Earlier today the widely respected securities industry trade publication, InvestmentNews, published a story titled “REIT with a twist — and a high commission — is new darling of independent brokers-dealers.” If that title sounds bad for customers, it is.
The REIT with a twist is a nontraded REIT packaged as preferred stock.
Nontraded REITs have come under scrutiny in recent years by the SEC, many state security regulators and the Financial Industry Regulatory Authority (FINRA). Although they may be a viable investment strategy for institutional investors, stockbrokers often sold them to elderly investors and those nearing retirement. The very people that need access to their funds suddenly found their shares couldn’t be liquidated. Investors sometimes must hold their shares for years before they can be liquidated.
Despite being bad for investors, stockbrokers love nontraded REITs because they pay huge commissions…. commissions that are often 7%. (Compare that with commissions on regular investments that are under 1%.) Brokers love them because they are easy to sell. With bank and treasury yields at historic lows, nontraded REITs claim high yields and monthly payments.
On paper, these products look great. Many brokers, however, didn’t properly educate their customers about the high commissions, high internal fees, low or no liquidity and high risk.
With nontraded REITs getting bad press, one promoter came up with a new scheme called “nontraded redeemable preferred shares.” John Williams launched Preferred Apartment Communities, a traditional non-traded REIT, in 2010. Shortly thereafter, Williams came up with a new scheme – a “twist” in the words of InvestmentNews – he offered preferred shares of stock in the REIT. For $1000, an investor gets one share of stock with a 6% yield and a warrant to buy 20 more shares of common stock.
Investors get their 6% yield for the next 5 years at which time they can redeem for the $1000 original purchase price. Williams offers a bit more liquidity by allowing early redemptions but subject to an early redemption fee.
We worry that Williams may have become the victim of his own success. Preferred Apartment Communities has raised so much money that it may not be able to keep finding quality properties capable of generating the cash flow necessary to pay big dividends and big commissions too. Like other similar REIT products, these shares pay 7% commissions. 6% yield plus 7% commissions, plus broker dealer fees plus high internal costs… can Preferred Apartment generate enough cash flow?
Another one of the things that worries us is Preferred Apartment’s outside management. Typical of many nontraded REITs, outside management usually means high fees.
Yet another worry is the lack of transparency. FINRA enacted rules requiring disclosure of the commissions on traditional non traded REIT investments but Williams skirts those rules by structuring shares as preferred shares. There are plenty of traditional real estate investment trusts without the liquidity problems, high fees and with much better transparency.
Wall Street has a habit of developing new products simply as a way of circumventing rules and disclosure. That these new preferred shares skirt the new FINRA commission disclosure rules is a red flag for us.
Probably the biggest problem with these investments is how they are marketed. Brokers have a legal obligation to fully understand their customers’ needs and risk tolerance. (Know Your Customer or “KYC” rules) They also have an obligation to only make investment recommendations that are suitable for their clients. While most follow the rules, a few are more interested in finding investments that generate the most commissions. Nontraded REITs are at the top of the list.
MahanyLaw and Nontraded REITs
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MahanyLaw – Stockbroker Fraud and Investment Recovery Lawyers
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