Real Estate Investment Trusts (REITs), Mortgage Real Estate Investment Trusts, and Master Limited Partnerships (MLPs): Shopping for Higher Yields Means Shopping for Higher Risks

by: Montgomery G. Griffin and Theodore S. Avery

We have written elsewhere about how high-yield investments reliably yield high risks.  This prior post addressed the risks inherent in junk (or high-yield) bonds.  Two more specific examples of this proposition can be found with Real Estate Investment Trusts (“REITs”) (including Mortgage REITs, or “mREITs”) and Master Limited Partnerships (“MLPs”).  REITs and MLPs are often marketed to elderly, retired and unsophisticated investors due to their relatively high distribution rates. Moreover, the positive attributes of REITs and MLPs (namely their high distribution rates, often exceeding 6% per year) make for easy sales by those financial advisors who do not make a balanced sales presentation to the investor (i.e., they omit the risks when presenting the idea). Truth be said, notwithstanding the healthy yields paid, the high risks inherent in these higher yielding investments make them unsuitable for many investors, especially elderly, retired investors whose savings should not be exposed to high-risk investments.  In all circumstances, the financial advisor must fully explain the risks to the investor. If a broker or financial advisor unsuitably purchases a REIT or MLP investment for a client or fails to fully explain the risks of a purchased REIT or MLP to the client, the client may have a basis to pursue legal recovery for any losses or underperformance of the MLP or REIT investment.  

High commissions are another drawback to these investments, especially non-traded REITs.  The term “non-traded” denotes that the REIT is not a liquid security that can be bought or sold on a recognized security exchange, such as the New York Stock Exchange or NASDAQ.  Frequently, the upfront sales commission to the financial advisor is as high as 6% to 8% of the amount invested—far more than even traditional brokerage commission charges on REITs traded on a recognized security exchange.

MLPs and REITs share similar structure and characteristics.  Both MLPs and REITs have special legal structures that enable them to be treated as pass-through entities, meaning that they do not pay federal income tax at the corporate level.  Instead, earnings are passed through to shareholders (or “unitholders” in the case of MLPs) and taxed at the individual shareholder’s level. In addition to the advantage of avoiding income tax at the corporate level, depending on the specific MLP or REIT and the particulars of its distributions, MLP or REIT distributions may have tax advantages over the distributions of traditional income investments.  MLP distributions, for instance, are frequently classified in large part as returns of capital, meaning that rather than being treated as immediately taxable income, they are treated as reducing the investor’s cost-basis in the investment, which in effect delays taxation on the distribution. The legal structures of these entities, which incentivizes and requires them to distribute their earnings or cash to investors and enables them to sometimes classify distributions in a tax-advantaged manner, contributes significantly to their yields.  

Risks Related to the Underlying Operations of the REIT or MLP (Can Lead to Reduction in Yield and Unit Value)   

A sales presentation of MLPs or REITs that merely focuses on their tax advantages, however, would not be fair and balanced.  Importantly, the cash flows that enable and drive the yields of REITs and MLPs are a result of their operations. If the operations of a REIT or MLP suffer, such as through taking on excessive debt or facing economic headwinds, cash flows will predictably decline, eventually leading to lower yields.  Furthermore, when concerns about challenges to the operations of a REIT or MLP mount, investors predictably rush for the exit gates, leading to dramatic depression in the prices of the REIT or MLP regardless of whether the REIT or MLP manages to maintain its previous distribution yield. 

REITs that are heavily invested in malls or shopping centers are a recent example of operational risk.  As with virtually all REITs, these investments have consistently offered seemingly compelling yields to their investors.  But with the rise of e-commerce, the trade war, economic concerns, and other pressures on the business prospects of traditional retail spaces, many of these REITs have recently seen dramatic price declines. Investors in many of these REITs have experienced capital losses that have far outweighed any distributions received along the way, and there is no definite end in sight for potential losses or distribution cuts.  Another example has been that many MLPs, which (due to legal restrictions) are frequently concentrated in the energy sector, have historically fallen in value in lockstep with declining oil prices.    

Risks Related to the General Economic Conditions (Can Lead to Reduction in Yield and Unit Value)   

Due to the often-cyclical nature of their operations, REIT and MLP investments often struggle during difficult economic times.  This risk may come as a surprise to investors if, when presented with the idea to purchase the investment by their financial advisor, they are led to believe that REITs and MLPs are suitable substitutes for traditional investment grade income investments.  This is true since, in reality, and unlike REITs and MLPs, the values of investment grade bonds tend to be stable and/or outperform during periods where economic concerns mount. 

REITs and MLPs Are Often Complex Securities

Typically, REITs and MLPs are complex securities that are difficult for ordinary retail investors (often referred to as unsophisticated investors) to evaluate and understand.  This is particularly true of mREITs (REITs that focus on mortgage-backed securities). The value of mREITS is subject to a dizzying range of difficult-to-predict factors such as the types of mortgages held, fluctuating interest rates, the status of the mortgage refinance environment, the types and amount of hedging employed, the types and amount of leverage used, and the timing of investment decisions, among other things.  As far back as 2003, FINRA reminded your financial advisor of certain duties related to making sure that the customer is advised of these complexities before they purchase a non-conventional investment, such as a non-traded REIT.

REITs and MLPs Can Be Unsuitable for Investors Seeking Income and Preservation of Capital 

For the reasons discussed above, and despite their apparent high yields, many REITs and MLPs may be unsuitable for investors who are risk-averse, reliant on a preservation of capital, unsophisticated with regard to securities, or who have other characteristics typical of income-seeking investors.  Additionally, the risks and complexities of REITs and MLPs leave much for brokers and financial advisors to explain to a client even if the broker or advisor believes a REIT or MLP to be suitable for the client. Financial advisors or brokers who unsuitably purchase MLP or REIT investments for clients, or who fail to disclose the commissions or risks inherent in those investments when purchased, may be liable for any underperformance of the investments relative to the returns that would have been attained with the same monies in a suitably constructed portfolio.  Contact the Law Offices of Montgomery G. Griffin for a free consultation if you have concerns regarding an MLP or REIT investment made due to a recommendation of your broker or financial advisor.   

For reference, examples of publicly traded REITs and MLPs are below (please note that there are far more REITs and MLPs than those listed below, and by listing them below we are not commenting on the characteristics or risks of any particular REIT or MLP):

REITs (including mREITs)

  1. Crown Castle International (CCI)
  2. CBL & Associates Properties, Inc. (CBL)
  3. Senior Housing Properties Trust (SNH)
  4. Tanger Factory Outlet Centers, Inc. (SKT)
  5. Dynex Capital, Inc. (DX)
  6. AGNC Investment Corp (AGNC)
  7. Cedar Realty Trust, Inc. (CDR) 
  8. Pebblebrook Hotel Trust (PEB)
  9. Simon Property Group (SPG) 
  10. American Tower (AMT)

MLPs

  1. Seadrill Partners LLC (SDLP)
  2. Kinder Morgan, Inc. (KMI)
  3. Enterprise Product Partners (EPD)
  4. Energy Transfer LP (ET)
  5. MPLX LP (MPLX)
  6. Targa Resources Corp (TRGP)
  7. Summit Midstream Partners LP (SMLP)
  8. Plains All American Pipeline LP (PAA) 
  9. Western Midstream Partners (WES)
  10. Phillips 66 Partners LP (PSXP)