This guest column was written by Dinah Bird, PhD, and Kim Renners, MBA.

Investment portfolio diversification and risk management are crucial components to an investment portfolio. It reduces risk and can potentially maximize returns. 

Diversification is especially important when facing historically volatile markets, like the ones we’ve seen the  past few years. Of course, these strategies need not be limited to the traditional stock and bond markets. One asset class that physicians should be aware of are real estate investment trusts (REITs).

In this article, we will explain the basics regarding one type of REIT called “Non-Traded REITs.”

Non-Traded REITs

Usually when financial planners and industry analysts refer to REITs (Real Estate Investment Trusts), they are talking about publicly traded REITs. However, another class of REITs exists and it is called non-traded REITs. While non-traded REITs have relatively limited liquidity, they offer the same benefits as their publicly traded counterparts.

The key benefit of non-traded REITs is that they are not yet publicly traded. Subsequently, they offer the reasonably predictable cash flow of publicly traded REITs without the volatility incumbent in the public markets.

Additionally, non-traded REITs receive the same tax benefits as publicly traded REITs. That is, by meeting certain requirements for taxable income distribution to shareholders, the REIT itself is not taxed, thereby reducing tax on the potential return on the investment, unlike traditional stock investing.

Concept: Economy of Scale in Real Estate Investing

In addition to their investment value and tax benefits, non-traded REITs also offer commercial real estate professionals another option for buying, selling, and managing real estate.

When a commercial real estate professional has several investors with common real estate investment objectives, a REIT offers the opportunity to achieve economies of scale and the benefits of diversification.

For example, one investor with a million dollars and some measure of leverage might be able to afford one commercial property. But 20 investors with a million dollars each may be able to acquire multiple properties — distributed among several geographic markets and many real estate sectors — at a lower cost per square foot.

Private vs. Public: A Trade-Off of Volatility & Liquidity
The REIT structure is simply a method of allowing common ownership of multiple properties. The compelling difference between publicly traded and non-traded REITs is the balance between liquidity and market volatility.

Assuming the REIT remains non-traded, the investor incurs a lack of liquidity since the primary outlet for selling shares is the REIT company itself (although one could find another investor to buy one's shares). However, reduced exposure to market volatility is an offsetting benefit – the value of the REIT is not subject to the swings of the market each day – but to the underlying value of the properties in the REIT.  The reverse is true of publicly traded REITs: Investors gain increased liquidity, but increased volatility exposure as well.

As mentioned above, as a counterbalance to the lack of market liquidity, most non-traded REITs offer repurchase agreements if an investor wants out prior to public listing. Typically, the repurchase agreement will specify a discount to the investor's initial purchase price in consideration of acquisition and organizational costs. The specified discount rate oftentimes is scheduled to diminish over time as the appreciation in property value supersedes the start-up costs.

Of course, commercial property values are not static. But property value changes are glacial compared to price changes in public trading markets. Therefore, both publicly traded and non-traded REITs have relatively stable net asset values. However, publicly traded REIT share prices can fluctuate wildly based on the volatility of the market and they rarely reflect the true net assets value (NAV) of the REIT properties. During bull market periods, the NAV of the publically traded REITs tend to lag the stock market. In contrast, during weaker or bear market periods, the RIETs tend to have higher returns.

As the demand for new issues also is on the upswing and the REIT market price/NAV increases, there is an optimal opportunity for non-traded REITs to consider listing their shares. Doing so gives investors increased liquidity via the public market — potentially at a premium to NAV — without enduring volatility along the way. Any appreciation in the underlying real estate before the REIT is listed should be reflected in the REIT's price once it begins trading.  If the stock market declines and the conditions are not favorable for listing the non-traded REIT, it is not obligated to list. Since the public non-traded REIT is not forced to list, it may offer investors a potential source of predictable income.  Making an investment into any security carries risk and the non-traded REITs also has risk. So, it is important that each investor review the REIT’s prospectus for the potential risks.

Now that you have a better understanding of a non-traded REIT, let’s look at an example of an investor who would use this type of REITs.

Case Study: Cindy the Cardiologist.

Cindy is 49 years old and is working as a cardiologist. She has a $1 million portfolio of 60% stocks and 40% bonds. Cindy’s feels:

• With bonds rates so low, she wants more yield yet also wants to keep some bonds so they can be cashed out if she needs liquidity. However, she is seeking a higher rate of return for her portfolio.
•  60% of her portfolio is already exposed to the stock market and she wants to add a non correlating asset to her portfolio and not add more exposure to market volatility.
• She is considering investing in real estate via non- traded REITs because they typically generate a higher dividend yield than public traded REITs. Cindy feels as long as she anticipates having her money invested, she might as well enjoy more yield and lower volatility of the public non-traded REITs versus the public traded REITs.

Public non-traded REIT Strategy

Cindy desires to implement a public non-traded REIT strategy for a portion of her portfolio. How does a public non-traded REIT strategy work?  Basically works like this: An investor buys into an REIT portfolio, ideally one where the underlying public non-traded REITs are hand-selected by an experienced REIT portfolio manager. The REITs, in turn, spin off annual cash income (presently about 7.0% annual income in one REIT-based portfolio) – income which is not correlated to the stock market or the interest rates so closely tied to bond yields. Because the REIT portfolio picks up some of the cash income slack, the portfolio has less volatility, can provide diversification and potentially produces better risk-adjusted returns.

To purchase a security there is a transaction cost. Each investment advisor or broker has their own fee schedule or commission charge for clients. The commission cost for the client could be as high as 7% with the non-traded REITs. Transaction costs can adversely affect the returns of securities including the non-traded REITs. Thus, it is recommended that clients discuss transaction costs with their investment consultant/broker.

Conclusion

For investors seeking ways to diversify traditional stock and bond portfolios, REITs offer an attractive alternative. But diversification is only part of a well-designed financial plan. Risk management, or reducing portfolio volatility, is just as important. Non-traded REITs can achieve both of these goals.

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Dinah Bird, PhD, CFP, CIMA is a portfolio manager at the national physician-focused consulting firm OJM Group, where Kim Renners, MBA, CPA (inactive) serves as a Director of Wealth Management.   They can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it or 877-656-4362.

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OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio.  OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon rmation pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

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This article contains general information that is not suitable for everyone.  The information contained herein should not be construed as personalized legal or tax advice.   There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances.  Tax law changes frequently, accordingly information presented herein is subject to change without notice.  You should seek professional tax and legal advice before implementing any strategy discussed herein.