The Origin of Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts or REITs came into being in the 1960s through the REIT Act. The act allowed investors to invest in income-producing real estate just like any other security, with certain restrictions.

For the next few decades, REITs were almost exclusively the province of institutional investors like pension funds, hedge funds, and high net worth individuals. However, over time this began to change. By the 2000s, like the real estate housing market, investment in REITs by retail investors heated up - some would say, overheated. In part this was a function of the hot real estate sector in general; and in part it was the result of financial advisors learning about a product which earned them higher commissions. Just like clothes and cars, certain investment products become fashionable at certain times. If REITs can be said to have had their “vogue,” it was probably in the mid-2000s, shortly before the 2008-9 Financial Crisis.

What Is a REIT Anyway?

A REIT is any entity that acts an investment agent for real estate. Often the associations or corporations running the investment also own and operate the underlying income-producing properties. (This can cause problems, since with so many corporate layers taking slices of an investor’s investment, often an unacceptably low amount of that original investment goes toward actual investing while the rest goes into the REIT managers’ pockets.) The properties can range from strip malls to apartment buildings to hotels. The REIT controls the property or portfolio of properties in which retail investors invest their money by purchasing shares. REITs enjoy tax benefits by being permitted to deduct dividends paid to owners from its liabilities. These dividends are determined by the managers of the REIT, and - misleading assurances from unscrupulous brokers aside - they are by no means guaranteed.

Critically, there are two kinds of REITs. Listed and unlisted (or traded and nontraded). Less inherently risky and more illiquid, listed REITs or funds made of REITs are REITs which can be traded on a secondary market. That means that if investors wish to or during times of financial hardship, investors may sell their shares to other investors. No such option - or virtually no such option - exists for unlisted REITs. There is no official secondary market for these investments. Therefore, if for personal financial reasons an investor wishes to exit the REIT by selling his or her shares; or if the REIT’s value begins to fall and the investor wishes to get out, such maneuvers are made all but impossible by the nonexistence of a secondary market. Incidentally, though this should hardly come as a surprise given the marginality and riskiness of these products, unlisted REITs offer financial advisors the highest fees for sale.

What Happens When a REIT Goes Bad?

When the Financial Crisis hit, and the real estate market collapsed, most REITs got crushed. Many unlisted REITs suspended redemptions (attempts by investors to redeem their principal) and reduced or terminated investors distributions. With no secondary market, investors were stuck with their REIT shares. Worse still, the value of unlisted REITs is notoriously difficult to determine accurately, again since there is no or virtually no market for trading in these investments.

This dire situation has provoked cries for reform in the REIT industry. FINRA, the securities’ industry regulatory body, has issued numerous notices and announced plans to demand more accountability and more accurate reporting of valuations from unlisted REITs. At the moment, although they sometimes contract third-parties, for all intents and purposes nontraded REITs assign themselves a value.

Industry Reform for REITs and the Broker-Dealers Who Sell Them

While the industry attempts to reform itself, investors who find themselves trapped in dying REITs may wonder how and why they ended up there in the first place - and what recourse they might have to get out or receive compensation for being wrongly placed in a REIT. Unfortunately, in many cases financial advisors do not understand REIT products or ignore the risks and illiquidity of these products in order to focus on the higher sales commissions they stand to earn by selling them to customers. Either way, this may be a violation of the broker’s fiduciary duty to his or her customers as well as a violation of FINRA’s suitability code, which insists that broker-dealers ensure each and every investment they recommend be suitable for all investors and suitable for the individual investor it is recommended to. Any breach of fiduciary duty or suitability standards may open the broker-dealer to legal action through FINRA’s dispute resolution process.

Looking back at the rise of the REIT, it appears that this suddenly very fashionable product was vastly over-recommended to unsophisticated retail investors who did not need a REIT product in their portfolio - and especially not an unlisted REIT. In many cases, however, financial advisors and broker-dealers had an irresistible incentive to recommend the REITs inappropriately to customers for the simple reason that they made more money from REITs than almost any other product on the market. Go figure.

For more on nontraded REITs from an expert on the subject, please click here.

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