There are several ways to invest in commercial real estate, and every investor needs to choose the one that works best for them. In most cases, the easiest and most direct way to invest in a real estate asset is to purchase a property. Direct purchases can yield excellent returns and important tax benefits, but not all real estate investors have the time, expertise, and resources needed to purchase and manage a property. 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 provide a guide to investing in REITs. We will describe what they are, the advantages and disadvantages of investing in them, and how they compare with the types of private equity syndications that we offer. By the end, readers will have a thorough understanding of REITs and will be able to determine if investing in one is a good fit for their own investment objectives.
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Brief Rundown of REIT Investing
As a type of investment vehicle, a REIT works through allowing individual investors to purchase a fractional share of a portfolio of commercial real estate assets. REITs can be privately held or publicly traded, and many REITS focus on a particular asset class. For example, some REITs invest mainly in retail properties, while others specialize in office buildings or multifamily apartment buildings.
Generally speaking, 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 a pro rata share of the cash flow and profits produced by the underlying assets. Most equity REITs specialize in a specific asset class, like shopping centers, data centers, self storage or healthcare facilities.
- Mortgage REITs: mREITs for short, mortgage REITS provide financing for the purchase of real estate assets. They invest in residential mortgages more frequently than commercial ones, but they can purchase loans for any type of income producing property.
- Public Non-Listed REITs: Public, non-listed REITS are registered with the securities and exchange commission (SEC) but not traded on public exchanges. They sometimes specialize in specific asset classes, but they do not have a high degree of liquidity because they cannot be bought and sold on public exchanges.
- Private REITs: Private REITs, or non-traded 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. They do not trade on public exchanges, which means that they are far less liquid than publicly traded REITs.
If the REIT is publicly traded, shares can be bought and sold on public exchanges by anyone with a brokerage account – much like a stock or exchange traded fund (ETF). For example, Prologis is one of the largest publicly traded REITs in the US and they specialize in warehouse and logistics facilities. Their shares trade on the New York Stock Exchange (NYSE).
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.
In most cases, individual investors opt for publicly traded REITs, but there may be certain circumstances where a non-publicly traded REIT may be a good fit. The vast majority of individual investors who invest in REITs choose equity REITs.
Advantages of Investing in REITs
REITs are a popular investment strategy for many investors, including individuals and institutional investors. There are good reasons for this as REITs investors enjoy many benefits. Let’s take a look at some of the most important ones.
Low Barrier to Entry
REITs are available to any investor, large or small, as long as they have a brokerage account and enough cash on hand to purchase at least one share of a publicly traded REIT. For retail investors who have limited capital to invest, REITs are a great way to get exposure to the real estate market and earn passive investment returns.
Portfolio Diversification
Investing in any type of REIT will almost ensure the investor of having a diversified investment portfolio of real estate assets. REITs also offer diversification away from traditional stock market investments like mutual funds and ETFs. Even within the REIT asset class, investors can choose to diversify further by purchasing REITs that focus on particular real estate assets, such as retail REITs, office REITs, or healthcare REITs. Investors might not have exposure to these areas through other investments.
Return Potential
Like other types of real estate investments, REITs have the potential to see capital appreciation over time and to generate returns for shareholders. According to Nareit, an industry association, all REITs in the FTSE Nareit REIT index have returned 9.09% annually between 1972 and 2022.
Dividend Payments
Under IRS rules, REITs are required to pay out at least 90% of their income and profits in the form of dividends. This means that REITs tend to have high dividend yields compared to other types of investments.
No Corporate Tax
As long as REITs follow the rules laid out by the IRS, they are able to claim special tax treatment, notably 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. This avoids double taxation and helps drive higher returns for investors. Additionally, the 2017 Tax Cuts and Jobs Act allows a pass through deduction of up to 20% on dividends received by investors. This means that investors can deduct 20% of the dividend income received from REIT investments.
Passive Income
Importantly, REIT investors are able to earn passive income on their investment. This means that after making the initial investment, the investor does not need to do anything else to earn a return on their capital. Real estate offers many ways to make money, but many are very time consuming, like owning and managing rental property or even shopping malls. REITs eliminate the need for the investor to manage the properties they own, hire property management firms, and deal with contractors, tenants, and leases.
