Hazardous DRIPs

I am constantly amazed at the popularity of distribution reinvestment programs (DRIPs) on illiquid entities such as non-traded REITs.  That as much as half of distributions from a non-traded REIT are reinvested indicates that investors are not carefully considering this decision.

First, I understand the rationale for wanting to reinvest.  Compounding returns are a very powerful investment force for wealth accumulation, and we are taught that interest and dividend must be reinvested to achieve compounding.  Furthermore, the REIT discounts the share price at which the distributions are invested.

However, these benefits do not overcome the major disadvantage of these securities, their illiquidity.  These distributions offer a small amount of liquidity from an investment that is not currently marketable, and whose liquidity timing is distant if not uncertain.  The bird in the hand principle applies here.

What about compounding?  Yes, this aspect of wealth accumulation will be sacrificed.  On the positive side, it will avoid compounding negative returns.  More to the point, the sensitivity of real estate returns to acquisition and disposition endpoints, along with the relatively large minimum investment commitments required, suggest that time diversification could be more valuable than compounding in this asset class.

The discounted price is an even easier issue to address: it is an illusion.  The regular price of a share is typically $10.  That price includes say, 75 cents of commission and 25 cents of marketing assistance that is not spent on the the reinvested distributions.  So the net proceeds to the REIT (comparable to a mutual fund's NAV) are $9.  The dividend reinvestment program will sell shares at $9.50, so those reinvested shares are immediately diluted by 50 cents.  Not a good deal.

I have long recommended that investors decline the reinvestment opportunity and accumulate the cash dividends in their investment account.  If they are concerned about compounding, an option (albeit imperfect) is to invest in one of the REIT mutual funds or ETFs.  Vanguard REIT ETF (VNQ) is a low cost option for tracking the MSCI REIT Index.