Just as important as finding a good investment is knowing what investments to avoid at all costs. If you simply manage to avoid putting any money into financial sinkholes, you’ll come out ahead. I’ve already mentioned the common mistake of cashing out your 401(k) when moving jobs.
Joshua Brown of The Reformed Broker has some great insights into the sales-driven world of products peddled to us retail investors. He talks about non-traded REITs (real estate investment trusts) as opposed to publicly-traded REITS that you can buy via a low-cost, diversified fund like the Vanguard REIT Index Fund (VNQ or VGSIX). Non-traded REITs have been increasingly popular in the current low interest environment as they are structured to look like they provide a solid income stream.
In this recent post, he shares a hilarious fictional conversation that would happen if the broker was abnormally honest about the fees involved. Read the whole thing, but here’s a snippet:
With your portfolio size and risk tolerance I would recommend a $100,000 investment. Given that amount let’s first go over the fees. If you invest $100,000 I will be paid a commission of $7,000. My firm is going to get $1,500 – $2,000 in revenue share. My wholesaler, the salesman that works for the investment’s sponsor company, will get $1,000. He is a great guy, buys me dinner all of the time and takes me golfing. The sponsor company is going to get around $3,000 to pay for some of the costs they incurred in setting up the investment. So all in on Day 1 there will be around $87,000 left over to actually invest. I bet you are getting excited.
You hand over $100,000, and after everyone has gotten their cut, there is only $87,000 actually left over to invest in anything. It doesn’t matter what property they buy, the odds are completely stacked against you already. Studies have shown that publicly-traded REITs have higher historical returns than non-traded REITs. On top of that, non-traded REITs have poor liquidity and you may be locked in for 5 years or more. Despite all this, over $20 billion of non-traded REITs were sold in 2013.
Here’s a Reuters article by James Saft that goes into more detail about the many disadvantages of non-traded REITs. Amongst the more amusing excerpts:
When a financial advisor tried to sell my sister a fee heavy non-traded REIT last year, pitching it as an alternative to fixed income, I told her she ought to fire him. […]
The Financial Industry Regulatory Authority, an industry funded oversight body, went so far as to issue an “investor alert” about non-traded REITs in May of last year, warning about inaccurate and mis-leading marketing of the vehicles as well as other risks. Just to give a flavor of the company in which non-traded REITs are traveling, the most recent FINRA investor alert was about marijuana stock scams.
Bottom line: Avoid non-traded REITs. If you want commercial real estate exposure, buy a low-cost fund like VNQ or VGSIX.