REITs

[figure 8]

I've been researching this topic, but I'm having trouble finding conclusive answers.

I have a financial advisor asking about using REITs for DB investments. The REITs would just make up a part of the assets - say 10% or something.

These particular REITs are illiquid for the first 12-18 months. During this time, their stated value does not change. Then, after 12-18 months, they become liquid, and their value changes at that point. This is how the FA described the REITs that they invest in to me.

It seems like REITs (at least publicly traded ones) should be fine as far as DB assets go. But what's sticking out to me here as a red flag is the illiquid part. For these REITs that he is describing to me, I'm trying to verify that a) they're not prohibited, and b) they would not require an annual audit.

Anyone have any experience with these type of REITs the FA has described to me?

Thanks!

[Bird]

I doubt what he says is accurate. The ones I've seen are sold for $x/share, let's say $10, and when you get statements on them, they show $10/share, but the fine print says that is the latest offering price, not current market value. Nobody knows what they are worth, which is the price a willing buyer and a willing seller will accept.

Now, there are publicly traded REITs which trade on markets and have readily determinable share prices. That doesn't sound like what is being offered.

[mbozek]

Illiquid reits go by another name- non publicly traded reits which have two unfavorable features: lack of liquidity and lack of transparency on FMV of the reit. Reits invest in RE or mortgages and pays at least 90% of their income to investors. Publicly traded reits are priced daily because they are sold on national exchanges where the trade price is disclosed. However private reits are not traded on an exchange so the investors have no clue about the FMV of the Reits. Many private reits guarantee above average rates of return on the investment such as 8% dividend instead of 4% on publicly traded reits . To make the interest rate the reit uses the RE as collateral for a loan that guarantees the dividend. Since the Reit is not traded on a public exchange the investors are unaware that the FMV of the Reit has been diluted by the loan. When investors are allowed to sell the private reit back to the issuer they discover that the the FMV of the Reit has declined by 60% or more because of the loan. So a Reit share purchased at $10 can only be sold for $4. Some private reits default on loans used to purchase RE in the reit without informing investors who only find out when they try to cash out the reit that it has 0 FMV.

If you want to see what can happen with illiquid Reits just google Apple Reit 8 which was sold to retail investors by david lerner Associates. You can also google the company name to see what actions the securities regulators took on the private reits.

[david rigby]

Be very skeptical about claims of liquidity.

[My 2 cents]

Not an investment expert or a lawyer, but is it not true that the selection of an investment of this sort is subject to fiduciary standards? Will the decision maker(s) be prepared to defend the prudence and diligence of the process that led to the decision to buy a currently illiquid, non-publicly traded REIT? Fiduciaries do not get much sympathy when challenged when they point to high expected returns when the investment turns out to be poor.

Why is the financial advisor suggesting this investment? How do the expected returns and volatility compare to those of equity investments in established companies? How does buying this investment instead of a publicly traded REIT do a better job of diversifying the investments?

[figure 8]

Thanks for the replies. Here's what I'm thinking...

If the DB plan invests in these non publicly traded (and temporarily illiquid) REITs, such investment is not prohibited and doesn't require an audit as long as there is a general prudent approach being taken towards the DB plan assets. In other words, it's fine as long as the DB plan assets are diversified, there is sufficient liquidity to pay benefit payments, and the overall investment strategy is well-researched/sound/not careless (not sure what the best word is here).

I guess I should clarify regarding the audit. After reading through the audit waiver requirements more closely, I'm still not immediately sure whether this type of investment is a qualifying plan asset. I think it is, because I think it's held by the broker-dealer, but I'm not really sure who holds it. But if it is a non-qualifying asset, then there's still no audit assuming a) the participant count waiver requirement is met and either b) the REITs make up less than 5% of the total assets or c) the REITs are appropriately covered by a bond.

[figure 8]

Not an investment expert or a lawyer, but is it not true that the selection of an investment of this sort is subject to fiduciary standards? Will the decision maker(s) be prepared to defend the prudence and diligence of the process that led to the decision to buy a currently illiquid, non-publicly traded REIT? Fiduciaries do not get much sympathy when challenged when they point to high expected returns when the investment turns out to be poor.

Why is the financial advisor suggesting this investment? How do the expected returns and volatility compare to those of equity investments in established companies? How does buying this investment instead of a publicly traded REIT do a better job of diversifying the investments?

The FA is suggesting this because they specialize in alternative investments and seem to feel strongly that they will help create a portfolio that will have high returns. I think your questions here make a lot of sense and kinda go along with the other post I just made. I think a major key is that a prudent approach is being taken to the investments.

I'm not an investment expert either though, so I personally don't know how to look at something like this and say, "Yes, there has been sufficient prudence and diligence taken with these investments."

[mbozek]

Adding an alternate investment to the plan is permissible if it increases diversification into asset classes that the plan has not invested in. RE is considered to be a separate asset class which can be a prudent investment if it is within the plan's Investment policy, the same as gold or other commodities which would be an acceptable alternate investment. Whether a particular RE investment is prudent for a plan depends on many factors in addition to rate of return. I don't think an illiquid reit investment would be a suitable investment instead of a publicly traded reit such as VNQ which has an ER of about .30 BP. Another factor to consider is whether the Reit invests in mortgages which could generate ubit. Check the prospectus to see if the Reit is suitable for IRAs and qualified plans.

[Bird]

Why is the financial advisor suggesting this investment?

Higher commissions.