Tangible Investments
REITs work well for many investors for the same reason that other real estate investments work well. Namely, the underlying assets are tangible, meaning they are physical assets that can be seen and touched. This is not the case with other asset types like stocks, or even debt instruments like mortgage-backed securities. Many investors find they are able to withstand short-term market fluctuations better knowing they own tangible investments.
Liquidity
Publicly traded REITS are liquid, which means that they can be bought and sold quickly. This feature provides investors with a high degree of liquidity that isn’t normally available in other real estate investments like a direct property purchase scenario.
Commercial Real Estate Access
Finally, buying REIT shares provides REIT investors with fractional ownership in a portfolio of real estate assets, often commercial real estate assets. One of the biggest roadblocks for investors interested in commercial real estate is that the asset class requires a lot of capital to get into. Many commercial properties cost millions of dollars, which the average investor does not have. By investing in a REIT, investors pool their money with others and are entitled to a pro rata share of the rental income and capital gains produced by the portfolio.
Downsides of REIT Investing
As with any investment, there are cons of investing in REITs. Let’s explore some of the most important ones that investors should be aware of.
Dividend Taxes
It’s important to know that REIT dividends received by investors are taxable income and subject to income tax. In fact, REIT dividends are taxed as ordinary income. Even though REITs have tax benefits related to dividend income, it is possible for an investor with a sizable stake in a REIT to incur a significant tax bill.
Interest Rates
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.
High Potential Fees
Investors should be aware that non-traded REITs may have high up-front fees or sales commissions. These REITS may also have annual management fees, and the management team may take a percentage of profits in the form of “promoted interest”. Together these fees can put a dent in the ultimate return that investors see.
Trends May Affect Value
Like with any real estate investment REITs are subject to volatility, which is often caused by trends in the marketplace or a certain type of property falling in or out of favor. For example, in the aftermath of COVID-19, people continue to work from home at a higher rate than they did previously. As a result, many companies have seen fewer employees come into the office, and this has reduced the need for some companies to lease or own as much space in office buildings.
Are REITs Risky Investments?
REITs tend to specialize in specific property types. For example, one REIT may purchase and operate office buildings. Others may seek to build a diversified portfolio of apartment buildings, data centers, shopping malls, self-storage facilities, or healthcare properties. For this reason, potential investors must consider the property specific risks that come with this type of specialization.
Like we discussed above, if a REIT specializes in office buildings, investors need to consider things that could negatively impact the demand for office space. Or, if a REIT specializes in apartment buildings, investors need to think about the risk of job loss and whether the property has enough amenities to support high levels of occupancy.
Investing in REITs vs Private Equity Real Estate
A REIT is not the only way to gain fractional ownership of commercial real estate assets. Another common way is to invest with a real estate private equity firm or syndication – which is the type of investment opportunity that we typically offer. Let’s explore some of the differences.
- Access: While REITs are available to anyone. Private equity investments are only available to accredited investors, who can demonstrate compliance with SEC mandated income and net worth hurdles.
- Diversification: While REITs are spread across hundreds of properties, an individually syndicated deal is for one property. While this does expose investors to increased diversification risk, it also gives them individual control over how their funds are invested. They can diversify their own portfolio by choosing which individual deals to participate in.
- Liquidity: While REITs provide a high degree of liquidity, private equity investments require a 5-10 year time commitment. While this may seem significant, it is ultimately beneficial because it gives the manager the time necessary to fully implement a property business plan.
Investing in a REIT or a private equity syndication can yield a profitable outcome, so real estate investors must determine which is the better fit for their unique circumstances.
Summary of REIT Investing Pros & Cons
A Real Estate Investment Trust – REIT for short – is a special type of real estate trust that owns, operates, and/or finances commercial real estate assets. REITs invest in all property types. Investors who like the REIT structure can purchase shares on a publicly traded exchange, from the REIT themselves, or through a broker-dealer network.
The benefits of a REIT investment include liquidity, diversification, and passive income in the form of high dividends. The potential downsides of a REIT investment include taxes, fees, and market volatility due to interest rate movements or trends in the real estate market.
Investors should weigh the pros and cons of a REIT investment, along with their own personal preferences to determine if a REIT investment is a good fit for their investment objectives.
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 info@fnrpusa.com for more information.
