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Nontraded REITs may be a suitable way for investors to earn good returns while diversifying their portfolios. However, FINRA is concerned about the way these programs are being marketed, particularly to retail investors. Many investors may not understand the risks of nontraded REITs, especially their lack of liquidity and the difficulty in valuing their shares. Other issues for investors are high fees (as much as 15%) and the fact that dividend payments may be confused with returns of capital.

What Are REITs? 

A real estate investment trust (REIT) is an entity that invests in real estate projects or real estate-related assets, such as shopping centers, office buildings, apartment buildings, hotels, and mortgages. REITs are designed to make it possible for individuals to invest in large-scale real estate projects. Their benefits include regular dividend income and the potential for capital appreciation.

A REIT is structured in a way that avoids paying corporate income taxes on its earnings. In order to qualify, a REIT must distribute 90% of its income to its shareholders each year in the form of dividends. Individual investors are responsible for paying taxes at ordinary income rates on the dividends they receive.

In order for an entity to qualify as a REIT and avoid corporate taxes, it must:

  • Be structured as a corporation, trust, or association
  • Be managed by a board of directors or trustees
  • Not be a financial institution or insurance company
  • Issue shares that are fully transferable
  • Have a minimum of 100 shareholders
  • Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year
  • Pay out at least 90% of its taxable income in the form of shareholder dividends
  • Invest at least 75% of its total assets in real estate
  • Derive at least 75% of its gross income from rent or mortgage interest
  • Have no more than 20% of its assets invested in the stocks in taxable REIT subsidiaries

Different Types and Different Advantages and Disadvantages

Many REITs are public companies registered with the SEC and listed on a major exchange. Nontraded REITs are public offerings that are registered with the SEC, but their shares are not listed on any of the exchanges. Note that there are also private REITs, which are issued as private placements under Regulation D—they are not registered with the SEC or listed on an exchange. Generally, only accredited investors may purchase private REITs.

A publicly traded REIT has certain advantages for investors who can easily determine the value of their shares and can liquidate them quickly. Of course, this does not protect them from steep losses if the market is not doing well, but at least investors have a quick exit. The disadvantage is that listed REITs may pay lower dividends than unlisted ones.

Most nontraded REITs are finite investments—they are not designed to last forever. After a certain number of years, they either list their shares on an exchange or liquidate (a liquidity event). In either case, there is no guarantee what the value of the investor’s shares will be at this point—they may be worth more than the original investment but they may also be worth less.

Investors in nontraded REITs will find it difficult to redeem their shares early. Often, the investor’s only avenue is to sell his shares back to the REIT itself. Some programs do offer early redemption options but the terms vary depending on the REIT and may be very limited—only a small percentage of shares may be redeemed each year, and/or the price may be below the purchase price or current estimated value. Investors must be prepared to hold their shares for as long as eight years, or until a liquidity event occurs.

Valuation Issues

The shares of a nontraded REIT are difficult to value precisely. Often, the only way to value the shares is through an expert appraisal of its underlying real estate holdings. For this reason, FINRA has special rules about how REITs may be presented on client account statements.

If the REIT’s annual report includes an estimated value of its shares, then the firm must include this information on the client’s account statement unless it is either outdated (more than 18 months old) or the firm has reason to believe that the estimate is inaccurate. The account statement must identify the source of the estimate and how it was developed. The statement must also explain that REITs are generally illiquid securities and the investor will not necessarily receive the estimated value if he wants to sell his shares.

A client account statement that does not include an estimated value of a REIT’s shares must state that REITs are generally illiquid, that the value of the securities may differ from their purchase price and, if applicable, that no accurate valuations are available.

Most nontraded REITs are currently issued at a nominal price of $10 per share. Annual reports may show this value for many years. FINRA has proposed a new rule that would require these programs to deduct the cost of fees from these valuations and make other changes in the way the valuations are calculated.


The illiquid nature of nontraded REITs means that they are not suitable for short-term investors. Registered representatives should always inform their clients that their capital will be locked up for many years and their shares difficult to value. Generally, only a small portion of an investor’s portfolio—usually no more than 10%—should be invested in nontraded REITs or other illiquid investments such as limited partnerships. Massachusetts and some other states have incorporated this limit into their regulations.

Investors in nontraded REITs must receive copies of the prospectus, along with any other relevant disclosure documents. These documents will explain the nature of the assets or projects in which the REIT invests along with its risks.

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—Securities Training Corporation

There are a number of important regulatory issues concerning sales practices associated with municipal fund securities and, therefore, 529 plans. The cornerstone of the securities industry is the principle that brokers, dealers, and municipal securities dealers conduct their business fairly with all persons and not engage in a deceptive, dishonest, or unfair practice. (The MSRB’s Rule G-17 is at the core of its customer protection rule.) This simple statement contains the underlying premise that sales activities may not mislead the public and that errors of omission or misstatements of fact are contrary to fair and equitable trade practices. Therefore, if a customer purchasing a Section 529 plan can benefit from an unlimited state tax benefit, then not informing the client of this fact violates MSRB and FINRA rules.

In fact, the MSRB stated in 2006 that dealers have an affirmative obligation to make the following disclosures to any client purchasing an out-of-state 529 plan.

• Depending on the state in which either the client or the plan’s beneficiary resides, favorable state tax treatment may only be available only if the client invests in his home state’s 529 plan.

• Potential state tax benefits are one of many factors that the client should consider in making a decision.

• The client should consult with his financial or tax adviser about his particular situation to determine the advantages and limitations of investing in his home state’s 529 plan. He may also want to contact his home state and other states to learn more about their plans.

One of the ways of fulfilling this “out-of-state disclosure obligation” is to include these disclosures in the plan’s official statement (program disclosure document). If this is the case, however, they may not be buried in the fine print—they must be included in a way that they are “reasonably likely to be noted by the investor.” The client must also receive the official statement no later than the time the sale takes place.

If these disclosures are not included in the official statement, then the dealer must provide them separately either before or at the time of the transaction.

In its guidelines concerning communications with the public, FINRA states that member communications must be clear and not overly complex or technical in order to avoid confusion. In such cases, a lengthy, highly technical explanation may be more confusing than shorter, less technical information. Sales material and advertising should also take into account the audience who receives the information. Different levels of explanation may be necessary for varied categories of clients, and it may be difficult to limit the audience to a particular piece of information. When using promotional material, it is important to state the potential tax implications associated with a particular product. General references to tax-exempt or tax-free may not be sufficient unless the product is in fact both federal and state tax-free. An indication should be made as to which taxes apply, if any, or which taxes do not apply. A registered representative should act prudently when recommending a particular 529 savings plan to an investor. Consideration should be given as to why the investor is purchasing the plan, when the funds will be needed, the risk of loss of principal, and market performance failing to meet expectations. A determination should be made as to the ultimate goal, i.e., how much money needs to be invested in order to achieve the desired result and whether the individual can sustain the program over the necessary time frame. The commissions that the registered representative expects to earn from the sale should not be part of this analysis.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation