By DAVID MOON, Moon Capital Management, LLC
March 30, 2014

In a search for decent yields in an almost zero interest rate environment, many frustrated investors are looking in places they might otherwise never consider. And sometimes they look—or are led—places they shouldn’t consider.

See non-traded real estate investment trusts for one example.

A real estate investment trust, or REIT, typically owns income producing real estate. Most REITs trade on some sort of exchange each day like stocks.

A relatively small number of REITs, however, are not publically traded. According to mutual fund giant Fidelity, there are approximately 70 of these non-traded REITs, owning more than $85 billion in assets.

Proponents and promoters of these non-traded REITs often tout the holy grail of investment marketing: price stability and higher yields.

The price stability is only an illusion. It seems to exist only because there is no price. When there is no market for a security, you can pretend that the value doesn’t change, but you are only pretending.

The higher yields these vehicles purport are often simply distributions of capital, either from borrowed funds or the investor’s initial investment. Either way, if a distribution isn’t fully supported by cash from operations, it is unsustainable.

It is common for a newly organized non-traded REIT to begin paying distributions immediately after the entity is organized and funded—even before the shareholder money is invested in a single property. These initial distributions are a return of investor capital, but give the illusion of an earned dividend.

Newly organized non-traded REITs typically don’t specify the properties they intend to buy, so an investor doesn’t know what will be purchased with 85 or 90 percent of his money.

But if he reads the details of the offering documents, he will find out where the first 10 or 15 percent of his money is likely to go. Commissions, fees and other expenses can easily consume the first 10 or 15 percent of a person’s investment—even before the REIT purchases its first piece of real estate.

That’s just the beginning of the fees. There are annual management fees, sometimes up to four percent of revenues. And property sales commissions and leasing fees, often paid to a related entity.

For the privilege of owning these things, investors commit their capital for lock-up periods of up to seven years.

Last year, the Financial Industry Regulatory Authority (FINRA) issued a rare warning about non-traded REITs. To give you some idea of how difficult it is to be the target of a FINRA investor alert, consider the most recent warning, issued in January this year.

It was about marijuana stock scams.

So why do these instruments exist, especially when there are publically-traded alternatives? Draw your own conclusion, but it is certainly not for the benefit of the individual investor.

In the mid-1990s, Kidder Peabody bond trader Michael Vranos described his job. “We’re not trying to outsmart the smart guys; we’re trying to sell bonds to the dumb guys.”

Vranos would have been an outstanding REIT salesman.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).