November 1, 2011
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The attraction of high yields comes at the expense of higher risk, a time-worn lesson that should be an ongoing focus for investors in non-traded REITs.
FINRA recently issued an investor alert with respect to non-traded REITs that outlined the products’ features and potential drawbacks, such as high fees and illiquidity. Those problems are significant enough that some firms and advisors are staying out of this space entirely. Given how frequently these products have been mis-sold and how high their risk levels are, FINRA’s action is understandable.
FINRA’s action comes at a time of increasing interest in non-market correlated assets, which include non-traded REITs. Non-traded investments often fall into this category and have characteristics that differ significantly from traded assets. Many non-traded investments have suffered impaired performance recently and, therefore, over the short-term at least, have not achieved their intended results. Moreover, in a yield-starved investment environment, assets that purport to pay out high dividends are particularly attractive.
Before you venture into the latest incarnation of a high stakes casino, here are the tough questions you must ask about this asset class.
- What is the proposed investment’s intrinsic value (or expected intrinsic value)? Estimate carefully. For example, some analysts favor using discounted cash flows, some favor relative valuation and others look at book value. Don’t trust the process and the result offered by the issuer, which are rarely transparent, as the law firm Snyder Kearney recently wrote.
- What is the margin of safety offered? Compare the issue price to your ascertained intrinsic value to make this determination. To reasonably expect a profit, this margin needs to cover up-front costs and ongoing expenses with an additional margin to spare. Your calculation should not yield a fixed number. Rather, it should reflect the uncertainty in your assessment of intrinsic value.
- Is the sticker price too high? The underlying assets should be acquired at favorable prices in light of current market capitalization rates, occupancies, leasing rates, comparable sales, replacement costs and other key metrics. Paying too much is a primary reason that, over time, many non-traded investments (such as Wells II and Inland REITs) underperform.
- What are the costs? Analyze these carefully. Even excellent underlying collateral can be severely hampered by the upfront, ongoing and back-end fees of an investment. Indeed, low fees are among the best indicators of future performance. With most non-traded investments, the upfront load includes sales fees and commissions, acquisition fees, origination fees, and the like. The maximum amount most non-traded vehicles can pay for offering expenses is 15% (and FINRA is seeking to cap the others at 15% too). Most issuers have offering costs in the range of 10% to 12%. Many of these products also have far too many ongoing fees. These can even be more difficult to overcome than the upfront load.
- Are the assets what they seem? Watch for “legacy assets” — assets purchased at market highs (e.g., real estate during 2005-2007). Sometimes such assets can appear in newer deals following acquisition from a related entity.
- Will distributions hinder performance? Although each private placement memorandum indicates the source of the funds to be used for distributions, the strongest offerings pay their distributions from operational cash flows. Look to see how and when operations create the cash flows so as to diminish and ultimately eliminate the significance of continuous fundraising to cover distributions.
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