[Bird]

I guess I should clarify regarding the audit. After reading through the audit waiver requirements more closely, I'm still not immediately sure whether this type of investment is a qualifying plan asset. I think it is, because I think it's held by the broker-dealer, but I'm not really sure who holds it. But if it is a non-qualifying asset, then there's still no audit assuming a) the participant count waiver requirement is met and either b) the REITs make up less than 5% of the total assets or c) the REITs are appropriately covered by a bond.I guess I should clarify regarding the audit. After reading through the audit waiver requirements more closely, I'm still not immediately sure whether this type of investment is a qualifying plan asset. I think it is, because I think it's held by the broker-dealer, but I'm not really sure who holds it. But if it is a non-qualifying asset, then there's still no audit assuming a) the participant count waiver requirement is met and either b) the REITs make up less than 5% of the total assets or c) the REITs are appropriately covered by a bond.

That's correct, or at least what I remember. That doesn't put it in the "no problem" category, at least for me. If it's a small-ish plan, it's going to terminate, sooner or later, and I guarantee there will be unhappiness of some sort when it comes time to try to raise cash.

[mbozek]

Isnt the most important question whether the Reit investment is a prudent investment for the plan, not whether there will need to be an audit. Just what kind of a bond do you think will be issued for an illiquid reit and who would insure such a risk of loss?

[figure 8]

Yes, I think that probably is the most important question. There are several questions at play though, and I guess I'm trying to figure them all out. But I'd agree that the issue of prudence is the most significant. If it's not prudent, then I don't even need to worry about the audit question. The questions:

First, is it even allowed to be considered, or is it prohibited? (I don't think it's specifically prohibited based on name)

Second, if it is allowed to be considered, will it be prudent? (seems like it would be circumstantial - I think it could possibly be argued to be prudent)

Third, if it will be prudent, is it a qualifying asset? (not sure - maybe sometimes yes, sometimes no?)

Fourth, if it is not a qualifying asset, will the requirements for waiving an audit be met? (would need to be under 5% of assets, because, as you point out, bonding might be difficult)

[My 2 cents]

Is there such a thing as an illiquid qualified asset?

[figure 8]

Is there such a thing as an illiquid qualified asset?

I don't know. According to 29 CFR 2520.104-46 (http://www.law.cornell.edu/cfr/text/29/2520.104-46), a qualifying plan asset includes any assets held by any of the following:

a. a bank or similar financial institution

b. an insurance company qualified to do business under state law

c. a broker-dealer registered under the Securities Exchange Act of 1934

d. any other organization authorized to act as a trustee for individual retirement accounts under IRC section 408

Could an illiquid asset meet any of these requirements? I would think it's possible. I feel like this stuff is getting beyond my current level of understanding of investments though (which is admittedly not a high level to begin with).

[david rigby]

Just an observation: there seems to be a implicit desire in some of the posts above to "justify" (my word) investing in an illiquid asset, where the justification is:
- it might meet the definition of "qualifying asset", and
- the financial advisor claims to "specialize in alternative investments".

Neither of these is a good reason. I hope that is obvious.

Why not put the onus of prudence and suitability on the FA, rather than the onus of unsuitability on the plan sponsor?

[My 2 cents]

Just an observation: there seems to be a implicit desire in some of the posts above to "justify" (my word) investing in an illiquid asset, where the justification is:

- it might meet the definition of "qualifying asset", and

- the financial advisor claims to "specialize in alternative investments".

Neither of these is a good reason. I hope that is obvious.

Why not put the onus of prudence and suitability on the FA, rather than the onus of unsuitability on the plan sponsor?

Fine with me! (for what that's worth) Long ago experience with investments that suddenly turned illiquid, especially with respect to plans that were trying to terminate, soured me on the idea for good. Surely there are enough investments out there, no riskier than your everyday equity fund, to make many "alternate investments" a bad idea for qualified retirement plans. Feel free to invest your IRA in them if you are feeling lucky (but watch out for liquidity issues when it's time for minimum distributions!). Still seems as though a normal REIT (if one wants real estate in the plan's portfolio), sold in established markets, would be more prudent than a private REIT that is going to be illiquid for a period of time.

[figure 8]

David, that's a good observation, and yes, I certainly agree that those are not good reasons. Really, I'm not trying to justify that they "should" do this - I guess I'm now trying to justify that they "could" possibly do this, because after doing some research, that's what seems to be the case. If my research was leading me to believe that they couldn't do this, then I guess I'd be trying to justify that they couldn't do this.

So I started this thread looking to ultimately justify whether they could or couldn't do this investment. Whether they should or shouldn't is probably outside the realm of my expertise though, I think.

I like your last question though. Ultimately, I think I'll go back to the FA to explain some things and tell them that this appears to be a gray area, and that they'll need to seek counsel / do more research if they want to definitively draw a conclusion - and/or they could play it safe and avoid these investments altogether for DB plans.

[figure 8]

And My 2 cents, that's certainly a good point about terminations as well. You won't always know 18 months in advance when a plan is going to want to terminate. I'd say that's a good reason to recommend not investing in these.

[AndyH]

Jumping into this conversation late but it's a good one and lots of good comments have been made.

One of the questions is about whether an "audit" is required, by that I assume a 5500 audit. In my mind, the question should be how FMV is to be determined. Is a reliable "appraisal" to be done periodically? Annually?

Also, this is a 5500 flag, A red one in my experience. IRS audits tend to follow such reporting of assets without readily determinable FMVs. Usually for good reason.