False Valuations Plague Nontraded REITs


The Financial Industry Regulatory Authority’s (FINRA’s) 2009 prohibition of broker-dealers using information that is more than 18 months old to estimate the value of a nontraded REIT is causing problems for the firms that are trying to abide by it, and is raising a basic question that is hard to answer ? what are these REITS really worth? See Bruce Kelly’s InvestmentNews article entitled “Re-pricing nontraded REITs: A thorny issue for broker-dealers.” As noted in the article, nontraded REITS are on FINRA’s radar screen.

Before 2009, it was a common practice in the brokerage industry to list the share price on client account statements at par value with the product typically priced at $10 a share.

Now that FINRA has instructed broker-dealers to adjust the prices on the investments more frequently, some nontraded real estate investment trusts are now reporting significantly lower share prices than in the past.

The reason for the lower prices has to do with declining real estate values and the fact that some REITs have resorted to tapping principal and even borrowed funds to maintain their dividend payments to investors.

In last week’s enforcement action against David Lerner Associates Inc. (“DLA”), FINRA said that DLA’s marketing shares in Apple REITs that had not been re-priced for several years was misleading, especially where the REITs were paying dividends with principal and borrowed funds instead of operating income.
“Earlier Apple REITs, under the same management, inappropriately valued the REIT shares at a constant artificial price of $11, notwithstanding years of market fluctuations, performance declines, increased leverage and excessive return of capital to investors,” FINRA was quoted as stating.

DLA has recommended and sold nearly $6.8 billion in Apple REIT shares since 1992, according to the article.

The article identifies a number of REITs that have adjusted their per share prices downward. They include Hines Real Estate Investment Trust (from $10 to $7.78), Behringer Harvard REIT I Inc. ($10 to $4.25), and Wells REIT II ($5.95 billion in total assets, scheduled to have a new price at the end of the year).

The adjusted valuations are supposed to account for changes in the underlying value of the fund’s real estate assets and the representative’s commission, typically 6% to 8%, as well as other distribution costs, according to the article. But do they? What valuation methodology is used, and is it being used correctly?

In addition to the valuation problems, another question is how much of an illiquid investment is suitable for the client’s portfolio? Real estate, by its nature, is an illiquid and long-term investment. “The virtue and curse of nontraded real estate” is that it doesn’t allow investors to move in and out of the security, Keith Allaire, managing director of Robert A. Stanger & Co., an investment banking firm specializing in real estate, was quoted as saying.

The sales hook for nontraded REITs is their relatively high yield in the current low-yield environment. “Yields of 6% to 8% are much more substantial than current interest rates,” Mr. Allaire was quoted as saying.

“Valuing these investments at cost or some illusory par value can be inherently misleading when the true value is much lower because of a deteriorating real estate market,” said investor attorney J. Boyd Page of Page Perry. “Many investors have a false sense that everything is okay when they see such numbers; they often don’t realize how much they’ve lost until it’s too late.”

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving private placement or Regulation D investments. For further information, please contact us.