain for both advisers and clients when buying illiquid alternatives.

As a private REIT that is limited in its number of investors and no longer sold through broker-dealers, the American Spectrum REIT is not indicative of the public nontraded-REIT industry. It isn't likely subject to last week's Finra proposal to the Securities and Exchange Commission.

Still, it is worth taking a look at as a cautionary tale for advisers and investors considering alternative investment funds.

Born in 2004 with a $25 million fundraising, the American Spectrum REIT I hasn't paid a dividend since 2009 and hasn't had an annual meeting of shareholders since 2010.

However, it is making money.

The REIT has six storage properties and generated about $3 million in income for the 12-month period ended last June, according to the 2013 second-quarter performance review sent to clients.

Gregory McAndrews, a spokesman for American Spectrum Realty Inc. (AQQ), a related company, confirmed that the REIT hasn't paid a dividend in more than four years and that no formal shareholders meeting has occurred since 2010.

“The properties were doing better during the first part of 2013,” he wrote in an e-mail

“It is quite possible that a dividend will be issued for the year ended Dec. 31, 2013, as was stated to investors,” Mr. McAndrews wrote. “We should report financials, any dividend and the valuation before the end of March.”

Although the REIT hasn't had an annual meeting of shareholders in a few years, it communicates with them regularly, Mr. McAndrews said.

The REIT's history is convoluted, adding to the potential for confusion. It was formerly dubbed the Evergreen Realty REIT Inc. but changed its name in 2010 to American Spectrum REIT I after American Spectrum Realty acquired the property management and asset management contracts held by Evergreen Realty Group and affiliates.

William J. Carden is the chief executive of American Spectrum Realty and is the only current board member of the REIT.

“The REIT had three directors through 2012, Mr. McAndrews said.

Since the last annual meeting of the REIT in May 2010, “there has been a lack of quorum to have an annual meeting,” he said. “This is not uncommon for non-SEC- reporting, small private REITs.”

The REIT has made transactions with related companies, which the REIT industry watches closely for potential abuses.

In a March 2011 letter to shareholders, the board said that it had made “several transactions in which certain of the REIT's assets were exchanged for operating-partnership units in American Spectrum Realty Operating Partnership, the entity through which American Spectrum Realty Inc. holds its assets.".

Such nomenclature is one of the most confusing aspects of the illiquid-alternative and nontraded-REIT business. This needs to be cleaned up so that investors and advisers have a truer understanding of which business owns what and who is really getting paid.

It is like Abbott telling Costello that “Who” isn't only on first, but “Who Realty” is on second, “Who Management Inc.” is on third and “Who Partners” is at short.

Indeed, those “operating-partnership units” could be converted to the common stock of American Spectrum Realty, a publicly traded real estate company with the ticker symbol AQQ, according to the letter.

“One immediate benefit to the REIT from these transactions is, the [operating-partnership units] constitute a liquid assets that can be easily sold for cash to meet the REIT's needs,” according to the letter.

That didn't happen.

Mr. Carden, the chief executive of American Spectrum Realty, the publicly traded company, bought 103,000 shares of AQQ common stock from the American Spectrum REIT I, according to a November 2012 filing with the SEC.

Remember, the REIT's investors were told 20 months earlier that those shares were an “immediate benefit to the REIT” because they were liquid assets.

“These are fully disclosed transactions, and have benefited investors so far,” Mr. McAndrews said.

And how did Mr. Carden pay for those shares?

He used “an unsecured promissory note issued by Mr. Carden in the principal amount of $308,091, representing a price of $3 per share,” according to the SEC filing.

His promissory note is due in August 2017.

Meanwhile, the REIT's investors still have no dividend and no liquid shares of the publicly traded American Spectrum Realty. But they possess Mr. Carden's “unsecured promissory note.”

I wonder how much that will be worth in three and a half years when investors knock on his door.


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