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Real Estate Investment Trusts (REITs) and Non-Exchange Traded REITs

Real Estate Investment Trusts (REITs) are companies that invest in real estate, owning and often operating income-generating properties and mortgages. They are eligible for a reduction in or an exemption from corporate tax on fulfilling certain stipulated conditions which includes the requirement to distribute at least 90% of their total income before tax, to investors. REITs were introduced with the intention of providing an investment avenue in the real estate sector which is similar to the option given to investors to invest in stocks through mutual funds. REITs may be privately held or may be public. The latter are often listed on stock exchanges where they are publicly traded.

For a company investing in real estate to be recognized as a REIT by the Internal Revenue Service (IRS) the company, besides fulfilling other conditions, undertakes to distribute 90% of its profit before tax as dividends. Unlike other companies that pay corporate tax on their taxable income and are free to either distribute their after-tax profits or reinvest it in the business, REITs have to compulsorily distribute almost the entire pre-tax profits in order to qualify for the exemption from corporate tax. REITs provide a way for an investor to share in the income generated by commercial real estate without actually going out and purchasing the commercial real estate.

Many brokers marketed REITs aggressively as a prudent, stable and suitable investment option. Sales of REITs for 2007 aggregated $12 billion and totaled $10 billion in the following year. Most investors though were not told that these sales generated huge commissions and expenses. Huge commissions were offered to induce brokers to promote non-public REITs as conservative, safe, low risk, stable investments, capable of providing a regular income and suitable for people including those who are approaching retirement or are already retired. All these efforts could not conceal the fact that most were risky investments, lacked liquidity and were not a suitable investment for most investors, including the elderly.

According to the SEC at its Investor.gov website, non-traded REITs (REITS that do not trade on a stock exchange) involve special risk:

Lack of Liquidity: Non-traded REITs are illiquid investments. They generally cannot be sold readily on the open market. If you need to sell an asset to raise money quickly, you may not be able to do so with shares of a non-traded REIT.

Share Value Transparency: While the market price of a publicly traded REIT is readily accessible, it can be difficult to determine the value of a share of a non-traded REIT. Non-traded REITs typically do not provide an estimate of their value per share until 18 months after their offering closes. This may be years after you have made your investment. As a result, for a significant time period you may be unable to assess the value of your non-traded REIT investment and its volatility.

Distributions May Be Paid from Offering Proceeds and Borrowings: Investors may be attracted to non-traded REITs by their relatively high dividend yields compared to those of publicly traded REITs. Unlike publicly traded REITs, however, non-traded REITs frequently pay distributions in excess of their funds from operations. To do so, they may use offering proceeds and borrowings. This practice, which is typically not used by publicly traded REITs, reduces the value of the shares and the cash available to the company to purchase additional assets.

Conflicts of Interest: Non-traded REITs typically have an external manager instead of their own employees. This can lead to potential conflicts of interests with shareholders. For example, the REIT may pay the external manager significant fees based on the amount of property acquisitions and assets under management. These fee incentives may not necessarily align with the interests of shareholders.

Other Risk Factors: Non-traded REITs generally have high up-front fees. Commissions and upfront offering fees typically total 9 to 10% of the investment, thereby lowering the value of the investment immediately after the purchase.

FINRA has investigated firms for their conduct in the marketing and solicitations of non-traded REITs to unsuspecting customers. The Inland Group, Behringer Harvard, Wells REIT, Grubb & Ellis, Cole REIT, KBS REIT, and Hines REIT are a few of the non-traded REITs that have cut or suspended their dividends and distributions and are now being questioned by many investors.

If you have a question regarding your REIT investment, contact Gregory Tendrich, at the Law offices of Gregory Tendrich. Our goal, to help investors recover their stock market and investment losses.

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