REITs and TICs
REITS and TICs are two acronyms that retail investors became familiar with as a result of the run up in real estate prices in the mid-2000s. REIT stands for real estate investment trust, a sort of mutual fund comprised of commercial real estate rather than stocks and bonds. TIC stands for tenant in common, which was a way of slicing up ownership in a single commercial property (usually an office building) and selling the interests to individual investors. Both REITs and TICs are types of “non-conventional” investments (“NCIs”) regulated by FINRA.
As a result of the increase in real estate values in the 2000s, promoters and speculators needed a way to offload highly appreciated commercial real estate, and found the brokerage industry, with its hundreds of thousands of registered representatives (and millions of retail investors) the perfect partner. REITS and TICs sold during this period have experienced problems due to the defective deal structures, overleverage, overly optimistic projections and the general decline of the real estate market.
Many of the REIT and TIC deals sold during this period utilized short term funding, which required refinancing of tens or hundreds of millions of dollars of mortgage debt within three to five years. In addition, due to overly optimistic projections, the deals only netted out a profit if the properties were fully occupied. Lastly, rather than arm’s length transactions, many of the properties underlying the retail TIC and REIT offerings were “flipped” by an affiliate of the promoter after a short holding period, and usually after a receiving a favorable appraisal, allowing a substantial mark up.
In NTM 03-71 FINRA explained that members engaged in the sale of non-conventional investments like TICs and REITs had to ensure that those products were offered and sold in a manner consistent with the members’ general sales conduct obligations, and to address any special circumstances presented by the sale of those products. Among the issues highlighted in NTM 03-71 are members' responsibilities to:
- Conduct appropriate due diligence
- Perform a reasonable basis suitability analysis
- Perform customer specific suitability analysis for recommended transactions
As a follow up, a year later FINRA released NTM 05-18 specifically governing the sale of TIC interests. In this NTM FINRA commented on the type of due diligence required prior to offering TICs to the public:
“Before recommending a TIC exchange members must have a clear understanding of the investment goals and current financial status of the investor. In many cases a TIC interest will constitute a significant portion of an investor’s total assets. Because of the favorable tax treatment, investors often elect to invest the entire proceeds from the sale of an investment property in a TIC exchange. Concentration of an investor’s assets in a single asset class, however, is not suitable for many investors. Members must, with respect to each customer for whom they make a recommendation consider the risks from over concentration against the benefits of tax deferral and the investment potential of the underlying real estate assets(s).”NASD NTM 05-18 pp 4-5
These two NTMs make it clear that performing a vigorous due diligence investigation, as well as a customer specific suitability analysis, with particular attention to overconcentration and tax issues is key to fulfilling brokers’ duties to a customer.