Brokers’ job to explain nontraded REITs

Finra last week took welcome steps to shed much-needed light on nontraded REITs. But, quite frankly, the changes being proposed should be information already being conveyed to investors by their brokers.

Nontraded real estate investment trusts have exploded in popularity in the past few years as investors have flocked to financial products that offer higher returns than they could get in traditional fixed-income investments.

Last year, $20 billion in nontraded REITs were sold, compared with $10.3 billion the year before. A like number of shares — or more — are expected to be sold this year.

Amid low interest rates, nontraded REITS can be a good choice for many investors, at least for a portion of their portfolios, provided they fully understand how the investments work and how much it costs to purchase them.

And there is the rub.

Until now, the nontraded-REIT market has rightfully been described as “murky” and “opaque.” Investor advocates have talked about “hidden fees” and “valuation problems.”

Under current rules, brokers can list the per-share value of nontraded REITs at $10 a share, the price at which they are usually sold, for up to 18 months after the sponsor stops raising funds, even though commissions and fees that can total up to 12% of the share price have already been deducted. Given that it can take two to three years to raise funds for a nonlisted REIT, that means investors could be receiving inflated valuations for al-most five years after they initally invest.

The proposed changes being sent by the Financial Industry Regulatory Authority Inc. to the Securities and Exchange Commission for final approval would mean true valuations sooner for investors.

Under one of the valuation methods, brokers would have to reflect commissions and fees on statements as soon as a nontraded REIT was permitted to access the offering proceeds to buy real estate. REIT sponsors would be allowed to use that valuation for a period of two years.

A second valuation method would entail getting a third-party expert to sign off on a REIT’s valuation.

INDUSTRY WORRY

The broker-dealer industry has a lot at stake regarding these new rules. Many had record revenue from nontraded-REIT sales last year, and they are worried that the new rules could hurt future sales if investors are seeing account statements that explicitly show the fees and commissions being charged for these investments.

But it should be the responsibility of every broker selling these products — even without the new rules — to make sure their clients understand how the products work and how much they cost.

For example, brokers need to have an honest discussion about illiquidity and the fact that the money invested in a nontraded REIT may not be available for a three-to five-year period. And new Finra rules notwithstanding, brokers should remind their clients that the value of their investments may actually be lower at times than their statements indicate.

In the end, nontraded REITS, like every investment, have to stand on their own merit.