New FINRA Guidelines for Non-Traded and Private REITs

In recent months, FINRA has been investigating how non-traded and private real estate investment trusts (REITs) are presented to retail investors. Last week, FINRA alerted broker-dealers that they had uncovered "deficiencies" in how these investments are sold, and issued Regulatory Notice 13-18 "to provide guidance to firms on communications with the public concerning unlisted real estate investment programs, including unlisted real estate investment trusts (REITs) and unlisted direct participation programs (DPPs) that invest in real estate."

Non-traded and private REITs are sold primarily through independent broker-dealers. As noted by several reports, regulators have been pushing recently to resolve some of the issues that we have described at length in the past. From the Notice:

Recent reviews by FINRA of communications with the public regarding real estate programs have revealed deficiencies. For example, some communications have contained inaccurate or misleading statements regarding the potential benefits of investing in real estate programs. Other communications have emphasized the distributions paid by a real estate program and failed to adequately explain that some of the distribution constitutes return of principal. In addition, some communications have not provided sufficient discussions of the risks associated with investing in the products in order to balance the presentation of benefits.

As we discussed last week, one of the issues with non-traded and private REITs is that their market value is unknown. For example, most non-traded REITs were sold at a constant share price (typically $10) even through the real estate collapse of 2007-8. Some broker-dealers described this 'lack of volatility' as a feature, 'protecting' investors from 'market fluctuations.' In actuality, the assets of the non-traded REITs' were declining in value, but such declines were masked by the constant offering price. FINRA's new guidelines specifically prohibit this type of misrepresentation.

Another issue is that non-traded and private REITs tend to pay out large distributions to investors soon after their initial offering, likely before they have acquired enough income-generating properties to justify that kind of outflow. In our white paper on non-traded REITs, we note that non-traded REIT distributions were often far larger than their operating income, meaning that a significant portion of these payments were a return of investor capital or funded from debt rather than operations. FINRA is now requiring a breakdown of distributions into components that show what portion of anticipated distributions will be from operations.

Along with the breakdown of the distribution of components, the communications must prominently state that if distributions include return of principal, "the program will have less money to invest" and, if the distributions include proceeds from debt issuance, "the distribution rate may not be sustainable."

Many of these issues will come as no surprise to those familiar with non-traded REITs. But FINRA's improved guidance may be the first step in preventing some of the mostegregious misrepresentations that have unfortunately become commonplace in the non-traded and private REIT industry.