Individual investors who are interested in the commercial real estate asset class face a good news/bad news scenario. The good news is that there are a variety of investment options, any of which have the capability of delivering strong returns. The bad news is that the sheer number of options can be overwhelming, making it difficult to select just one.
Two potential options that an individual could pursue are a commercial real estate investment through a REIT or by purchasing a property directly. In this article, the pros and cons of each are explored.
Comparing REITs and Direct Investment
For this discussion, it makes logical sense to begin by defining exactly what each of these options are.
What is a REIT?
The term “REIT” is an acronym for Real Estate Investment Trust. These are specialized types of real estate investment companies that are formed specifically for the purpose of acquiring and managing commercial real estate assets.
REITs can specialize in property types (like office buildings or multifamily) and they can be publicly traded on major stock exchanges or they can be privately held (NOTE: Private REITs are only available to Accredited Investors). For example, the largest publicly traded REITs include American Tower – which owns and operates cellular phone towers – and Prologis which is a major holder of industrial and warehouse space.
When investing in a REIT, an individual is not purchasing fractional ownership in a number of commercial properties. Instead, they are purchasing shares in the company that owns commercial properties, which entitles them to a proportionate share of cash flow and income that they produce.
What is a Direct Investment?
As the name suggests, a direct real estate investment occurs when an individual – or group of individuals – purchases a commercial property directly (instead of indirectly, like a REIT). To accomplish this task, a limited liability corporation (LLC) is typically formed and used to purchase the asset.
With a direct purchase of a commercial real estate investment property, real estate investors are entitled to all of the income and cash flow produced by the asset.
Which is Better?
Given the direct comparison between the two real estate investment strategies, it makes sense to ask which one is better.
Pros and Cons of a REIT Investment
The primary benefit of a REIT investment is the income they produce. Under IRS rules, a REIT must pay out at least 90% of its income in the form of dividends, which means that REIT dividends can produce a steady stream of taxable income based on the rental payments of the underlying properties. Other REIT investment benefits include:
- Diversification: A REIT investment is a purchase of shares in a company that owns many commercial rental properties. So, there is an element of diversification embedded within the investment. The REIT investment portfolio could be diversified by property type, real estate market, tenant base, or all of the above. This is a net positive for investors.
- Liquidity: Publicly traded REITs in particular offer a degree of liquidity not available in other real estate investments. Shares are bought and sold on public exchanges with relative ease, which allow investors to convert their holdings to cash quickly. NOTE: Private REITs do not offer the same liquidity.
- Quality: A REIT investment is supported by institutional grade commercial real estate properties that an individual investor would likely not be able to purchase on their own.
- Relationships & Expertise: REITs are operated and managed by individuals and firms with a significant amount of real estate expertise. In addition, they have extensive networks of relationships with brokers, owners, tenants, and operators that give them access to the best deals. Ownership of REIT shares provides investors with indirect access to these networks and expertise.
The primary drawback to a REIT investment is that individuals have no say in how a REIT’s capital is deployed. This decision is outsourced to the REIT manager. Additionally, investors have no say in a property’s day to day management decisions. Generally, a REIT is a passive investment.
Other REIT drawbacks include share price volatility (for publicly traded REITs) and the fact that dividends can be taxed as ordinary income. For these reasons (and others), commercial real estate investors often seek out REIT alternatives.
Pros and Cons of Direct Real Estate Investment
In some ways, the pros and cons of a direct real estate investment are the inverse of a REIT investment.
The primary benefit is control. By purchasing a specific property directly, investors are in control of every aspect of its acquisition and management. In addition, they are entitled to 100% of the income, capital gains, profits, and tax benefits (such as depreciation) that the property produces. Finally, price movements for individual properties do not experience the same types of fluctuations as publicly traded REITS. They tend to rise slowly over time.
The major drawback to pursuing a direct real estate investment opportunity is the cost, both in terms of money and time. Commercial properties are expensive and institutional grade assets are likely out of reach for all but the wealthiest individual investors. They are also very time consuming to manage and require a significant amount of expertise to do it effectively. Other disadvantages of direct real estate investing include:
- Lack of Diversification: Because commercial properties are so expensive, individuals often need to use most or all of their investment capital to purchase one. This leaves them exposed to diversification risk.
- Liquidity: Because it can take years to fully implement a business plan, a direct investment tends to be illiquid.
- Transaction Costs: The transaction costs associated with buying and selling commercial assets are high, often 3% – 5% on both ends of the deal. These costs can erode profits.
- Time & Responsibility: Finally, a direct investor is also a direct owner. This means that they are directly responsible for collecting rental income and all property management activities. These tasks can be incredibly time consuming and require a significant amount of expertise and experience to perform well.
Direct investment is not a part time job. It requires complete focus to be successful and many individuals may not have the time needed to make this happen. For this reason, a direct investment is likely not the best strategy for most individual investors.
REITs vs. Direct Investment: Which Is The Best Investment Strategy?
It is always tempting to try and figure out which strategy is the “best.” So, it may come as an unsatisfying answer to the question above that “best” strategy is subjective and depends on a number of factors, including:
- Individual Risk Tolerance: Each individual has a different level of comfort with risk. Some may be willing to accept more of it in pursuit of higher returns. Others may want to avoid it at all costs and would be willing to accept a lower return for relative safety.
- Time Horizon: Some investors may be looking for a relatively short investment (1 – 5 Years). Others may want more of a long term investment (5+ years).
- Available Investment Capital: Some investors may have a relatively modest sum available to invest. Others may have significant resources.
- Income vs. Growth: Some investors may prefer to receive their returns in the form of steady income/dividends. Others may prefer to pursue a growth strategy, where the bulk of returns come from the profits made on the difference between the purchase price and sale price.
So, depending upon which end of the spectrum an investor falls with regard to the above factors, the best strategy and investment approach may become clear. For example, a risk averse real estate investor with a small amount of capital, short time horizon, and a desire for steady income will likely be a better fit for a REIT investment approach. On the other end of the spectrum, an investor with significant capital, a long term outlook, and a tolerance for more risk would likely be a better fit for a direct investment.
But, What About Private Equity?
REITs and direct investment are not the only available options in the commercial real estate sector. A third, and equally viable, option is an investment with a private equity firm.
A private equity firm is also a specialized type of real estate investment company that invests in and operates commercial real estate assets. However, they are structurally different from equity REITs and are not required to pay out a high portion of their income as dividends. Per rules outlined by the Securities and Exchange Commission (SEC), private equity investments are only available to investors who meet certain income and net worth requirements. For those that meet them, a private equity investment combines the best elements of both a REIT and direct investment.
In some cases, private equity firms offer real estate investments in a specific deal as opposed to an entire real estate portfolio. Like a direct investment, this allows investors to choose exactly what type of property, market, and tenant they want to invest in. Like a REIT, the private equity structure offers certain tax advantages and the private equity firm acts as the property manager. As a private equity firm ourselves, we believe that a private equity commercial real estate investment is an option worth considering as an alternative to both a REIT and a direct investment.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate (CRE) 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 info@fnrpusa.com for more information.
