For many years income investors have turned to real estate investment trusts for a steady stream of income and the ability to create/invest in a diversified real estate portfolio. There are two ways in which these investments have taken place -- public traded REITs (which we read about -- and write about -- frequently on Seeking Alpha) and public non-traded REITs (which are, essentially, real estate partnerships with many partners).
Much like the eREIT [equity REIT like Kimco Realty (KIM)] and mREIT [mortgage REIT like Annaly Capital (NLY)] debate, there has been an ongoing debate about traded REITs and non-traded REITs and which is higher risk for the given distribution. There are benefits to both forms of REITs -- traded/non-traded, eREIT/mREIT -- and drawbacks to each form of REIT. Essentially what it comes down to is the risk/return profile of the investor/client.
Unfortunately for the non-traded REITs, the only time you hear of them is when something goes wrong and investors get burned. There are a greater amount of non-traded REITs that have worked well for investors. Well, once again the non-traded REITs are in the news -- courtesy David Lerner and Apple REIT.
Background on Apple REIT Companies
Apple Real Estate Investment Trust Companies consist of four non-listed, public, real estate investment trusts collectively referred to as the Apple REIT Companies. These four separate companies, Apple REIT Six, Inc., Apple REIT Seven, Inc., Apple REIT Eight, Inc. and Apple REIT Nine, Inc., each with a focus on the acquisition and ownership of high quality income-producing real estate, primarily in the lodging sector (which I just wrote an article on - timing being everything).
Background on complaint
Filing of complaint by FINRA (all emphasis mine):
The Financial Industry Regulatory Authority (FINRA) announced today that it has filed a complaint against David Lerner & Associates, Inc. [DLA], of Syosset, NY, charging the firm with soliciting investors to purchase shares in Apple REIT Ten, a non-traded $2 billion Real Estate Investment Trust (REIT), without conducting a reasonable investigation to determine whether it was suitable for investors, and with providing misleading information on its website regarding Apple REIT Ten distributions. DLA has sold and continues to sell Apple REIT Ten targeting unsophisticated and elderly customers with unsuitable sales of the illiquid security.
Since January 2011, as sole underwriter for Apple REIT Ten, DLA has sold over $300 million of an open $2 billion offering of the REIT's shares. Apple REIT Ten invests in the same extended stay hotel properties as a series of other Apple REITs closed to investors. Apple REIT Ten and the closed Apple REITs were founded by the same individual, and are all under common management. DLA has been the sole underwriter for Apple REITs since 1992, selling nearly $6.8 billion of the securities into approximately 122,600 DLA customer accounts. DLA earns 10 percent of all offerings of Apple REIT securities as well as other fees. Apple REIT sales have generated $600 million for DLA, accounting for 60 to 70 percent of DLA's business annually since 1996.
The complaint against DLA alleges that since at least 2004, the closed Apple REITs have unreasonably valued their shares at a constant price of $11 notwithstanding market fluctuations, performance declines and increased leverage, while maintaining outsized distributions of 7 to 8 percent by leveraging the REITs through borrowings and returning capital to investors. As sole distributor, DLA did not question the Apple REITs' unchanging valuations despite the economic downturn for commercial real estate.
In its solicitation of customers to purchase Apple REIT Ten, DLA's website provided distribution rates for all of the previous Apple REITs. These distribution figures were misleading and omitted material information because they did not disclose recent distribution rate reductions or that distributions far exceeded income from operations and were funded by debt that further leveraged the REITs.
Okay, this is going to sound a little cold - I will wait for the smackdown, but folks, these are non-traded REITs. Illiquidity kind of goes without saying, no? As well, return of capital happens with public REITs (and partnerships) quite often. Why the big surprise?
It is unfortunate that these investors might lose money. Until the exit event, one does not really know. Of course, I do not know how Apple was valuing the partnerships - they may be completely fraudulent (not saying they are by any means, just saying they might be) or they might of had a compelling rationale (I doubt it, though).
My point is that not all non-traded REITs are bad or dishonest. There are many that have worked out quite well for investors and provide investors with a means of investing in the various real estate markets. Ultimately, the investor/advisor has to determine the suitability of the investment for each individual client (despite the huge payout to the advisor). That is why the complaint is against Lerner, not Apple (unless there are other things brewing in agencies away from FINRA).
Real estate can be a tricky game, but there are many avenues investors can pursue to build a diversified portfolio with a stable income stream. While I am not a huge fan of non-traded REITs, don't let one bad apple spoil the whole darn bunch.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.