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The Once and Future Cataclysm?

I'm reading a two-year-old "StangerGram," published by Robert A. Stanger & Co., and wondering whether the planning profession is dumb enough to repeat one of the worst mistakes in its short history. Some of you may remember Bob Stanger's Stanger Report, which was considered the bible of tax shelter sponsors, and which rated their "deal terms" for the planning community of the 1980s. Virtually all of those partnership programs, regardless of how great or awful their deal terms happened to be, blew up and cost investors billions of dollars. Broker-dealers and advisors faced a blizzard of lawsuits from angry clients, and in the aftermath, some 25% of all advisors were forced (often sued) out of the business. At the time, I remarked that this was not far from the mortality rate from the Black Death in Europe in the Middle Ages.

The StangerGram looks like a one-time snapshot that was offered on the website of the Investment Program Association, with what appears to be excerpts from the modern version of the Stanger Report, only this time it reports on the various activities of, and predicts bullish days ahead for "non-traded REITs"–illiquid real estate investments with generous up-front costs in the neighborhood of 15%. The prediction was accurate: non-traded REITS are now managing $80 billion in aggregate, and the $10.3 billion raised in 2012 represented a 28.7% increase over 2011. In the first quarter of this year, $3.9 billion more was raised–largely through the advisory profession.

Even FINRA, whose accommodating regulatory posture reminds one of factory building inspectors in Bangladesh, seems to be worried. On May 3, it warned broker-dealer firms that they should be giving better information when they sell the heck out of non-traded REITs. In particular, FINRA thought that investors should know that the generous dividends they're receiving from day one actually is their own money being given back to them, rather than distributions of profits from operations.

One possible reason for FINRA's concern: the state of Massachusetts has reached regulatory settlements with LPL Financial ($500,000 in fines; $2 million in investor restitution), Ameriprise Financial Services ($400,000 in fines, $2.6 million in investor restitution), Commonwealth Financial Network ($300,000 fine, $2.1 million in investor restitution), Securities America ($778,000 in restitution and a $150,000 fine) and Lincoln Financial Advisors ($100,000 fine and $504,000 in restitution). These settlements, mind you, cover the sales in just one of 50 states. If the regulators of, say, New York, Texas, Illinois, New Jersey and California begin looking into underwater non-traded REIT holdings of their citizens, one can imagine fines and restitutions orders of magnitude larger than the numbers you see here.

Taking money out of the initial investment pool to pay distributions of 6-8% makes these vehicles look awfully attractive to credulous consumers in this yield-starved investment environment. Paying 5-6% up-front commissions makes them attractive to the high number of BD reps who still live from year to year on what they sell. There has been off-the-record talk of lucrative shelf space payments to broker-dealers disguised as due diligence allowances or, in some cases, very generous payments for a booth at the BD's annual conference, which makes these programs extremely attractive to a broker-dealer whose margin of profit can be measured in the low single digits.

And therein lies the problem. In the 1980s, when I was editor at Financial Planning magazine, the limited partnership sponsors–who seem to me to be virtually indistinguishable from today's non-traded REIT sponsors–were flooding all channels with seemingly unlimited amounts of money. They were some of the biggest advertisers in our magazine, so much so that the management of the IAFP, which owned the magazine at the time, constantly harangued me and the other editors about the evils of exposing issues like, well, routinely paying dividends out of cash reserves rather than operating revenues. Broker-dealer executives hung onto these programs even as they were crashing and morphing into lawsuits because limited partnerships were their sole lifeline to profitability. Their reps–mainstream advisors back in the day–continued selling the programs even as the industry was falling apart, because, well, this was where the money was.

Are we headed for a similar catastrophe today? Fee-only advisors, a small minority back in the 1980s, roughly half of the independent profession today, are clearly not taking the bait. The non-traded REIT industry seems not to have found a clever way to stuff wads of hundred dollar bills into the shirt pockets of fiduciary advisors, and there is every indication that this would be considered offensive if they did.

I am far more worried about the independent BD world and the roughly 70% of its reps who are still in "eat-what-you-kill" mode, living from commission to commission, sale to sale. With mutual fund commissions virtually extinct, and variable annuities a harder sell with the lesser guarantees, non-traded REITS must look to them like manna from heaven. They clamor to the BD home office for access to the money that non-traded REITs put in their pocket, the BD is not averse to generating a nice profit on its sales activities for a change, the magazines are muted by the prospect of advertising dollars, and everybody is happily collecting money until the whole thing collapses in an ugly metastasizing scandal where, with the benefit of hindsight, we come to the astute realization that when you take 15% upfront out of an investment, and then leak out distributions for months or years before the properties have been purchased, that investment cannot ultimately be good for investors.

When we finally get to see all the added distribution costs (via the discovery process in thousands of lawsuits), it will become clear that certain non-traded REITs were far better at taking in and spending investor capital than they were at generating competitive returns. In the end, the only real skill they had was knowing whose palms to grease in order to get access to client nest eggs.

Of course, I could be wrong about all this. History seldom repeats itself this neatly, and I suppose there is no reason to think that just because Bob Stanger was a big part of the limited partnership mess of the 1980s, his key role in today's non-traded REIT world presages a similar outcome. On the other hand, it may just be that enough time has passed, and the profession has forgotten the worst scandals of its history well enough, that crafty sponsors and promoters can make the same old formula work once again. Back then, with all the money flowing around, the people who walked away with the cash were not the BDs, not the reps who raised billions of dollars, and certainly not the investors. The promoters and sponsors had their exits all planned out, their money safely stashed away from reach of the lawyers, and walked away from the disaster they created to lead rich and comfortable retirement lifestyles.

That opportunity to siphon a lot of money into your own pocket and then walk away may be the most powerful motivating force of all when illiquid, non-transparent investments change hands. I'm going to stick my neck out and predict that some years down the road, many of the promoters of these programs will have exited stage right with a big haul of investors' retirement money, and everybody else in the feeding chain who thinks they've hit the gravy train will wind up losing their shirts for having dealt with these people.

I sure hope I'm wrong.