The North American Securities Administrators Association (NASAA), a non-governmental organization that recommends securities regulations for state adoption, has published proposed rules that would limit the ability of individuals to invest in unlisted real estate investment trusts, or REITs. A REIT is a company that owns, operates or finances income-producing real estate. The new NASAA rules are aimed at REITs that are not listed for trading on a national exchange and, as a result, for which there is limited liquidity. However, the proposal goes well beyond non-traded REITs.
Broadly speaking, the revised REIT guidelines would make changes in four areas:
- Update the suitability standards that brokers selling or recommending REIT shares must consider, including new SEC Regulation Best Interest. This proposal doesn’t really change the investment landscape significantly and is relatively uncontroversial.
- Adjust minimum net worth and income standards for non-traded REIT investors for inflation from standards adopted in 2007. The net worth threshold would increase from $250,000 to $340,000, and net income from $70,000 to $95,000.
- Prohibit non-traded REITs from using capital raised as a source of distributions back to investors, which, according to NASAA, creates “phantom yield” (in essence, a Ponzi scheme). Although this restriction has not garnered a lot of attention, it is reasonable to ask why REITs, and not other investment vehicles, would be restricted in this manner.
- Recommend concentration guidelines limiting participation to 10% of the investor’s liquid net worth (cash, cash equivalents and marketable securities). This provision is the most controversial aspect of the proposed rule, in part because the 10% limitation applies to non-traded REITs, affiliates of non-traded REITs and other non-traded direct participation programs (known as DPPs). Note that many DPPs are invested in other sectors, like energy, and may not be real-estate focused.
NASAA claims that these restrictions are necessary for investor protection because non-traded REITs “are heavily marketed to elderly investors,” “are a significant source of customer complaints and have resulted in various criminal enforcement actions over the years.”
Ohio’s Commissioner of Securities Chairs Committee Recommending Limitations
What may come as a surprise is that Andrea Seidt, Ohio’s Commissioner of Securities serving under Republican Governor Mike DeWine, is chairing the NASAA committee recommending these limitations on personal investment decisions. And not everyone is happy about the proposal. On September 9, the Ohio Business Roundtable responded to the proposed rules, arguing that “[t]he proposal thus would limit investor choice without improving investor protection,” further stating:
“By thwarting real estate investment in Ohio as in other states, it could deprive the Ohio economy of needed capital.” Stanger Investment Banking has noted that NASAA seems to be basing the proposed regulations on “outdated and flawed studies.”
Stanger explained that the investor protection issues raised by NASAA relate to first-generation REITs, so called lifecycle REITs. The second-generation NAV REITs (for net asset value) account for 99.9% of current non-traded REIT fundraising and provide greater liquidity and protection. Stanger further notes that the 10% concentration limitation
“Override[s] the judgement of both the investor and his or her financial advisor, in effect forcing them to contemplate greater exposure to risky unregulated private offerings or volatile stock and bond markets.”
Proposal Poses Issues
From a legal perspective, the proposal poses some interesting issues as well. The concentration rule applies to non-traded REITs and their “affiliates.” Because NAV REITs are often sponsored by large asset managers like Blackstone Group, Apollo Global Management and Starwood Capital, the 10% investment cap would apply to wholly unrelated funds sponsored by the same asset manager, further complicating implementation of the rule and limiting investor choice. Further, NASAA’s proposal does not exempt accredited investors (generally, individuals with net worth of $1.0 million or income of $200,000 or $300,000 with their spouse or spousal equivalent and various institutional investors). Previously, the analysis has been that accredited investors have the wherewithal to protect themselves, so restricted investments would be an unusual limitation. Furthermore, the Securities Act of 1933 exempts from state regulation certain offerings to accredited investors. If the NASAA REIT rules are adopted as proposed without exempting accredited investors, they would likely be unconstitutional.
It’s worth noting that several states already impose restrictions on non-traded REIT investments. The question now is whether NASAA will push further regulation or back away from the proposed restrictions in the face of significant criticism.
KJK’s Corporate & Securities practice group will continue to monitor the status of these proposed rule changes. For further questions or concerns, please contact Christopher Hubbert (CJH@kjk.com; 216.736.7215).