Amid the recent market fluctuations, non-traded real estate investment trusts have been popular among investors searching for yield and asset classes with low correlations to equities. In fact, non-traded REITs have raised about $10 billion in new money so far this year, the highest inflows seen since 2007, according to the Investment Program Association. But given the risks, the recent regulatory crackdowns on this investment and new efforts by lawyers to target them, non-traded REITs are raising red flags in the industry, and many are re-evaluating their exposure.

“It may be the best thing since sliced bread, but if I can’t sit down face-to-face with a client and explain the fees, how the investment works, it’s something I’m not comfortable doing,” said William Muller of Common Cents Planning Inc. in Glen Mills, Pa. Muller has decided not to use non-traded REITs in his practice altogether because of their illiquidity, lack of transparency, high fees and the way they’re valued. Recent FINRA scrutiny is also raising red flags for Muller.

Increased scrutiny

In May, FINRA filed a complaint against independent broker/dealer David Lerner & Associates, claiming the firm failed to do adequate due diligence into “valuations and distribution irregularities” of Apple REIT Ten. Since then, the industry has become increasingly concerned about non-traded REITs in general.

FINRA is cracking down on this issue in other ways, working on a proposal to shorten the amount of time b/ds have to come up with estimated valuations for non-traded REITs. And most recently in October, FINRA issued an investor warning about non-traded REITs, saying that these investments can be heavily subsidized by borrowed funds, early redemption is often limited, and fees can be high. In fact, on Tuesday FINRA fined Wells Investment Securities $300,000, claiming the firm used misleading marketing materials in the sale of its Wells Timberland REIT, a non-traded REIT.

“Confronted with a volatile stock market and an extended period of low interest rates, many investors are looking for products that offer higher returns in turbulent times,” said Gerri Walsh, FINRA’s vice president for investor education, in a statement. “However, investors should be wary of sales pitches that might play up non-traded REITs' high yields and stability, while glossing over the lack of liquidity, fees and other risks.”

After the SEC went after private placements from Medical Capital and Provident Royalties, broker/dealers with exposure to them faced arbitrations and litigation from investors to whom they recommended the securities. Since then, many of these firms have imploded. No one wants to see the same thing happen with REITs, although there have been no allegations of fraud.

That said, lawyers are already starting to mobilize around non-traded REITs, including Andrew Stoltmann in Chicago. On his website, www.reitfraudrecovery.com, it says the firm are only suing the brokerage firms and banks with FAs who recommended the REITs, not the individual FAs themselves or the REIT sponsor.

Other law firms targeting broker/dealers who sold non-traded REITs include San Francisco-based Girard Gibbs, the firm that filed against David Lerner; Vernon Healy in Naples, Fla.; and Shepherd Smith Edwards & Kantas in Houston, Texas.

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