Sulzberger Capital Advisors


Understanding the Valuation Rules When Owning Non-Traded REITs

Unlisted real estate investment trusts (REIT) and direct participation programs (DPP) have been popular investment vehicles, in particular between 2009 and 2015. The pull back in the real estate markets in 2008, created an opportunity for investors to make money in real estate by buying low and waiting for the real estate market to recover.

REITs and DPPs were ways for many investors, especially smaller investors, to participate in the real estate rebound. A REIT is a company that owns, and in most cases, operates income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and even timberland (this author is only talking about privately held unlisted REITs, not publicly traded REITs). A DPP is a business venture designed to let investors participate directly in the cash flow and tax benefits of the underlying investment. DPPs are generally passive investments that invest in real estate or energy-related ventures.

These investments are illiquid investments. Many of these investments have been illiquid from three to seven years, some even longer. These investments have a history of going back further than 2008. One of the biggest issues REIT investors have faced has been the length of time before they have a liquidity event. After 2008, some REITs became more aggressive about creating liquidity events. During the time a client held this investment, the client’s statement would often reflect the offering price as the market value of the asset while the asset was still in the offering stage, which could be a number of years. A Regulatory Notice put out by FINRA in January of 2015 on these types investments (Regulatory Notice 15-02) stated that historically the market value/offering price would “often remain constant on customer account statements during this period even though various costs and fees have reduced investors’ principal and underlying assets may have decreased in value.”

After obtaining approval from the SEC, FINRA set out new rules with Regulatory Notice 15-02 to govern the estimated values of these investments on client statements. These new rules took effect in April of 2016.

Existing NASD Rule 2340 required that securities governed by this set of regulations provide at least quarterly statements to customers with a description of the security, balances and account activity since the prior statement. The new amendment, Rule 2340(c), sought “to ensure that the per share estimated value is reliable” on client statements and requires either of two methodologies be used for calculating the per share estimated value for a REIT or DPP.

Methodology 1: The Net Investment Methodology. The net investment market, stated simply, is the amount of the investment reflecting deductions for sales commissions, manager fees, and offering and organizational expenses. Also, if any distribution that has been made from the fund represents a return on capital, this will reduce the estimated per share value on the client’s account statement.

Methodology 2: The Appraised Value Methodology. The valuation is based on a disclosed appraised valuation that is filed with the SEC. Appraisals must be performed annually, using a third party valuation expert utilizing standard industry methodology.

If a client owned a REIT or DPP investment in their portfolio, chances are they saw a reduction in the market value of their investment on their statement April statement, especially if the net investment methodology was utilized.

So what does all of this mean and what is going on here? Why is this happening and why has this investment class been singled out?

First of all, it should be noted that this author and a number of experts in the industry believe in the investment philosophy behind non-traded REITs. (Also, this author works with a Registered Investment Advisory firm (RIA), not the broker/dealer environment, and does not take commissions.) REITs and DPPs provide investors the opportunity to invest in real estate without actually having to own individual pieces of real estate. They also provide opportunities for investors to invest smaller amounts of money in this industry. A number of other private real estate investment products have six figure minimums.

Also, the Net Investment Methodology method is the methodology commonly used early on in the investment product’s lifetime. The Appraised Value Methodology is required to be used once the 150 days after the fund’s second anniversary of breaking escrow passes, roughly 2-1/2 years into the fund. It requires annual qualified appraisals.

However, there have been concerns in this industry, notably that broker/dealers (those that make commissions off investments) were receiving substantial commissions from these investment products, upwards of 7-8%. (Many RIAs--Registered Investment Advisory firms—unlike broker/dealers, do not receive commissions on investment products. Dually-registered advisors do receive commissions, however.) Regulators found some commissions excessive and the Net Investment Methodology was a way for investors to see the fee taken by broker/dealers on their statements right away. The theory is if an investor buys a $100 investment and their statement says it is worth $92 in the first month, an investor and broker/dealer would need to be having a detailed conversation about this fee from the outset.

It should also be noted that other fees besides commissions are included in the Net Investment Methodology calculation. These include closing costs, maintenance fees, insurance, property taxes, inspection fees, attorneys’ fees, etc... Anyone who has done a closing on a house will know that there are many fees and costs when purchasing real estate. Commissions are not the only cause of these reduced market values on REITs when using the Net Investment Methodology.

I think it prudent for an investor to consider the following real estate analogy when thinking about the Net Investment Methodology with REITs. When a family buys a house for $500,000, there are many upfront costs. If the family were to net those costs against the purchase price of the home, the net value of the home on day one might be $450,000. If the family were to rent out the home, there would be rental income coming to the family. Let’s assume 6.5% of the purchase price or $32,500 per year.

However, the upfront costs do not deter people from buying homes. If the family were to sell that same home a few years later, they might be selling it for more than they purchased it for, plus the income they received annually. The likely scenario is that the family would be believe that they made a good investment based on the combination of rental income and potential property appreciation and that expenses were recouped in time.

So the purpose of this rule change has been to provide greater transparency to investors of their account value. The rules do not affect the underlying investments or the fund they are in.

So after getting through the technical terminology and the new rules and methodologies, what have the new FINRA rules meant to investors and these investment products? The result is that the industry has seen a big pull back in investing in REITs and DPPs. There is a lot of pressure to reduce fees and change fee structures. There are also new generations of REIT investment structures being created so as not to need to comply with these new rules. A number of existing REITs have stopped receiving new money and have delayed creating a liquidity event, as these rules take effect and are absorbed into the industry.

From personal experience, I have found that investors are confused with the new valuation methods. Investors want to know if the real estate product and their real estate in the product is still worth what they put in it. This can be difficult to ascertain under the Net Investment Methodology, in particular, when it has a focus on costs and not the resale value of the property.

As for new investors in these products, it is hard for an investment advisor to recommend an investment product where on day one the investment is showing a value worth less than what the investor put into the fund. It results in advisors not wanting to put these investments forward to their clients.

The other lens this issue needs to be looked through is the DOL’s new fiduciary standard rule taking effect in 2017. One of this rule’s aims has been to lower the commissions that broker/dealers receive. The REIT and DPP market is just one of a number of areas in the broker/dealer universe that needed to be examined. The broker/dealer environment is expecting drastic changes over the next year.

My fear with these changes is that the market for REITs and DPPs will drop too much, especially in their availability to the investor wanting a low minimum investment size. REITs and DPPs can be a solid tool in the investment arsenal as firms strive to generate returns for clients. The current disruption in this market has made it very difficult to champion these investments going forward. The RIA market, too, has borne the brunt of these new rules even though they don’t take commissions. RIAs are seeing the same drop in the availability for these investments and investor confusion in the values placed on the investments.


  • Sulzberger Capital Advisors, Inc. is registered as an investment advisor with the state of Florida. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration as an investment advisor does not constitute an endorsement of the firm by securities regulators nor does it indicate that the advisor has attained a particular level of skill or ability. The firm is not engaged in the practice of law or accounting.
  • This article should not be construed as personalized investment advice or as an offer to buy or sell the securities mentioned herein. A professional advisor should be consulted before implementing any of the strategies presented. All investments and investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's investment portfolio.

Gene C. Sulzberger is president of Sulzberger Capital Advisors, a registered investment advisor, in Miami, Florida. He works with U.S. and international clients, helping them meet their wealth management goals. Gene is a CERTIFIED FINANCIAL PLANNER™ and a registered trust and estate practitioner (TEP). He is also an attorney who previously practiced law in the area of trust and estate planning. He has over 20 years of experience in financial services and financial planning. Gene can be reached at (305) 573-4900 or