NEW YORK (TheStreet) -- Nontraded real estate investment trusts are never a good investment decision. It's that simple.
Nontraded REITs have little alignment between the interest of corporate managers and investors, come with such high transaction fees that you lose 15% of your investment on the first day you invest and are one of the least transparent financial products.
Nevertheless, some financial advisers pitch nontraded REITs as a low-risk, secure investment with steady annual returns. In this case, the phrase "too good to be true" has never been more accurate.
Unknowing investors often buy into this sales spiel, which is how they raked in about $20 billion in 2013, although the number fell to a still sizeable $15 billion last year, according to The Wall Street Journal.
REITs are corporations or trusts that purchase portfolios of income-producing properties such as shopping centers, office buildings and hotels, and in some cases manage those properties. The nontraded variety are registered with regulators but don't trade on a national exchange.
Three key factors make nontraded REITs unattractive: high up-front costs, little transparency and a lack of liquidity.
When customers choose to invest in a nontraded REIT, they typically end up paying a 10% fee right off the bat. This is because nontraded REITs don't employ their own sales force, choosing instead to outsource this job to broker-dealers and financial advisers.
The 10% fee is a commission split by the investment adviser and broker-dealer for selling the nontraded REITs. This gives advisers an incentive to recommend this type of investment and puts their interests at odds with those of their clients.
Nontraded REITs often charge an extra 5% to 10% in ancillary fees such as company formation expenses, acquisition fees, financing fees and advisory fees.
Ultimately, the investor suffers as these fees eat away at returns and only serve to line the pockets of advisers, broker-dealers and the nontraded REIT's management.
You'll rarely see a financial adviser invest in a nontraded REIT. This suggests they know just how bad of an idea these investments are.
No customer in her right mind would want to invest in anything that would be down 15% the first day and where the sponsor isn't willing to have any skin in the game.
When you look at the fees generated by nontraded REITs on an annual basis, it is evident that they are a "Heads I win, tails you lose" proposition. The REIT management team is compensated very well, regardless of the whether the REIT is profitable for its shareholders.
If your financial adviser tries to sell you a nontraded REIT, first ask him how much he has invested in the product, then go find a new financial adviser. He's either trying to take advantage of you or is incompetent and didn't do his research. Either way, he's of no service to you.
One of the most enticing attributes of nontraded REITs is their facade of stability.
Nontraded REITs typically issue shares at a price of $10 and, even though an investor's stock is immediately worth less due to the aforementioned fees, the REIT rules allow the value to still be reported as $10 to the investor.
Management accountability in public companies shows up in share price, but nontraded REIT executives are exempt from this kind of transparency. They don't have to report actual values, leaving investors with the illusion of safety and stability.
What's more, because nontraded REITs are not traded on a national stock exchange, investors cannot easily check on their daily market valuations.
These REITs attracts investors by offering a steady dividend, but they often can't buy enough property to provide the dividends promised. Their solution is to borrow from banks or from investors' future equity to pay existing investors their dividends. There's a term to describe this sort of process: Ponzi scheme.
Practices like these lead to customer heartbreak when purchasers find out that instead of their investment producing steady returns as promised, it only decreased in value, causing them to lose the majority of what they originally put in.
The share price provided by nontraded REITs is meaningless and is not based on value creation, value erosion, or market conditions.
Management encourages investors to reinvest their dividends by offering them a 5% percent discount to an imaginary share price of $10 per share, because they often don't have the cash flow from the properties to pay the dividends that they promised would be the top feature of the investment.
In this last cycle, many investors discovered later that the market value of their nontraded REIT was more than 50% lower than the price at which they had been reinvesting dividends. These investors find out the actual value of the company only when it liquidates.
No matter the situation, nontraded REITs consistently limit investors' returns and increase the probability of losses through their exorbitant fees.
If an investor decides that he wants to get out of a nontraded REIT and attempts to sell in a secondary market, he can expect to encounter difficulty.
Customers are often stuck in nontraded REITs for several years, first bound by a lockout period during the first year, then by the REIT's resistance.
Nontraded REITs and the legal documents associated with them tell investors that they have a mechanism for liquidating their interests, but the reality is that nontraded REITs also have a clause that permits them to not allow investors to allocate money if it harms the company. The liquidity here is an illusion.
Although the Securities and Exchange Commission and the Financial Industry Regulatory Authority have recognized questionable practices surrounding nontraded REITs, triggering ongoing investigations and stricter regulations, the fact remains that nontraded REITs make up a multibillion-dolar industry -- one that you should avoid.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.