REITs

A Real Estate Investment Trust (REIT) is a real estate entity that typically offers common shares for sale to the investing public. Not all REITs are publicly traded companies, many are formed and sold to investors as privately held partnerships. REITs have two unique qualities. They are primarily in the business of managing income producing real estate and must distribute most of their profits as dividends on an annual basis.

To qualify as a REIT with the Internal Revenue Service (IRS), a real estate company must agree to pay out in dividends at least 90% of its taxable profit (and fulfill additional but less important requirements). By having REIT status, a company avoids corporate income tax. Regularly formed corporate entities pay taxes on their profits, then decide how to allocate their after-tax profits between dividends and reinvestments, a REIT simply distributes nearly all of its profits and in return is not taxed on those profits.

Real Estate Investment Trusts (REITS) were heavily pushed by many brokers in the past few year as stable, conservative investments. Sales for REITs totaled over $12 billion in 2007, followed by over $10 billion in 2008. What is hidden behind the numbers is high commissions and expenses giving brokers the incentive to market nonpublic REITs as conservative, reliable income investments suitable even for those reaching retirement and beyond. The marketing and talk, however, could not hide these investments for what they truly were: lacking liquidity, risky, and unsuitable for many.

REITs use investors' capital to invest in a multitude of properties with profits being generated on rent and capital appreciation. For many, misleading marketing and broker misrepresentations hid the fact that nonpublic REITs had an artificially stable share price, lacked liquidity, and concealed high broker commissions from investors.

Mortgage REITs

Fewer than 10% of REITs fall into a special class called mortgage REITs. These REITs make loans secured by real estate, but they do not generally own or operate real estate. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to manage their interest rate exposure.

Equity REITs

The vast majority of REITs focus on the “hard asset” business of real estate operations. These are called equity REITs. Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office buildings or lodging facilities. Some are diversified and some are specialized, meaning they defy classification – such as, for example, an REIT that owns golf courses.

Hybrid REITs

Hybrid REITs invest their assets in mortgages and hard assets. In effect, they employ strategies used by both Equity REITs and Mortgage REITs.

What Type Of Asset Class Do REITs Belong To?

REITs are dividend-paying stocks that focus on real estate. If you seek income, you would consider them along with high-yield bond funds and dividend paying stocks. Consider 20 years of returns for the NAREIT Equity REIT Index (an index of about 150 traded REITs) between 1984 through 2003. Returns solely from dividends have averaged about 8% and never fallen below 4.8%. Stable dividends combined with price volatility create a total return that is often promising for investors, but volatile nonetheless.

Artificial Share Price

Because nonpublic REITs were not traded publically, the REIT managers would determine the value of the portfolio themselves, as opposed to free market valuation. This created a conflict of interest with the managers who selected the properties for the REIT being the same ones that determined their value. When investors went to sell their nonpublic REIT, they would be quoted as low as $.45 per dollar invested, though their most current statements showed the value as being $.85 per dollar invested.

Lack of Liquidity

One component of many nonpublic REITs was a redemption program that would allow investors to sell their shares if they so wished. However, these programs usually limited investors to selling their shares only at certain times, and only allowed investors to sell a small percentage of their shares. For those that needed quick access to their capital, this was an unsuitable investment.

Lack of Transparent Commissions

There were many nonpublic REITs that charged 15% of initial investor capital as, "fees." What was not frequently disclosed, however, was that more than half of that 15% was often given to a broker as commission for selling shares of a given REIT to an investor. In some cases, such an omission of fact is considered a violation of state and/or federal securities law. In 2009, Ameriprise Financial Services paid $17.3 million to settle a Securities and Exchange Commission (SEC) complaint that customers were not informed about incentives Ameriprise brokers received to sell nonpublic REITs.

With the collapse of the housing markets and real estate sector, REIT fraud has become more apparent. Investors are bringing claims against their brokerage firm or financial advisors that recommended unsuitable, for fraudulent REITS that were Ponzi schemes or for failing to disclose the high fees and commissions associated with the sale of REIT investments.

If you are an investor that lost more than $100,000, you should consider all legal options.