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Private REITs Not a Good Choice for Small Investors

haunted-houseReal estate is one of the asset classes I recommend including in a diversified portfolio. For many small investors, the best way to hold real estate is through a REIT, or real estate investment trust.

So far, so good. But some REITs are about as appealing as a condemned apartment house beside a railroad track. I’m talking about high-cost private REITs.

First, a little background. REITs can only invest in real estate or mortgages. The majority of REITs only own real estate; most own scores of different classes of property including residential, commercial, and hospitality properties covering the demand on finding oceanfront homes, etc. This makes them a simple and safe way for small investors to add a diversified investment of real estate to their portfolios. Another advantage of REITs is that they must annually distribute almost all of their rental and capital income as dividends to shareholders, which results in some favorable tax benefits.

There are two ways to purchase shares of a REIT. The most popular is by buying shares of a REIT that is publicly traded on an exchange. Like any share traded on an exchange, this makes them very liquid and transparent. When you buy traded REITs, you know what they own and you can analyze their track records.

The second way is to purchase shares of a nontraded or private REIT. It receives the same tax treatment as those publicly traded, but that is where most of the similarities end. A private REIT actually looks and smells more like a limited partnership. Usually, all the money needed for the investment is raised on the front end. Since the shares are not listed on an exchange, once you are in it’s very hard to get out. You often don’t know the full extent of the properties the REIT will purchase, and they often are not as diversified as their publicly traded cousins. Of course, a private REIT has no track record.

Why would anyone want to buy a private REIT? Ask a broker who sells them, and you will get a laundry list of the benefits, like stable pricing and higher dividends, so enticing you will wonder why anyone wouldn’t buy.

But private REITs are sold, not bought. They can pay up to 12% in marketing fees and commissions to the brokers that sell them. Public REITs pay no commissions.

Aside from the high cost, maybe the biggest reason to avoid private REITs is that they grossly underperform public REITs. According to an article in ThinkAdvisor.com by Michael Finke, a 2014 report by an independent REIT rating publication called Green Street Advisors concluded that privately held REITs underperformed publicly traded REITs by about 3.6% per year.

According to Finke, “The darker side is that these products contain many opportunities for sponsors to take advantage of the lack of transparency that exists within the industry. High commissions erode shareholder value. Lack of management oversight can lead to excessive fees and the purchase of property for which there are frightening conflicts of interest. There is an abundance of horror stories of nontraded REITs gone bad in which dividends have been sliced, property values have plummeted either from bad markets or abuse, and investors are left with no ability to sell even their nearly worthless shares.”

Finke also quotes Green Street Advisors co-founder Jon Fosheim as saying sponsors may view private REITs as a way to “charge outrageous fees, have plenty of conflicts that we can exploit, and no one will know the difference because we won’t list on an exchange.”

Given these drawbacks, I am not willing to gamble even the smallest portion of my retirement portfolio on a private REIT.

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