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Non-Traded REITs Have Gotten a Bad Rap for Lack of Transparency. Can They Be Trusted?

A recent fraud case brings the sector’s transparency issues back into focus.

Nick Schorsch once reigned as the king of public non-traded REITs. But his empire started to unravel in 2014 after an accounting scandal first came to light.

At the heart of the debacle was American Realty Capital Properties Inc., a publicly-traded net lease REIT. Authorities alleged that Schorsch and some of his colleagues had wrongly siphoned millions of dollars in fees from the merger of the publicly-traded REIT with two non-traded REITs. Brian Block, former chief financial officer of American Realty Capital, was sentenced to 18 months in prison for securities fraud. Block, Schorsch and REIT sponsor AR Capital LLC subsequently agreed to pay more than $60 million in penalties to settle the U.S. Securities and Exchange Commission (SEC) case against them.

American Realty Capital has since rebounded under a new name, VEREIT Inc., and a new management team. And the whole fiasco is now largely in the past, with Phoenix-based VEREIT having spent hundreds of millions of dollars to settle legal action stemming from the American Realty Capital fraud.

Today, the Schorsch catastrophe and a more recent case involving a different non-traded REIT serve as cautionary reminders about this breed of REIT.

To be fair, the vast majority of the estimated 65 active non-traded (or non-listed) REITs in the U.S. operate well within legal and ethical boundaries. And some of the biggest, most trusted names in commercial real estate manage non-traded REITs, including Black Creek Group LLC, Blackstone Group Inc., Hines LP and JLL.

“In my opinion, there’s not any more fraud in the non-traded REIT space than there is in any other … type of financial market,” says Stacy Chitty, managing partner of Cumming, Ga.-based Blue Vault Partners LLC, an independent provider of research about non-traded REITs and other alternative investments.

These days, it’s easy for a law firm to encourage an unhappy, confused investor in a non-traded REIT to pursue a fraud case against the financial adviser or broker-dealer that handled the investor’s purchase of the REIT shares, Chitty notes.

Chitty emphasizes that the non-traded REIT sector has “weeded out” most of the bad actors like Schorsch. But, he adds, the sector is “still picking up the trash from the mess [Schorsch] created.”

A 2018 report from New York City-based investment manager Cohen & Steers Inc. notes that with “the emergence of ‘new and improved’ non-traded REITs … some investors have shrugged off the industry’s checkered past.”

Jim Sprow, senior vice president of research at Blue Vault, acknowledges the rocky past of the non-traded REIT sector, but says the industry “has evolved quite a bit” during its three-decade existence.

For years, critics have complained about high upfront fees for investments, Sprow notes. However, a number of non-traded REITs have reduced those fees from around 7 percent to around 3 percent, he says. Plus, publicly-traded REITs also pass along management costs to investors, Sprow adds.

The Financial Industry Regulatory Authority cautions that upfront fees assessed by non-traded REITs can go as high as 15 percent.

Another longtime knock against non-traded REITs has been their lack of liquidity.

Unlike shares of publicly-traded REITs or other publicly-traded companies, shares of non-traded REITs can’t be easily bought and sold, Chitty notes. Whereas an investor can buy or sell publicly-traded shares online, someone typically must trade shares of non-traded REITs by contacting a financial adviser. Plus, if an owner of shares in a non-traded REIT wants to liquidate those holdings, they probably won’t be able to do so for months or even years down the road since they’re not traded on an exchange. That’s in contrast to shares of publicly-traded REITs, which are traded freely and frequently.

Sprow points out, though, that the rise of non-traded NAV REITs has allowed investors in these vehicles to cash out their shares on a quarterly basis, in many instances.

Non-traded REITs offer better long-term distributions (yields of 6 percent to 7 percent) than their publicly-traded counterparts (typically less than 4 percent) and lack the market volatility that publicly-traded REITs face, Sprow adds. These REITs also provide a way to diversify a portfolio, Chitty and Sprow point out.

In its report, Cohen & Steers notes that non-traded REITs have historically underperformed publicly-traded REITs, with a weighted-average annualized return of 5.7 percent for non-listed REITs from 1990 to 2018, compared with 13.3 percent for publicly-rated REITs.

Cohen & Steers complains that the non-traded REIT sector “has had little accountability, with too many examples of ineffective management, inefficient fee structures and conflicts of interest between sponsors and shareholders. Yet because of the industry’s opacity and marketing allure, [non-traded REITs] have continued to see commercial success.”

Scott Silver is managing partner of Silver Law Group PLC, a Coral Springs, Fla.-based law firm that represents plaintiffs in cases involving investment and securities fraud. He says that “without anyone looking out for the investor’s best interest, [non-traded REITs] are ripe for fraud because of limited government oversight and no public market to set a fair value on the investment.”

Although both types of REITs must file regular reports with the SEC, scrutiny of non-traded REITs is less intense than it is for publicly-traded REITs, Silver notes.

As for the “fair value” argument, the SEC notes that although the market price of a publicly-traded REIT’s shares can be easily determined, it can be hard to figure out the value a non-traded REIT’s shares. Why? Because non-traded REITs typically don’t provide an estimated per share value until after an offering closes. “This may be years after you have made your investment,” the SEC advises.

Chitty admits non-traded REITs operated for years with “very little transparency.” That has changed in recent years, but even with that sort of data available to the public, SEC cases like the one involving a businessman named Suneet Singal stoke the concerns of attorneys like Silver.

On Dec. 13, the SEC alleged that Singal lied about his ownership of 12 hotels and his contribution of those properties to First Capital Real Estate Trust Inc., a public non-traded REIT based in New York City, in order to secure a $15.2 million interest in the REIT’s operating partnership. The SEC claims Singal made misrepresentations and omissions about the hotels in several SEC filings. As a result, First Capital REIT reported pumped-up NAV and issued stock to investors at inflated prices, the SEC alleges in its fraud complaint.

Singal, former chairman and CEO of First Capital Real Estate Trust, serves as CEO of First Capital Master Advisor. New York City-based First Capital Master Advisor is a privately-held real estate sponsor and investment finance company.

In a Dec. 13 letter sent to First Capital Real Estate Trust and filed with the SEC, Singal wrote that he was stepping down as chairman and CEO of First Capital Real Estate and its affiliates. Singal added that he’d found a buyer for the REIT’s common shares, preferred shares and operating partnership units at prices above the original amounts paid, and that an interim management team was coming aboard to wrap up the REIT’s regulatory filings and complete the stock buyout.

Zar Aamer, director of strategy at First Capital Master Advisor, says that upon the advice of his attorney, Singal can’t discuss specifics about the SEC case against him. “Mr. Signal is vigorously defending the matter, and is of the opinion that he will prevail in the end,” tells NREI.

In light of such situations, Silver has trouble defending non-traded REITs.

Non-traded REITs “were initially created as a vehicle for sophisticated investors to pool their money in a real estate project,” he says. “The rule has now been butchered to allow the sponsors of non-listed REITs to sell these products to retail investors in exchange for a high commission.”

“Investors who don’t understand real estate should steer away from these products because the lack of transparency and high commissions or management fees lead to many bad actors entering the marketplace,” Silver adds. “Ultimately, investors have no way to get out—even after the misconduct is exposed—because of the lack of a marketplace.”

Anthony Chereso, president and CEO of the Institute for Portfolio Alternatives, views non-traded REITs through a much different lens. In 2018, he told REIT magazine that the continuing evolution of non-traded REITs has led to a better-positioned, solid, diversified investment vehicle.

“If you look at fee structures, the quality of asset managers, the portfolios that are being designed and built, it is a much better product,” Chereso said of non-traded REITs.

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