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FINRA Attempts to Plug Loophole for Valuing Non-Traded REITs

Last month, the SEC approved FINRA's proposed rule change requiring broker-dealers to provide customers with an estimated per-share value for Non-Traded REITs. The current practice is to value a Non-Traded REIT on a customer's account statements at the purchase price, generally $10/share. This practice creates the illusion of stability, since the value of the investment does not fluctuate.

FINRA's proposal adopted by the SEC requires brokerage firms to list the value of its customers' Non-Traded REITs under either one of two methods. The net investment methodology requires the per-share value to be based upon the per-share amount actually available for investment in real estate after deducting commissions, fees, offering expenses and organizational expenses (which together may exceed 15%). The appraised value method requires that the per-share value be based on an appraisal of the investment's underlying assets and liabilities.

FINRA has been struggling with the Industry's valuation of Non-Traded REITs for several years. In its Regulatory Notice 09-09 (issued February 2009), FINRA advised its members that Rule 2340 requires the brokerage firm to estimate a reasonably current (within 18 months) value of the illiquid, non-traded securities held in their customers' accounts. FINRA further advised that during the offering period, a reasonable "estimated value" may be the offering price of the security. This created two huge loopholes for issuers and sellers of Non-Traded REITs.

First, many broker-dealers, especially smaller independent ones, sell their customers Non-Traded REITs, register them directly with the issuer and never carry the investments on their account statements. Since the investments do not appear on the customers' account statements, there is nothing for the broker-dealer to value. Clever, huh?

The second way to circumvent FINRA's guidance was also clever. Issuers would simply keep the Non-Traded REIT's offering period open for several years, thereby making it "reasonable" to value the illiquid investments at the price it was being sold to new investors.

While the new rules are a step in the right direction in regards to valuing Non-Traded REITs, they do not address the larger, underlying issues - the excessive costs, commissions and fees, conflicts of interests, and illiquidity - which make these securities a poor investment choice.

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