Whither Non-Traded REITs

Non-traded real estate investment trusts are a product that was developed to offer to the retail investor, including through their retirement accounts, an investment opportunity in U.S. real estate offering a relatively high current yield. Especially in the current low rate environment, many investors were attracted to these securities by the promised significant current returns.

These securities are sold typically through independent broker-dealers, many of whom are affiliated with the sponsor/advisor of these REITs being offered. Until recently, the usual fee structure had significant upfront costs – 3% commission to the broker and 7% fees to the advisor, sometimes even higher. The product also provided limited liquidity, at least until there was a liquidity event that wasn’t expected to occur for at least five years or more after the offering period.

There can be little doubt that there has been a serious downturn in the sales volume of these products since sales peaked in excess of $19 billion in 2013. The reasons for the drop can be traced to several events which, in the last few years, seem to have combined to have a major adverse impact on the market for this investment type.

These events have arisen from increased regulatory scrutiny and regulation, as the popularity of the product type increased, adverse developments affecting some of the major industry players, and the increased probability of at least a temporary halt in the rise in the real estate market in general.

SEC, FINRA and DOL

The SEC has shown increasing interest in examining non-traded REIT offerings for several years. In 2013, it issued additional disclosure guidance for offerings of non-traded REITs and in August 2015, it released a cautionary Investor Bulletin to help “educate investors about investing in non-traded REITs.”

FINRA, primary regulator for broker-dealers, has also released an investor alert titled “Public Non-Traded REITs—Perform a Careful Review Before Investing.” And it has significantly increased the disclosure obligations brokers have to their customers regarding the value of their customers’ holdings of non-traded REIT securities.

Where once a broker could show on quarterly client statements an investment in a non-traded REIT at its original cost for potentially a long period after the purchase, regardless of the fees and commissions charged and without reflecting changes in the value of the REIT’s assets, there are now much more stringent rules on valuing these investment currently. The most recent amendments to these rules, designed to improve the level of accuracy and reliability of the valuation of non-traded REIT securities, were only approved by the SEC in April of this year.

In addition, the Department of Labor’s recent rules imposing fiduciary duties on investment advisors for retirement accounts may make it harder for advisors to recommend non-traded REIT products with the traditionally high levels of fees and costs.

Investor Concern

The news in the market recently has not been kind to the non-traded REIT industry. While there has always been dislike of this product in some quarters of the advisory community, current events have heightened investor concern. Several of the major players in the industry are the subject of investigations by regulators and law enforcement.

Claims of accounting problems in connection with an acquisition have dogged Nicholas Schorsch, the founder of American Realty Capital, now called AR Capital, and his non-traded REIT empire for over a year now. And claims of fraud at another major sponsor of non-traded REITs, United Development Funding, have further added to the storm clouds hanging over the industry.

Although the real estate business in general, and traded REITs in particular, have done well for several years, there is some evidence of possible headwinds, at least in the short term, with the possible expected rise in interest rates and where trophy properties in hot markets are trading at or near historic highs. Whether these negative consequences materialize, there is certainly additional uncertainty affecting today’s property markets arising from the unknown effects of Brexit on the domestic property markets, positive or negative, the presidential election and slowing growth in much of the worldwide economy.

Of course, the non-traded REIT market is adapting to the changing environment. The product is evolving, for example, by significantly lowering the upfront fee structure. It is too early to get a good idea whether these adaptations will reverse the fall in popularity.

What About Large Law Firms?

How will these trends affect the legal market at large law firms?

Non-traded REITs are but one type of real estate investment product, so negative developments particularly affecting them shouldn’t be expected to materially impact the career of the typical real estate lawyer.

For those lawyers who deal with the complex broker-dealer and securities issues that arise in offerings of non-traded REITs, the short-term outlook may not be as rosy. However, most of these attorneys have broader knowledge in the related legal fields, even though they may have developed a specialized expertise in this product.

The demand for legal specialists in the non-traded REIT has certainly dropped, but many lawyers who work in the area, especially those with wider experience, should be able to redeploy their skills in other areas relying on their general knowledge of the relevant legal issues.