The Death of a Murder Hole

I’ve been slaying the non-traded REIT here on the site and in my book Backstage Wall Street for the better part of five years. I’ve never heard a convincing story for why investors should want to buy one and the conflicts abuses of the sales process for these things were so obvious they could be seen from a mile away. See here, here and here for three of dozens of examples.

For the uninitiated, non-traded REITs are income vehicles typically sold to the unsophisticated retail clients of third-tier brokerage firms because the commissions involved are partly hidden and typically enormous. They purport to offer investors exposure to properties and one of the most oft-cited benefits brokers tout is that they’re less volatile than public REITs because they don’t trade on an exchange. I’ve referred to this as a Schrodinger’s Cat argument – just because you haven’t opened the box yet, that doesn’t mean the cat inside is still alive. Just because your non-traded REIT doesn’t mark its holdings to market each night, that doesn’t mean they haven’t moved in value.

The other issue is that, when you start 10 to 15% in the hole, its hard to make money on any investment. Paying a double-digit commission or selling concession for a partial ownership in a portfolio of apartment buildings is an absolute killer. Not being able to trust the sponsor and having additional costs and expenses tacked on ex post facto just makes it all worse.

A study done recently found that “Investors purchased at least $116 billion in nontraded REITs over the last 25 years and are at least $45 billion worse off than they would have been if they had merely invested in a diversified portfolio of traded REITs.” Further, “In their study, Dr. McCann and his colleagues found that nontraded REIT investors pay upfront fees that average 13.2% of the purchase amount, and in some cases are as high as 16%. These fees dramatically reduce the capital available to purchase portfolio holdings. A significant chunk of these costs goes to the brokers who recommend these products.”

I’ll let you wipe the vomit from your chin before continuing…

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Okay, welcome back.

One of the biggest purveyors of these murder hole products has been through the ringer lately. The firm has been accused of every conceivable violation related to non-traded REITs under the sun. And now, as the drum beat for a Fiduciary Standard gets louder, they’ve finally spit the bit.

Here’s the New York Times:

AR Capital, the real estate investment company built by Nicholas S. Schorsch and William M. Kahane, said Monday that it would stop creating new investment products and close existing ones to new investors to focus on managing the $19 billion it has in current investments.

The company cited “regulatory and market uncertainty” that was affecting its ability to raise investor money.

Basically the brokers who’ve sold these products are no longer interested in the liabilities and bad vibes that accompany these massive commissions. Or the clients have smartened up. Or the firms are running away from the products now that the word is out on the sponsor. Or some combination of all three.

My friend Michael Kitces has a killer quote that sums it up: “There were serious problems with their lack of transparency and the interrelationship with affiliated companies.”

Kitces says this boils down to “now that the market is requiring transparency, we don’t think we can sell these any more.”

I would bet that this is the end for the product, at least in its current incarnation. Private real estate is not a bad asset class. It’s the packaging and sales techniques that did these funds in. The new version will likely become more transparent and significantly less commission-driven. We’ll see if there’s a real market for it once the obscene selling incentives go away.