A Fool and His Money

Non-Traded REITs And Other Monetary Diversions

May 22, 2014 · 6 min read

by Moshe Silver, Hedgeye Risk Management, LLC

Non-Traded REITS: A Fool and His Money

Individual investors are increasingly desperate for a rate of return, as the Fed continues its generational program of sucking yield out of the marketplace. Money market funds are paying below 1% interest, and in order to get anything even remotely worthwhile in Treasurys, you have to go out at least ten years — and be willing to take the risk that markets might turn ugly, slashing the market price of your holdings.

Enter a plethora of high-yielding instruments designed to lure the individual investor — and keep them prisoner for the long term. Hedgeye’s energy sector guru, Kevin Kaiser, has written extensively on the pitfalls awaiting the investor in the oil and gas Master Limited Partnership (MLP) space. Many MLPs are structured, not as operating companies, but purely as exercises in creative accounting. As a recent example, Linn Energy (LINN) just announced a swap with Exxon (XOM) in which LINN is giving up is most attractive deposits, in return for a largely depleted XOM producing field.

Kaiser’s characteristically blunt assessment:

· Exxon is a real company trying to create value for its shareholders. LINN’s aim is financial engineering. Exxon is making this deal because it believes that it is giving up less value than it is receiving. If Exxon is right, LINN made a bad deal. Or should we believe that LINN handed Exxon the short end of the stick?

LINN is exchanging unexploited proven reserves for a partially-depleted producing field. They appear to be swapping a whole bush-full of fatted fowl for a tired old bird in the hand. But LINN is not in the oil and gas business; they are in the business of paying their unit-holders from the revenue streams from producing properties. In the process, they also pay themselves handsomely.

At current price levels of around $29 per LINN share, the stated distribution comes out to about a %10 annual yield. As long as they can keep paying it, that is, which Hedgeye and Kaiser are convinced will not be forever. We have no way of knowing what the catalyst will be, but by the time the other shoe drops, we think retail unit-holders will have already been crushed as the MLPs are forced to cut or forego distributions.

What’s a retail investor to do?

Oil and gas aren’t the only sure thing in America today. There’s also real estate (“they’re not making any more of it!”) and the ultimate investor candy: getting to invest alongside Smart People.

In 2011 FINRA, the feckless self-regulatory organization on whose one-eyed watch the brokerage industry has tromped and trounced the investing public for two generations, proposed a rule that would require certain private investments to be reflected on investors’ brokerage statements at their actual monetary value. It should surprise no one that the rule has not been implemented.

These private instruments are called “non-traded REITS” and other “Direct Participation Programs” (DPPs). The words “non-traded” and “direct” signify the illiquid nature of these investments. And since the primary function of the marketplace is its price discovery mechanism, through which real transactions establish a real-time market price, it stands to reason that the price at which these instruments are reflected on your statement is purely subjective.

How are these instruments priced, in fact? Well, currently all non-traded REITS are $10 a unit. That’s how FINRA permits them to be valued on brokerage statements. They are sold to the investor at $10 a share, and there they remain on the brokerage statement. And since REITs and other DPPs invest in real estate or in operating businesses, they are very long-term instruments. Infinite, in fact.

Non-traded REITS have become increasingly popular — about $10 billion worth were sold in 2012, and double that last year, as investors grew desperate in a world without yield.

Non-traded REITS are marketed as being “stable” — because they’re not subject to market price fluctuations. And “almost like investing in actual real estate” — because you’ll never be able to sell it. Maybe not so great for you, but non-traded REITS are a great deal for the firm that sells it to you.

A typical non-traded REIT can pay 7% commission to the salesperson, plus a 2.5% dealer management fee, plus 3% in offering expenses — all calculated against your investment dollar. This means that you end up with 87.5 cents of every dollar actually invested in the instrument: your REIT has to appreciate 14% in value before you are even.

In addition, the managers of the REIT pay themselves ongoing fees. One real-world example had managers paying themselves a 4.5% annual management fee, plus 3% for leasing properties.

But wait — there’s more. Because they are often blind pools, once they are funded the REIT managers then have to go out and buy the real estate (and there appears to be no law or regulation barring them from selling their own operating properties to the REIT they manage, a massive self-dealing loophole, courtesy of the SEC and FINRA).

While the managers are in the process of acquiring the properties to put into the REIT, they make regular payments to the investors. These payments are non-taxable. Can you guess why? It’s because, since there are no operating properties in the portfolio, they’re just giving you back your own cash. And recording it as yield.

How come you don’t know about this?

The main reason is that FINRA can’t get a rule passed requiring disclosure of the actual value of your investment. Nothing has taken place since the rule proposal in 2011. Until this month when FINRA released a statement saying, now that the public rule comment period had ended, rather than send the proposal to the SEC for approval and implementation, FINRA is mulling over the comments they received.

The comment period appears to have stretched from September 2011, when the rule was first proposed, to March of this year. That’s two and one-half years during which the regulatory agency compiled thousands of objections from the firms who market these instruments. As with many other public comment exercises, if you want to know what the average retail investor thinks of these non-traded REITS, don’t ask FINRA. They don’t know.

As sales of these instruments swelled from $10 billion in 2012, to $20 billion in 2013 FINRA took the unusual step of issuing Investor Guidance. Here’s the link: http://www.finra.org/investors/protectyourself/investoralerts/reits/p124232 We suspect that FINRA’s legal counsel advised the regulator that these charges are so egregious, FINRA risks exposing themselves to charges of negligence and financial reckless endangerment if they don’t do something.

If you take the time to read through this dry-as-sawdust publication, you just might come away with the impression that it would be a better plan for your financial future to play Russian Roulette with all six chambers loaded than to buy one of these things.

The uselessness of FINRA and its pathetic efforts at investor protection goes a long way towards explaining the explosion in these types of investments. “You gonna listen to them?!” says the salesman. “They don’t know the first thing about the markets,” goes the argument. “That’s why they become regulators instead.” While we generally can’t argue with that proposition, it does not logically follow that one is better off embracing the advice of a salesman who won’t tell you how much he’s getting paid on the transaction (if you ask, he is required by law to give you a full description of commissions, fees and charges.)

The Fed’s prolonged QE was intended to boost asset prices, raising the dollar price of securities by creating dollar inflation and praying that wealth would magically “trickle down” throughout the economy, a fairy tale Washington and Wall Street have been telling us for two generations.

For all its ivory tower prowess, the Fed never learned the basic lesson of the world of finance: the money business brings out the worst in people.

Legendary former Bear Stearns head Ace Greenberg warned in the early stages of the great bull market of the 1980’s that the growth in the financial sector would attract criminals and scam artists in their legions. While Ace was slugging it out in the trenches, Bernanke and Yellen were assiduously taking notes in their advanced Econ seminars. If you want to know why the store is in such rotten shape, you need only look at who’s minding it.

copyright (c) 2014 by Hedgeye Risk Management LLC


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