Practical analysis for investment professionals
21 November 2014

A Scandal That Should Shock Nobody

Recently, I was struck by some of the commentary on Seeking Alpha surrounding American Realty Capital Properties (ARCP).Their chairman is Nick Schorsch, who is also chairman of American Realty Capital which is built around the origination and distribution of non-traded Real Estate Investment Trusts (REITs). While conventional, publicly traded REITS have their place in an investor’s portfolio, the non-traded variety represent a far more dubious sector.

In February, I wrote about a non-traded REIT not managed by ARCP, Inland American Real Estate Trust. Like many others, it’s a great investment for brokers, but far worse for their hapless clients. It includes such features as 15% of your investment as fees up front, additional fees for buying and managing properties, incentive fees, and myriad conflicts of interest, in addition to which you can’t sell it because it’s not publicly listed. Forgoing a public listing is sensible if you’d rather not invite the attention of sell-side research analysts to the egregious fees you charge buyers of your product. No public listing means no trading, so no commissions and not much point in writing about it if you work for a sell-side research firm.

This is, of course, all disclosed and, therefore, quite legal. American Realty Capital is the largest manager of non-traded REITs, with a portfolio of $30 billion in assets. But the growth of the industry speaks more to the power of high fees to induce some brokers whose clients’ interests lie substantially below their own to push such products. It’s hard to conceive how anybody associated with an investment that starts out by pocketing 15% of your money could, in good conscience, claim to be helping you grow your savings.

So now we turn to the recent news on ARCP, which is that it is being investigated by the SEC for knowingly misstating its financials. Two employees have resigned because they apparently concealed the misstatement. Their bonuses were set to be higher with the higher figures.

The stock has fallen 40% since the disclosure, as the company has announced that 2013 financial statements previously issued could no longer be relied upon. Some investors wonder publicly whether to hold or sell, seeking to balance what they perceive as the good versus what is reported to be the bad in their comments.

And yet, ARCP is headed by someone who has built a business by selling  securities through ethically-challenged, fee-hungry intermediaries with little regard for the reasonableness of the resulting economics for their clients. ARCP is not American Realty Capital (their confusingly similar names initially confused me as well) but if a company’s tone is set at the top,  ARCP is run by someone who clearly cares more about fee generation that the interests of his clients.

It Must Be Part of the Culture

It reminds me of Bernie Madoff. Many of his investors believed that his persistently attractive and steady investment returns were derived from the ability of his hedge fund to front run the orders of its brokerage clients. Harry Markopolos reports that this was so in his terrific book on Madoff’s scam, No One Would Listen. As hedge fund investors, they thought they were the passive beneficiaries of such illegal behavior.

They believed they incurred no risk and probably expected that if the front-running behavior was detected, the authorities would simply punish Bernie Madoff but not his investors. They were perfectly fine investing with someone who they knew to be dishonest, reasoning that the dishonesty was directed at unwitting others and that their crooked investment manager was honest with them. Such tortured logic delivered its own type of just reward when the truth revealed no such profitable front-running activity at all, delivering large losses to the gullible.

The analogy of ARCP with Bernie Madoff is not perfect, but the non-traded REIT business is not an area that reflects well on the people who traffic in them.  It’s not a nice business. ARCP investors should look carefully at the people with whom they’re invested.

Non-traded REITs are quite rightly coming under increasingly negative scrutiny. the Financial Industry Regulatory Authority (FINRA) even has an investor alert on its website warning investors about some of the unattractive features of these instruments. It’s not a bad idea to be aware of instruments for which FINRA has issued such alerts so that if your broker recommends one, you can ask some good questions. But in addition, if you’re invested in the equity of a company (such as ARCP) whose products are deemed worthy of a FINRA alert, don’t be surprised if you receive the same type of shoddy treatment FINRA is warning about.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockPhoto.com/retrorocket

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About the Author(s)
Simon Lack, CFA

Simon Lack, CFA, is founder of SL Advisors, LLC. Previously, he worked at JPMorgan, where he sat on the investment committee and founded the JPMorgan Incubator Funds, two private equity vehicles that took economic stakes in emerging hedge fund managers. Lack is the author of The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True and Bonds Are Not Forever: The Crisis Facing Fixed Income Investors. He serves as vice chair of the Market Integrity Committee of the New York Society of Security Analysts.

3 thoughts on “A Scandal That Should Shock Nobody”

  1. Chris says:

    While I agree with the sentiment of the post, I’m not sure it’s entirely accurate. You’re 100% focused on the non-traded REIT business that ARCP owned (Cole Capital). First off, that business was a very small portion of their overall revenues. Second, ARCP was in talks to sell the entire business to RCAP just a week prior to the accounting misstatements. They were attempting to rid themselves of the entire business so that they could focus on their “main” business of owning, managing, and leasing triple-net properties around the country.

    This sentiment regarding the dubious morality of duping investors into funneling their money into non-traded REITs in order to drive fee income would be much more accurate if directed at RCS Capital (another Scorsch enterprise), where substantially all of their revenues are sourced from that business. ARCP, however, seems like a questionable target at best.

  2. Jared J says:

    Yes. All financial planners are evil and think of themselves before their clients.

    It’s far better to recommend a traded REIT to a client that trades at a 30 to 50 percent premium to the true value of the REIT because the price has been bid up due to the low interest rate environment. I’m sure the average 20 percent decline in traded REITs last year simply because the fed announced they were going to start tapering was very good for clients. .. much better than the Cole REIT III which liquidated last year with a 10 percent gain.

    Oh, and of course the fee based planner has nothing but the client’s best interest at heart when they put that client in said significantly over valued traded REIT and charge them 1 to 2 percent per year in “advisory” or “management” fees so that the planner can build up a big enough pot of money to get recurring revenue year after year regardless of if you do work for the client or not.

    Let’s be real. Non traded REIT commissions are 7 percent, not 15 percent. Traded REITS almost trade at a significant premium to their net asset value… way more that a 10 percent load you would pay on a non traded REIT, and a “managed” fee account fee where the client is being charged 1 to 2 percent per year results in exponentially higher long term fees than a front loaded product charges.

    Instead of writing about something you obviously no absolutely nothing about, why not just admit that the only real way to do planning g that has no conflict is hourly fee non investment management planning… and even then there’s a conflict to take a long time to do the planning so you can bill your client more.

    There’s more than two sides to each story. It’s not just traded reits are good and non traded bad. There’s advantages and disadvantages to each. Advantage on non traded: buy closer to true NAV, more like actually owning real estate, and lower long term fees paying an up front load than 1 to two percent in perpetuity. Advantage of traded: liquidity.. and that’s about it.

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