It is easy to get caught up in a good thing, and for financial advisers, the risk of doing that cannot be overstated. Take the nontraded real estate investment trust business, for example. Last year, independent broker-dealers sold $20 billion of these investments, and all signs are pointing to another banner year in 2014. Nontraded REITs are lucrative, with a 7% commission for brokers and 1% to 1.5% commission for their broker-dealer.
The risk, however, is that brokers simply ride the wave of good times, not looking back but only ahead to the next sale. Chances are that clients won't protest too much, because, after all, times are good and performance is solid. They're getting a nice stream of income at a time when traditional income-generating investments just aren't doing the job.
Last year not only was a big one for sales, but mark-ed a shift in which nontraded REITs returned capital to investors more quickly than ever. This year, the industry has had at least five liquidity events, which can include a merger or a listing on a stock exchange. Three of those events happened just last month, when formerly illiquid products were listed: two REITs and one business development company.
Liquidity events return capital to investors — also a good thing — but they also force advisers to search for new revenue-producing products. Of course, with the market booming, the natural inclination might be to simply pour that cash into the next nontraded REIT and keep moving.
But plenty of questions remain. Some critics argue that with commissions of up to 8.5%, the sales loads are too high. Such lofty upfront fees also create a formidable hurdle for REIT managers to overcome to produce returns for investors. Others point out that investors who want real estate exposure can buy shares of publicly traded REITS, which offer liquidity and don't tie up investments for years at a time.
Those concerns are on the operational side, but the issues are no less significant on the regulatory side. Over the past year, both state and federal regulators have been watching the nontraded REIT business more closely, and have been quick to crack down on firms for putting too much client cash into these investments.
Last September, Massachusetts Secretary of the Commonwealth William Galvin, one of the more aggressive state regulators keeping an eye on independent broker-dealers, announced a settlement with five firms concerning sales of nontraded REITs. The five agreed to pay $10.75 million in restitution to clients who bought those products from 2005 to the date of the deal. That settlement came on top of $6.1 million in restitution and $975,000 in fines the five broker-dealers agreed to pay four months earlier.
The five firms were: Securities America Inc., Ameriprise Financial Services Inc., Lincoln Financial Advisors Corp., Commonwealth Financial Network and Royal Alliance Associates Inc. Adding the restitution that LPL Financial agreed to pay, the six broker-dealers agreed to a total $21.6 million in restitution and $1.5 million in fines.
Those levies were related largely to the reality that broker-dealers need to be increasingly vigilant as the business grows. Remember: Too much of a good thing is not a good thing.
Last September, Mr. Galvin summed up the crux of the matter this way: “Our investigation showed widespread problems with adherence to the firms' own policies, as well as the state rule that an investor's purchase of REITs cannot be more than 10% of that person's liquid net worth.”
Advisers and independent broker-dealers would be wise to follow the advice of Brian Kovack, president of Kovack Securities Inc., who spoke recently with InvestmentNews senior columnist Bruce Kelly about this potential problem.
“The real issue is not the money being poured into the space, but whether [the nontraded REIT] is suitable with respect to its concentration in the client's holdings,” he said. “Are firms reviewing the concentration of REITs with regards to their suitability for clients?”
It's simple: Put the client first, and don't get too caught up in a good thing.