On behalf of Mihalek Law posted in Securities Law on Tuesday, December 2, 2014.
In October, the SEC approved FINRA’s proposed rule change requiring broker-dealers to provide customers with an estimated per-share value for Non-Traded REITs.
The current practice is to carry the Non-Traded REIT on the customer’s account statement at its purchase price, generally $10/share. Such practice creates the illusion of the investment’s stability; and it ignores the facts that: 1) 15% or more of the purchase price goes to pay commissions, fees to the sponsor and (oftentimes) affiliated entities and other organizational expenses; and 2) distributions to owners include return of capital (and not return on capital).
REITs can be registered and publicly traded on national exchanges, and when they are, they share liquidity features of publicly traded stocks and bonds. However, Non-Traded REITs are illiquid. There is no market – they can only be liquidated back to the issuer according to terms dictated solely by the issuer, which terms can be changed at any time.
FINRA’s proposal adopted by the SEC requires brokerage firms to list the value of its customers’ Non-Traded REITs under either the “Net Investment Methodology” or the “Appraised Value Methodology”. The net investment approach requires the per-share value to be based upon the per-share amount available for investment, as set out in the issuer’s offering prospectus, after accounting for commissions, fees, offering expenses and organizational expenses. If those fees and expenses aggregated to 15% of the offering price, then the per-share price would be reported at 85% of the offering price. In such a case, an investor’s account statement would not reflect the value of the Non-Traded REIT as its purchase price, say $10/share; rather as the purchase price less total fees and expenses (15% in our example), or $8.50 per share.
The appraised value method requires that the per-share value carried on customers’ account statements be based on the valuation of the investment’s underlying assets and liabilities, i.e., an appraisal. The rule requires that the appraisals be performed at least annually by, or with the material assistance of, a third-party valuation expert.
The new rule would also require FINRA firms that use the net investment method to disclose prominently on the customers’ account statements the following disclosure: “IMPORTANT – Part of your distribution includes a return of capital. Any distribution that represents a return of capital reduces the estimated per-share value shown on your account statement.”
Irrespective of the new rules, in our view, Non-Traded REITs are structurally flawed investments and not suitable for most retail clients.