A Commercial Real Estate Investor’s Guide to Hybrid REITs
One of the nice things about commercial real estate investing is that there are different ways an investor can get involved and gain exposure to commercial properties and securities. The most direct way to invest in a real estate asset is to purchase a property. While this approach can yield excellent returns and important tax benefits, not all real estate investors have the time, expertise, and resources needed to purchase property directly. For these investors, fractional ownership of a commercial property may be a compelling option, and one of the ways this is accomplished is through the purchase of shares in a Real Estate Investment Trust – REIT for short.
In this article, we will focus on a particular type of REIT known as a hybrid REIT. We will describe what hybrid REITs are, how to invest in them, the benefits and risks of doing so, and how they compare with the types of private equity syndications that we offer. By the end, readers will have a thorough understanding of hybrid REITs and will be able to determine if investing in one is a good fit for their own investment objectives.
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What is a REIT?
Before we dive into the specifics of a hybrid REIT, let’s take a moment to understand real estate investment trusts in a more general sense.
A REIT is a specialized type of real estate investment vehicle that allows individual investors to purchase a fractional share of a portfolio of commercial real estate assets. Many real estate investors use REITs as a way to generate passive income for themselves. REITs can be privately held or publicly traded and often specialize in a particular asset class. For example, some REITs may invest in retail properties while others may concentrate on office buildings or multifamily apartment buildings.
There are four types of REITs:
- Equity REITs: Most REITs are equity REITs and they offer an equity ownership stake in a diversified portfolio of commercial real estate properties. In return, investors receive their pro rata share of the cash flow and profits produced by the underlying assets. Again, equity REITs are likely to specialize in a specific asset class like shopping centers, data centers, self storage or senior living facilities.
- Mortgage REITs: mREITs for short, mortgage REITS provide financing for the purchase of real estate assets. They are more commonly associated with residential mortgages than commercial ones, but they can originate loans for any type of income producing property. They can also provide liquidity to the marketplace by purchasing mortgage-backed securities.
- Non-traded REITs: Public, non-traded REITS are registered with the securities and exchange commission (SEC), but not traded on public exchanges. They may also specialize in certain asset classes, but they do not have a high degree of liquidity since they cannot be bought and sold on public exchanges.
- Private REITs: Private REITs are exempt from SEC registration requirements as long as they comply with a certain set of rules, most notably they can only sell shares to accredited investors. Likewise, they do not trade on public exchanges, which means that they are far less liquid than their publicly traded REIT counterparts.
Hybrid REIT Definition
One particular type of REIT is known as a hybrid REIT. Hybrid REITs were designed to provide real estate investors with exposure to two types of REITs listed above – equity REITs and Mortgage REITs. Hybrid REITsgive investors exposure to equity by acquiring ownership stakes in rental property and subsequently managing the property. They also provide exposure to the income-generating benefits of mortgage REITs by holding loans or mortgage-backed securities.
Investing in a Hybrid REIT
The mechanics of making a REIT investment depend on whether the REIT is publicly traded or privately held.
If the REIT is publicly traded, shares can be bought and sold on public exchanges by anyone with a brokerage account – much like an exchange traded fund (ETF). For example, Starwood Property Trust is a large publicly traded REITs in the US, and they specialize in commercial lending as well as owning property. Their shares trade on the New York Stock Exchange (NYSE) for ~$20 each at the time of writing.
Many hybrid REITs are available to purchase on public markets, similar to an exchange traded fund (ETF) or mutual fund.
If the REIT is not publicly traded, shares can be a bit more difficult to purchase. First, they are only available to accredited investors and often come with minimum investment requirements in the $25,000 – $50,000 range. Often, non-publicly traded REIT shares must be purchased directly from the REIT or through their broker-dealer network.
There are many benefits to investing in hybrid REITs, but the most notable include:
- Dividend Income: Under IRS rules, REITs are required to pay out a high percentage of their income and profits in the form of dividends. So, they can be an excellent way to earn passive income from high dividend yields. However, it should be noted that REIT dividends received are taxable income and subject to income tax. They must be accounted for as such.
- Diversification: As we saw earlier, hybrid REITs take diversification to another level by offering investors exposure to debt as well as equity positions in investment property. The purchase of one REIT share provides investors with exposure to a diversified portfolio of professionally managed assets. In addition, buying REIT shares provides additional portfolio level diversification away from the standard stock/bond/mutual fund split. In both cases, this type of diversification reduces risk for investors.
- Taxes: As long as REITs follow the rules laid out by the IRS, they are not taxed at the entity level. Instead, the income and profits are passed through to shareholders, where they are taxed at the individual level. Avoiding double taxation can help drive higher returns for investors.
