The Costs of Illiquidity — II

I thought it was bad enough to try to dissuade people from buying life contingent cash flows.  Now I get to talk about Non-Traded REITs.

This is the first time I heard about them.  Doing a little digging, there is controversy around them.  But let’s talk about the benefits first:

  • You receive a high and steady income.
  • The stated value of your holdings remains stable, thus insulating investors from the chaos of the market.
  • Professional management of commercial real estate is now available to small investors, with high returns.

But then there are the limits:

  • Liquidation through the sponsor is limited.  (Dated, but gives you some idea…)
  • You likely can’t cash out in full except through illiquid secondary markets where you take quite a haircut.
  • If the underlying real estate does not do well, your income will shrink or disappear.
  • You have little data on how the underlying real estate is doing.  Is the dividend they are paying coming from income or return of capital?

Long-dated, illiquid assets exist for two reasons:

  1. To illustrate high yields to non-knowledgeable investors.
  2. To pay large commissions to those that sell them.

It’s hard to tell which of those are more important, but this is another reason why I continue to talk about illiquid investments, and why most people should avoid them.  It is much easier to cheat people when there is no liquid market available to validate what is happening with the investment.  It is not that Non-Traded REITs protect investors from volatility, as much as they hide volatility from investors.

Large commissions on investments are only possible when there is a lock-in where surrender charges pay off the commission.  Where there are large commissions, misguided investing is more likely.

Look, I could set up 10-year stock trusts.  I will tell you what I will invest in, but since you have no withdrawal rights, you’ll have to wait 10 years for liquidity.  That does not sound like a better investment than going to Vanguard.  But many don’t go to Vanguard because they will not do their homework.  Should we begrudge those who sell to the fools that will not do their own homework?

I wish that we could.  Hey, the SEC is going after them.  Why not?  It is a reply of the limited partnership era of the ’80s.  Illustrate high returns — deliver capital losses.  I could not get why my first boss bought his limited partnerships, because of the losses taken in the era.

It follows the paradigm for illiquid investments — Offer high yields, suck in money, pay high yields, and if things go bad, deliver large capital losses.

With publicly traded REITs low yields have returned better then high yields.  The attempt to generate high yields requires a strategy where everything must go right.  That doesn’t work.  The low yield strategy does work, because there is more flexibility to manage, and raise payouts only after strategies have succeeded.

It is the same for Non-Traded REITs.  They offer high yields after paying high commissions.  Those high yields rely on capital gains on the properties.   Relying on capital gains is poison.

I will say it plainly: unless you are an expert who knows more than the seller, avoid buying illiquid investments.

Closing notes

There are many well-dressed people in this business.  But none discuss the scandal surrounding it.

This an example of those that prey upon small investors to get them to invest in non-traded REITs.

This is a growing area of investment, as people seek yield.

Pricing of Non-Traded REITs is controversial.

Here’s an example of a Non-Traded REIT that failed.

Look, my view is that that value of liquidity is usually underrated.  Liquid investments allow you to shift when opportunity favors such a move.  Whether you are ready for such a move is another matter, but whether you are ready to give up liquidity should require a similar degree of thinking.

I would not invest in Non-Traded REITs, the protections are lower than comparable investments.  Avoid illiquidity.