Regulators Focus on ‘Nontraded’ REITs

May 3, 2013, 6:03 p.m. ET

Regulators Focus on ‘Nontraded’ REITs

By CAITLIN NISH

Wall Street’s leading self-regulator has been watching how brokerages market “nontraded” real-estate investment trusts to customers, and it doesn’t like what it sees.

Brokers too often offer misleading information about the potential benefits and incomplete explanations of the risks of nontraded REITs, the Financial Industry Regulatory Authority said in guidance it issued to firms Thursday. Sales materials often stress the income the investments generate in distributions but can fail to make sufficiently clear that these may actually tap the investor’s principal, the regulator said.

“The notice provides clear standards that can be applied consistently by firms,” said Thomas A. Pappas, Finra’s vice president for advertising regulation, in an email. When firms follow the guidance, “investors will have a better understanding of the products and their features.”

REITs give investors an equity interest in a pool of assets such as land, shopping centers or hotels, or in mortgages secured by real estate. REITs don’t pay income taxes if they distribute at least 90% of their earnings to investors, and they often attract investors seeking higher payouts than other investments offer.Most REITs typically trade on stock exchanges, but many brokerages also offer clients nontraded REITs or real-estate “direct participation programs” not listed on an exchange.

There’s about $62 billion in total equity invested in these types of publicly registered products, according to Robert A. Stanger & Co., a Shrewsbury, N.J., investment-banking firm that specializes in nontraded REITs, and an unknown amount in ones that aren’t publicly registered.

Finra’s guidance comes less than a year after its high-profile settlement with a New York brokerage firm accused of using unfair practices to sell shares in a $2 billion nontraded REIT.

David Lerner Associates, based in Syosset, N.Y., last year agreed to pay about $12 million in restitution to customers to settle charges ranging from misleading marketing to false claims about returns in a nontraded REIT it sold. The firm, which neither admitted nor denied the allegations, declined to comment.

Nontraded REITs have occupied a spot on Finra’s annual list of products that could be too risky for many investors for the last couple of years, amid worries that low interest rates are leading investors to chase yield in risky investments they don’t fully understand.

Finra also told brokers that any sales material must make a balanced presentation of benefits and risks—and those risks cannot be relegated to a footnote or disclosed only in a prospectus or other separate document.

Descriptions of distributions must be clear about where that money is coming from, Finra said, and should include a breakdown of how much cash is generated from investments or operations, from borrowing or from principal.

Brokerages also were told not to use terms such as “yield” or “current yield” in describing distributions because they wrongly suggest the investment is similar to a bond or note.

Rules on redeeming the investments must be spelled out, Finra said, including whether those rules can be changed or redemptions simply halted. “The fact that the real estate program has not satisfied all investor redemption requests in the past could be considered a fact that should be disclosed under this provision,” the regulator noted.

At the same time, brokers must be careful in describing performance by past programs, Finra said, and avoid cherry-picking from programs or periods with higher returns. Firms also have to be careful that any historical information is framed in a way that investors can easily distinguish it from information about the program being offered.

Sales materials for new programs often feature pictures of properties that only resemble those that may be purchased—and aren’t the actual properties targeted. Finra said investors must be clearly told that the property they see isn’t the one they’ll be investing in.