When looking for potential commercial real estate investment opportunities, it is common for individuals to spend a lot of time focusing on the commercial real estate property type and/or asset class. While these characteristics are important – and require consideration – they aren’t the only things that potential real estate investors should think about. It is also important for individuals to consider the legal structure of an investment as part of their due diligence.
In the article that follows, the differences between two common commercial real estate investment structures are discussed, REITs and Limited Partnerships. By the end, readers will learn what these structures are, the risks and benefits of each, their relative tax consequences, and how they compare to the types of private equity investments we offer. To learn more about our current commercial real estate investment opportunities, click here.
Let’s start with key definitions.
What is a REIT?
REIT is an acronym for Real Estate Investment Trust, which is a company that owns, operates, or finances commercial real estate. REITs can be publicly traded, which means their shares can be bought and sold on major stock exchanges. Or, they can be privately traded, in which case shares cannot be bought and sold on publicly traded stock exchanges. Instead, they can only be purchased by “accredited investors” who are high net worth individuals that meet certain income and net worth requirements, as defined by the Securities and Exchange Commission (SEC).
From a legal standpoint, REITs can be structured as a corporation or a trust. For the purpose of this article the focus is on the corporation structure. Corporations can issue equity shares to raise capital, but one of the major drawbacks of a corporate structure is so-called “double taxation.” Corporation profits are taxed at the entity level and their investors are taxed at the individual for the amount of income and capital gains that their investment produces.
However, one of the major benefits of the REIT structure is that it is not taxed at the entity level (even though it is a corporation) as long as they meet the following three IRS rules:
- The REIT must invest at least 75% of its total assets in real estate
- The REIT must derive at least 75% of its gross income from rents or interest on mortgages
- The REIT must pay at least 90% of its taxable income as shareholder dividends.
When a REIT meets these rules, it acts as more of a “pass through entity” and real estate investors are only taxed at the individual level for the dividend income and capital gains earned. This lack of double taxation results in more income for real estate investors.
When comparing the differences between a REIT and a Partnership, the key takeaway from REITs is that they are legally a corporation, but taxed as a partnership. When contrasted with a Master Limited Partnership (MLP), the opposite is true.
What is a Master Limited Partnership
A Master Limited Partnership – MLP for short – is an entity structure that also works as a hybrid of a corporation and a partnership. It is a corporation in the sense that it has the ability to issue shares or “units” to raise capital for investment purposes. It is a partnership for taxation purposes because it too is not taxed at the corporate entity. Instead, the partnership passes proportionate cash flow and gains to unit holders, where they are taxed at the individual level. Income and capital gains are documented at year end through the issuance of a document known as a K-1, which each individual files as part of their own personal income tax return.
In a commercial real estate investment context, it is common for large institutional properties to be purchased through a Master Limited Partnership. In this case, there are two classes of partners, the General Partner (the GP) and the Limited Partner(s) (LPs). The GP acts as the deal leader and they are responsible for organizing every aspect of the transaction. They form the purchasing entity, find the property, arrange its financing (including raising capital from investors), and even manage it once the transaction is closed. The Limited Partners are passively involved. They provide capital, but have no say in the day to day management decisions concerning the property.
The MLP structure is most closely associated with private equity commercial real estate transactions and the key takeaway is that it is formed as a partnership, but has the ability to issue shares like a corporation.
In addition to the structural elements, there are a number of other differences between REITs and Master Limited Partnerships that potential commercial real estate investors should be aware of.
REITs vs. Master Limited Partnerships: Key Differences
For the sake of this article, the scope of the discussion is limited to publicly traded equity REITs and private equity investments as a proxy for the MLP structure. With this in mind, there are key differences between the two.
By definition, publicly traded REITs are very liquid. Shares can be bought and sold at will with transactions executed in just a few minutes. This provides real estate investors with the liquidity of a stock while gaining exposure to real estate assets.
At the other end of the spectrum, MLPs do not offer the same type of liquidity. In fact, they may require real estate investors to commit capital for a period of 5-10 years or more. While this may seem significant, it is often necessary to fully implement a property’s investment strategy.
The minimum investment for a publicly traded REIT is small, whatever it takes to purchase a single share. In many cases, this could be $100 or less.
The minimum investment for a Master Limited Partnership is set by the General Partner, but it can range from $25,000 to $100,000 or higher.
REIT investors build equity when rising property values drive share price increases. When this happens, REIT shareholders can experience capital appreciation.
Commercial real estate investors in a MLP build equity in much the same way, except MLP shares are not publicly traded. So, there is no immediate market for the shares. In many cases, real estate investors may need to wait until a property is sold to fully realize capital appreciation.
Requirements / Accessibility
Publicly traded REITs are available to anyone with a brokerage account. For this reason, they are the more accessible option of the two.
As previously mentioned, investments in a Master Limited Partnership are typically only available to Accredited Investors. This is a smaller population so access to these types of investments tends to be more limited.
Despite the different legal structures, fundamentally both investment options involve commercial real estate assets. For this reason, the risks are similar. They include the market risk that rental rates can change, the credit risk that tenants will default on their lease payments, the interest rate risk that it could become more expensive to borrow money, and the execution risk that the property is managed efficiently. All of these factors have the potential to impact the market value of the property.
The value of a publicly traded REIT share changes constantly, with the broader movements in the stock market. As a result, it can experience periods of intense volatility, particularly in times of economic distress.
The value of properties held within a MLP are not marked to market continuously. Instead, the values tend to change slowly over time in conjunction with movements in the broader real estate market and changes in the cash flow of the property itself.
Within the context of these differences, each investment vehicle has its own pros and cons.
Pros and Cons of a REIT Investment
Commercial real estate investors like publicly traded equity REITs for their liquidity, diversification, tax benefits, and high dividend payouts. But, the downside is that their prices can be volatile, and those high REIT dividends are taxed as ordinary income.
Pros and Cons of a MLP Investment
Commercial real estate investors like the MLP structure for its tax efficiency, passive involvement, and the alignment of financial incentives between the General Partner and Limited Partners. In addition, individual investors have the opportunity to access the expertise, network, and experience of the General Partner.
But, MLPs can require a significant time commitment, tend to be relatively illiquid, and there are fees that may erode the overall profitability of the investment.
So, given these pros and cons, it is tempting for individuals to ask, which is the better real estate investment?
Which is A Better Investment?
Neither of these structures is objectively better than the other. Instead, one may be a better fit for an individual’s personal preferences, risk tolerance, and time horizon.
Individuals who have a shorter term investment horizon and a preference for liquidity may be a better fit for the REIT structure.
Accredited investors with a long term time horizon and a desire to gain fractional ownership of institutional grade assets may be a better fit for the MLP structure.
The more important point is this, potential commercial real estate investors in either structure should take the time to understand how it works, the pros and cons, and the required time commitment. With this information in mind, they should choose whichever option is most suitable for their personal preferences.
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 would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.