Advisor Practice, Regulatory

NASAA, Reg BI, and Non-Traded Securities

THE Securities and Exchange Commission adopted regulation Best Interest (Reg BI) in 2019 and it became effective in 2020.  Now, the North American Securities Administrators Association (NASAA), the organization representing state securities regulators, has issued a report on exams conducted by its members.  Recently, Wealth Management published an article about the organization’s findings as they relate to nontraded securities, among other investments.

NASAA notes that the firms examined relied heavily on suitability standards for evaluating these investment programs for customers.  Notes WM: “…too many firms failed to recommend lower-cost or lower-risk products for clients in lieu of REITs, including individual equity purchases of a real estate company, a real estate-focused mutual fund or ETF, or a publicly-traded REIT.”  NASAA acknowledges that firms typically limited the portion of a client’s portfolio that can be allocated to non-traded securities, and further qualified the clients with income, net worth and liquidity minimums and age-related guidelines.

NASAA seems to believe that all real estate securities are the same thing:

As non-traded REITs are both high-cost and high-risk, states asked firms whether they
considered or offered any of the following lower-cost and lower-risk products before
recommending non-traded REITs: individual equity of a company in the real estate sector,
a real estate focused mutual fund, a real estate focused ETF, or a traded REIT. While
specific investment recommendations have pros and cons outside the scope of this
Report, the above-listed products will often be viable alternatives to non-traded REITs. All
are lower-cost options than a non-traded REIT and, at a minimum, do not carry the same
liquidity risk. Certain specific products within these product types also pay a similar
dividend or yield to a non-traded REIT.

While certain non-traded REITs (and some non-traded BDCs) will have substantial similarities to traded counterparts, the investment programs exist because they are fundamentally, substantially, qualitatively, and deliberately different from similar liquid investments.  Non-traded REITs (and BDCs) are concentrated in a single industry, Real Estate (corporate debt), often in a single sector, with a single strategy.  The capital structure of the entity will vary with the strategy being employed, with most non-traded REITs employing more leverage than the traded counterpart.  

But the most significant difference is that non-traded securities are illiquid.  By design.  It’s a feature, not a bug.  Yes illiquidity is a risk factor, but risk factors are expected to provide benefits to the portfolio, both risk control and return enhancement.  The academic literature confirms this.

And illiquidity mitigates another sensitive issue in the Reg BI regime: relatively high commissions.  Liquid assets are subject to churning.  Non-traded securities cannot be turned into cash, or exchanged for another asset quickly or easily.  Our observation of commission rates for liquid and illiquid securities over our career indicates that advisors aim to be compensated approximately 1% of a client’s per year. So, a  non-traded REIT with an expected hold of 5-7 years with a 6% commission is the same as a mutual fund with an average holding period of 4 years with a 4% commission.  And both are the same as a managed account charging a 1% annual fee.

NASAA distinguishes private placements from non-traded REITs.  And it seems that NASAA’s view on non-traded REITs is applicable to all non-traded securities.  So, all of NASAA’s observations regarding non-traded REITs can be applied to private placements, as well as our commentary above. 

And private placements are further distinguished from the typical liquid portfolio components.  Many private placements are structured to provide significant and valuable tax benefits.  Oil and Gas drilling programs offer immediate deductions against ordinary income. Delaware Statutory Trusts facilitate the deferral of the recognition of capital gains on the sale of real estate, thus deferring the tax liability, perhaps indefinitely. Opportunity Zone programs provide for the deferral of tax liability for capital gains already recognized, and the ability to achieve tax free investment growth of the capital invested in the program.  We have found no publicly-traded or immediately liquid securities which provide any of these benefits.

Further, most equity private placements are organized as pass-through entities for tax purposes.  This can prove valuable for certain retail investors.  So private placements provide a unique benefit superior to most non-traded securities and nearly all liquid investments.

It is disappointing that state regulators seem to not understand or discount the benefits that can realized by investment in illiquid securities.  It is even more discouraging that the firms examined could not identify these benefits to the client in a manner that the regulators could not ignore or minimize.  The report does not provide enough detail to know which party bears a heavier burden in this regard.  Both sides have room to improve.