There are several good reasons that portfolio managers turn to REITs when developing effective wealth management strategies for their clients. Funded by multiple investors, these real estate investment trusts generally offer a higher rate of return to investors when market interest rates are lower.
If you have recommended REITs to your clients, you probably already know that there are two main types: those traded on public exchanges and those that are publicly registered with the SEC, but not traded on the exchanges. The REITs not traded on the exchanges are known as “non-traded” REITs.
Both types share many similarities but also have significant differences that investors need to understand. Both types of REITs are subject to the same IRS requirements, must distribute 90 percent of taxable income to the investor shareholders and are required to make SEC disclosures on a regular basis. Features that make the non-traded REITs different have both pros and cons when compared to the exchange-traded REITs and other types of mutual funds.
Pros of investing in non-traded REITs
- Hedge against inflation. Both types of REITs offer some protection against inflation. Since the REIT owns the income-producing properties, it can raise the rents to cover rising costs, depending on the underlying lease structure.
- Deliver regular dividends. Non-traded REITs are designed to provide investors with a regular dividend stream until the REIT is liquidated.
- Higher than average distributions. In 2015, these REITs produced average dividends of 5.5 to 6.5 percent per year, net of fees. Traditional REITs produced dividends near three percent. At the same time, other fixed-income securities were producing much less and the 10-year Treasury yield was at only 2.5 percent.
- Immunity to other market swings. REIT performance does not usually correlate with swings in the traditional markets. This acts as a buffer against volatility and helps diversify an investor’s portfolio.
- Liquidation can occur in many ways. The Board of Directors can decide to restructure the entity as an exchange-traded REIT, can merge it with another company or sell some or all of the commercial properties in the portfolio. These REITs are set up to deliver consistent dividends as long as possible but the REIT itself is not designed to live forever.
Cons of investing in non-traded REITs
- Are not liquid. An investor must understand that up to 100 percent of the funds invested may be tied up for several years, often as long as eight years.
- Carry large early-termination fees. If the investor wishes to exit the REIT before the liquidation date, the fees and costs associated with early termination can result in a negative return on investment.
- Distributions may be suspended, halted or be made from borrowed funds. Distributions are not guaranteed and the decision to make a distribution is within the Board of Directors’ discretion. REITs can distribute funds from the principal rather than earnings.
- Front-end fees can be close to 13-15 percent of the price per share. The fee includes selling compensation, external management expenses and additional offering and organizational costs. Exchange-traded REIT fees are about half this amount.
- At exit, investors may receive more, or less than their original investment amount.
- Investment properties may not be identified. When REITs are funded by investors, it may not yet own any property. However, the more properties that it owns, the better investors can assess the risks associated with investing in this type of REIT.
- Uncertain share value. Because non-traded REITs are not publicly traded, the market value at a certain period of time is difficult to determine.
Given the pros and cons of non-traded REITs, appropriate investors are those whose risk profiles and needs meet the criteria for these products. Although subject to material upfront fees, they can generate relatively high yield for clients in low interest rate environments, and serve as a hedge against the volatility of the public markets.
