Investing in Real Estate Part 2: How Not to Invest in Real Estate

Last month, we discussed some of the benefits of including real estate in your investment mix. These include income, diversification and, in the case of owning property directly, some significant tax advantages for owning income properties.

I also mentioned that there are some versions of real estate investing which are more attractive than others. A Real Estate Investment Trust or “REIT” is a company which invests in real estate. Most are publicly traded on the exchanges, and investors can buy and sell the stocks of these companies just like any other. One such company based in San Diego is Realty Income Corp (NYSE: “O”). Another familiar one is Westfield, which is owned by a Europe-based REIT and operates shopping malls around the U.S. and the world.

Many mutual funds focus on investing in REITS as well, making them fairly accessible to most investors at (sometimes) reasonable cost. Sophisticated and higher net worth investors may also look to partnerships where a builder or operator will pool funds (often with significant investment minimums) for specific projects or sets of projects. These are complex legal arrangements which offer the potential for higher returns (but also significant losses).

My least-favorite way to invest in real estate is called a Non-traded REIT. They are structured a lot like partnerships but with much smaller investment minimums to make them accessible to smaller (and generally less sophisticated) investors. They blend characteristics of REITs (professional management, multiple properties, net asset value like a stock) with some of the characteristics of partnerships (illiquid, opaque, high cost).

Here are some of the reasons why this mix doesn’t work:

Cost. Non-traded REITs can be grotesquely expensive, with front end sales commissions up to 10% and internal annual expenses that can run as high as 2.75%, significantly higher than most listed REITs and even most REIT mutual funds. More importantly, the sponsors of these REITs are often also service providers through shell companies, dramatically increasing the conflicts of interest and the costs incurred at every stage of the process.

Illiquidity. The Non-traded part is sold as a feature but it’s actually a negative. Once purchased, they are almost impossible to get rid of. If you purchase them inside a retirement plan and then switch jobs, they are extremely difficult to transfer to your new plan. Selling the Non-traded REIT is sometimes possible, though often at steep discounts to their stated value.

Opacity. Non-traded REITs only value their assets when absolutely required. The result is a net asset value that rarely changes on your statement. Beware though, these values may often be so stale as to be grossly inaccurate. For example, one REIT was sold in 2005 at $10 per share and listed as such until 2010 when regulators forced the sponsor to value the properties honestly. Investors were stunned when their shares were suddenly worth only $4.25. Things are better now, but the values can still be 18 months or more out of date.

Leverage. Non-traded REITS are often highly leveraged, frequently using funds borrowed from banks (or paid in by new investors) to fund distributions to existing shareholders. Non-traded REITs may be twice as leveraged as a similar listed REIT traded on an exchange. While increasing your potential returns, leverage also adds significant downside risk to your investment.

Underperformance. According to one study, from 1991 to 2018, private real estate funds (partnerships) underperformed listed REITs by almost 4% per year. That same study shows non-traded REITs performed even worse over the same period.

In the final analysis, non-traded REITs are great for the brokers who are paid hefty commissions to sell them to unsuspecting clients. But there are much better ways to add real estate to your portfolio if you feel that would be a good investment for you. If you have questions about investing in real estate or want to learn more about diversifying your portfolio, talk to a Fee-Only fiduciary investment advisor; someone who isn’t compensated by commissions.

At Blankinship & Foster, we help clarify and organize your finances, maintain a sound financial plan and navigate life’s transitions with confidence. Contact us to learn more about how our proven process brings clarity, confidence and direction to your finances.

About Rick Brooks

Rick Brooks, CFA®, CFP® is a partner of Blankinship & Foster LLC and is the firm’s Chief Investment Officer. He is a lead advisor, counseling clients on all aspects of personal financial management. Rick serves on several boards. He is the Chairman of the Board of Girl Scouts San Diego, and also chairs the San Diego Foundation’s Professional Advisor Council. Rick and his family live in Mission Hills. Rick enjoys spending time with his family, theater, cooking, skiing, gaming and reading.

Comments are closed.