- Liquidity: Publicly traded REITS are liquid securities. This means that they can be bought and sold at any time during normal trading hours, providing investors with a high degree of liquidity not normally available in a direct property purchase scenario.
- Time: REIT assets are professionally managed by a third party firm, which reduces/eliminates the time that must be spent on things like negotiating leases, managing accounts payable, or collecting rent. This allows individuals to get their time back and spend it on things they enjoy like their family or traveling.
- Fractional Ownership: Buying REIT shares provides REIT investors with fractional ownership of a portfolio of real estate assets. Thus, investors are entitled to their pro rata share of the rental income and capital gains produced by the portfolio. These can drive total returns for an entire investment portfolio.
There are a few potential disadvantages to investing in hybrid REITs investors should be aware of before allocating capital to this asset class. Let’s take a look at a few of the most important drawbacks.
- Volatility: Share prices in publicly traded REITs can experience periods of significant volatility – along with the stock market – even if there is no change to the fundamentals of the underlying portfolio. For many investors, these periods can test their nerves, but they should remember that these movements tend to be cyclical and will eventually move the other way. This is why REITs should be considered a long term investment.
- Control: REIT investors have no control over the management of their assets. They have no say in when to buy or sell or what rent to charge or how much to place in operational reserves. Some investors may not like this and prefer to control things themselves.
- Interest Rates: Many REITs use debt to purchase their assets and work with a wide group of lenders to source it. Depending on the structure of their debt (e.g. fixed rate vs. variable rate, short term vs. long term), REIT share prices can be very sensitive to movements in interest rates – especially when they go up.
- Tenant Risk: The entire REIT investment strategy as it relates to equity REITs is predicated upon the idea that tenants will continue to pay their rent every month. So, whether dealing with an office REIT, healthcare REIT, retail REIT, or residential REIT, gross income is derived from tenant rental payments. When tenants decide to vacate their space or go out of business, the REIT’s income can be reduced and, if enough tenants stop paying rent, so can their dividends.
- Market Risk: Real estate markets are dynamic. They go up and down in response to macroeconomic conditions. These changes can impact property values and investment returns.
Hybrid REIT Example
Let’s take a closer look at Starwood Property Trust, the hybrid REIT we mentioned earlier, to get a better idea of how it works.
According to the company’s website, Starwood Property Trust trades on the New York Stock Exchange and employs about 350 individuals. It pays a dividend of $1.92 per share at the time of this writing.
The REIT has a portfolio of commercial and residential loans totaling over $25 billion. It also owns about $2.4 billion in real estate assets. Ownership in these assets represents the equity portion of the fund for investors. Because the REIT owns a large portfolio of loans as well as a smaller, but still sizable, portfolio of properties, this is considered to be a hybrid REIT.
Investors who are interested in investing in this REIT or any hybrid REIT need to take the time to understand both the debt and equity portfolios before allocating capital to the REIT.
Private Equity Real Estate vs Hybrid REITs
A hybrid REIT is not the only way to gain fractional ownership of commercial real estate assets. Another common way is to invest in a real estate syndication – which is the type of investment opportunity that we typically offer.
In many ways, the types of syndications we offer are similar to a REIT, but there are a few key differences:
- Syndications are not publicly traded. They are privately held investments that are subject to the same type of liquidity constraints as a privately held REIT.
- Our syndications are for one property, whereas shares in a REIT are for an entire portfolio of assets. There are both pros and cons to this type of strategy.
- Returns from a syndication are split with the transaction sponsor based on the performance of the property. This helps incentivize the transaction sponsor to drive returns and capital appreciation.
- Syndicated deals are available to accredited investors only. Thus, they must meet certain income or net worth requirements.
- Finally, since syndicated investments are not publicly traded, they cannot be purchased on an exchange. They are typically purchased directly from the syndicator or through the real estate companies that run them.
Investing in a hybrid REIT or a syndication can yield a profitable outcome, so real estate investors must determine which is the better fit for their unique circumstances. In general, syndications tend to be a better fit for high net worth investors who have a long term time horizon and a moderate risk tolerance.
Summary of Hybrid REITs
A REIT is a specialized type of real estate investment vehicle that allows individual investors to purchase a fractional share of a portfolio of commercial real estate assets. Hybrid REITs are one specific type of REIT that combine the features of equity REITs and mortgage REITs. Many investors seek exposure to both debt and equity as part of a portfolio diversification strategy, and hybrid REITs fill this need. As with any REIT, hybrid REITs are overseen by a professional management team that is responsible for uncovering investments, performing due diligence, ensuring that properties under ownership are managed well, and that investor communications are issued timely and in accordance with securities laws.
Many investors who are interested in hybrid REITs also invest in private equity commercial real estate syndications. Investing in a syndication can yield a profitable outcome for real estate investors who meet the requirements for doing so.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.