In a recent interview on CNBC, superstar bond fund manager Jeffrey Gundlach commented that the credit markets are being “grossly manipulated” by the Federal Reserve. In announcing QE3 (“QE” stands for “quantitative easing”) and in other recent statements, Chairman Bernanke has made it plain that the Fed plans to continue this manipulation indefinitely.
The impact of the Fed’s manipulative policy is being felt most heavily by those trying to live on their retirement savings. Today, the prudent retiree can earn at best about 1 percent on insured CDs, so a nice $500,000 nest egg can produce an income stream of barely more than $400 per month.
Because of the extremely low interest rates imposed by the Fed, the life annuity, which should be a viable retirement income option that the retiree cannot outlive, is now typically generating an investment return of less than 2 percent. A quick visit to the Berkshire Hathaway website will tell you that a 66-year-old person putting the same $500,000 into a lifetime income annuity would produce only about $2,600 per month, with no adjustment for future inflation over the retiree’s 20-year life expectancy. And all of the retiree’s capital is gone once the annuity starts, even if the retiree lives but a few days. Of course, one could arrange the annuity to guarantee a minimum number of payments, but that will reduce the monthly income accordingly. At least with the CD approach, if interest rates go back to a more typical rate of, say, 4 percent, the retiree’s income would quadruple, and the retiree would still have the nest egg to leave as a legacy to his or her heirs.
Never underestimate the efforts of Wall Street to separate investors from their hard-earned money. A gimmick that some brokers are now pushing to address the minuscule interest-rate environment engineered by the Fed is the unlisted or “nontraded” real estate investment trust (REIT) featuring high initial payout yields. Many investors are familiar with publicly traded REITs, which became available in the 1980s. The REIT is a “pass-through” entity for tax purposes that invests in real estate. As long as it passes 90 percent of its income out to its investors in the form of dividends, the REIT pays no income tax.
The typical sales pitch for the nontraded REIT goes like this: Ordinary investors have the opportunity to participate in real estate while earning dividends higher than those available from publicly traded REITs and free from the volatility of the markets.
The reality is otherwise.
First, nontraded rates are broker-sold, so the investor faces hefty commissions that eat up as much as 15 percent of the invested capital. Often, the nontraded REIT doesn’t begin acquiring any real estate until after completion of an initial offer period that may last many months. Until real estate is purchased, dividends to earlier investors are paid out of money invested by later investors (does that sound like a Ponzi scheme?).
The nontraded REIT only needs to report the values of its underlying real estate every 18 months, and because few if any analysts scrutinize nontraded REITs the way they do publicly traded ones, overstatement of real estate values is much more likely with the nontraded REIT.
Suppose you learn that your nontraded REIT has overstated the value of its real estate, meaning its value per share is less than what you paid for it. Tough luck: You have no easy way out. What few buyers you’re likely to find will offer to purchase your holdings only at a steep discount. And this is no hypothetical problem. According to Bruce Kelly of Investment News, “Eight of the largest nontraded real estate investment trusts have lost a collective $11.3 billion, or 37 percent, of their equity value over the past seven years.”
Green Street Advisors of Newport Beach, a well-known real estate research firm, cautions that the relatively high average dividend rate paid by nontraded REITs of 6.7 percent in the first quarter of 2012, while higher than the 4.2 percent average paid by publicly traded REITs, is misleading. What’s more important is the investor’s total return, which includes appreciation (or depreciation) as well as dividends. Green Street, which has long criticized the nontraded REIT industry, offers as an example a nontraded office REIT that generated no investment return for its investors over its life. After investors paid fees equal to 16 percent of their investment, the REIT then paid $175 million to acquire an advisory company made up of its own executives. Through these tactics, all the real estate investment returns ended up in the hands of management—and none in those of the investors. While this may be an egregious example, the lack of transparency and liquidity makes such shenanigans much easier to pull off in a nontraded vehicle.
In another example, FINRA, the self-regulatory authority for brokers, recently cited David Lerner & Associates, promoter of the Apple REIT Group, in connection with the sale of Apple REIT 10, a $2 billion offering. FINRA alleged that Lerner misled investors about returns and sold shares without conducting a reasonable investigation to determine whether the REIT was suitable for the investors to whom it was offered. (Lerner has called the allegations “baseless.”)
You can avoid these pitfalls. The next time someone wants to tell you about the next great opportunity in nontraded REITs, run, don’t walk, away.
