Hiding in Plain Sight

A recent article in InvestmentNews discussed the duration risks of nontraded REITs and said it was a problem “hiding in plain sight.” Unfortunately for thousands of REIT investors, the predictions are probably 100% accurate.

Nontraded REITs that invest in triple net leases won’t be able to distribute cash as rates rise. That could cause a drastic drop in value.

Many brokers tout the benefits of nontraded REITs. Regulators across the United States, however, have long warned of their many dangers. While Real Estate Investment Trusts – REITs – offer some benefits. Their risks – especially the risks associated with illiquid, nontraded REITs – far outweigh the benefits for many investors. Folks who need access to their money or who are nearing retirement should steer clear from the nontraded or private varieties of REITs.

Many REITs invest in triple net properties. According to Investopedia.com, a triple net lease property is defined as: “A lease agreement that designates the lessee (the tenant) as being solely responsible for all of the costs relating to the asset being leased in addition to the rent fee applied under the lease. The structure of this type of lease requires the lessee to pay for net real estate taxes on the leased asset, net building insurance and net common area maintenance. The lessee has to pay the net amount of three types of costs, which how this term got its name.”

After the economy tanked, many investors looked to the safety of real estate and in particular, triple net leases. Nontraded REITs in particular are filled with triple net lease properties. Most triple net properties are on long term leases to low risk tenants. Think of an anchor tenant in a shopping center, for example.

Sounds pretty safe for investors and during uncertain times, that sounds appealing.

Interest rates will not stay low forever. Many believe that rates are about to rise. Because the rental periods associated with triple net leases is often long term, landlords (property owners) can’t raise rents. When interest rates rise – and they will – and nontraded REITs are stuck with long term fixed rent leases, the value will plummet. This is called duration risk.

According to InvestmentNews, 77% of all nontraded REIT portfolios invest in triple net lease properties. Worse, many of these properties were financed with floating rate debt. That means as interest rates rise so will the cost of servicing that debt. Unfortunately, rents wont rise meaning these REITs will both lose value and be unable to distribute cash. Because most are illiquid, there is no way to sell or get out either.

Many institutional investors understand these risks. Unfortunately, the investors we often speak with had no clue. Worse, the stockbrokers who recommended these investments either did not understand these risks themselves or chose to ignore them.

Non-traded REITs pay brokers commissions far above average making them popular with many stockbrokers. Unfortunately, they are not suitable for the average investor. Luckily, investors who purchased these investments may be able to get back their money, especially if the investment was not suitable or if the broker failed to fully explain the risks of these investments.

Cases against stockbrokers are usually handled on a contingent fee basis meaning no legal fees unless money is recovered for you.

About the author. Brian Mahany is an attorney and author of the tax and fraud blog, Due Diligence.

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