There is general consensus in the investment community that commercial real estate assets can be an excellent way to diversify a traditional investment portfolio beyond just stocks and bonds. But, institutional grade commercial properties can be incredibly expensive and they can require a significant amount of experience and expertise to operate. As a result, a direct purchase of one is likely out of reach for most individual investors. Fortunately, there are alternatives.
In this article, two such alternatives are described, REITs and fractional ownership. In it, readers will learn what each option is, their pros and cons, and how they compare to the types of private equity investments we offer. To learn more about our current investment opportunities, click here.
What is a Real Estate Investment Trust?
A Real Estate Investment Trust (REIT) is a company that buys, sells, operates, or finances commercial real estate. REITs can be privately traded, which means that they are only available to accredited investors who meet certain income and net worth requirements. Or, they can be publicly traded, which means that their shares can be bought and sold on major stock exchanges by anyone with a brokerage account.
Because each type of commercial real estate (CRE) asset has their own operational quirks, REITs tend to specialize in specific property types like office buildings, healthcare buildings, data centers, self-storage, multifamily apartments, or retail shopping centers. For example, Prologis is a large publicly traded REIT that owns and operates industrial/warehouse properties and American Tower is a publicly traded REIT that specializes in communications infrastructure like cell phone towers.
When an individual purchases shares in a REIT, they are buying shares in a company that owns a diversified portfolio of commercial properties. As such, they are entitled to a portion of the cash flow and profits that they produce. While nuanced, there is an important distinction between REIT ownership and fractional property ownership.
What is Fractional Ownership?
Fractional ownership is exactly what it sounds like. With it, a group of investors come together to form a “special purpose vehicle” or “SPV” through which they purchase a commercial property. Through the SPV, a minimum “ticket size” is established that represents a percentage ownership of the property and each investor can purchase as many “tickets” as they wish. In return, each investor earns their pro rata percentage of the property’s rental income and gains.
When comparing fractional ownership to REIT investment, the key difference is this. A REIT investment involves the purchase of securities in a company that owns commercial real estate. Fractional ownership does not involve securities. Instead, it involves direct, fractional ownership of a physical property. There are pros and cons to each approach.
REITs vs. Fractional Ownership: Pros and Cons
To fully consider the pros and cons of REITs and fractional ownership, it is most helpful to make a direct comparison between the two on their major offering points.
Property Type
According to REIT operational rules, at least 80% of a REIT’s investment portfolio should be invested in income generating properties. This means they need to purchase existing assets.
In a fractional investment model, there is no such restriction. As such, the fractional ownership model allows for the purchase of both existing properties and those under construction.
Property Selection
REIT investors have no say in the property selection process. This decision is left up to the investment manager.
In fractional real estate investing, those members involved in the SPV’s ownership have complete autonomy over which real estate properties they purchase.
Lockup Period
Publicly traded REITs do not have a defined lockup period, meaning that investors are free to sell their shares any time they wish. This gives a REIT investment a fair amount of liquidity. However, investors may be constrained by changes in the market value of their asset and can only achieve a profit if the shares are sold at a price higher than what was paid.
Fractional ownership doesn’t have a defined lockup period either. Investors are free to sell their stake in the property any time they wish. However, there may be some work required to determine the valuation of the investor’s stake.
Earnings Potential
REITs are required to distribute at least 90% of their taxable income in the form of dividends. This is done at regular intervals and provides investors with a stream of passive income.
In the fractional ownership model, the income produced by the property is also distributed to investors at regular intervals, usually monthly or quarterly. However, the fractional ownership structure is not required to pay out a high percentage of their income as dividends. As such, dividend payments may be somewhat irregular depending on the capital needs of the property.
Both options have the potential for capital appreciation through changes in the REIT share price and/or the value of property.
Transferability
REIT investors do not own a property directly. As such, they are not able to transfer property ownership. They can, however, sell their shares when they wish.
In a fractional property investment, investors are free to transfer their fractional ownership stake.
Diversification
REIT investors achieve diversification through the purchase of their shares. By definition, REIT portfolios are diversified by real estate market and real estate sector so investors are not actively involved in the portfolio construction process.
With the fractional investment option, investors control the diversification process. They can choose which properties and asset classes to invest in on their own.
Investment Minimums
Publicly traded REITs do not have established minimums. Investors just need enough capital to purchase at least one share.
In a fractional model, the entry cost can be much higher, depending on the “ticket size” determined. Often minimums can range from $25,000 to $100,000 or higher.
Valuation
REITs require property valuations at least twice per year. In addition, the stock price for publicly traded REITs changes constantly and can be obtained by looking up the ticker symbol for the REIT.
With a fractional ownership investment, the property is valued at regular intervals so that shareholders know what the value of their investment is. This is particularly helpful when unit holders need to sell their holdings.
Volatility
The share price of publicly traded REITs can experience significant fluctuations, along with the broader stock market, during periods of economic distress, even without any significant changes in the fundamentals of the underlying properties.
In a fractional ownership scenario the property is valued over longer intervals, usually monthly or quarterly. As such, values tend to be less volatile.
Term
Publicly traded REIT investments tend to be open ended, meaning that individuals can sell their shares whenever they wish.
Fractional ownership is a longer term investment that tends to have a defined holding period, usually 5-10 years.
Which Is The Better Investment?
With all of the differences between the two real estate investment options, it is only logical to ask, which is the better investment? The truth is, neither one is objectively better than the other. They both have the capability of producing healthy returns.
But, each commercial real estate investor has their own individual preferences, risk tolerance, and time horizon. As a result, one of the two options may be a better fit for an individual’s needs. This is why it is important that each investor perform their own due diligence and choose the option that is most suitable for their unique situation.
How Do These Compare to Private Equity Deals?
In a way, the types of individually syndicated deals that we offer are a hybrid of these two options. Private quity deals are similar to a REIT in the sense that shares are sold to real estate investors to finance the purchase of a property. But, they are similar to a fractional investment in the sense that the shares are not publicly traded and involve a single property only.
But, with an individually syndicated private equity deal, commercial real estate investors get the benefit of the expertise and network of the private equity firm who has the task of finding suitable properties and managing them efficiently. For this reason (and others), an individually syndicated deal can offer a compelling alternative to the REIT or Fractional Ownership models.
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 info@fnrpusa.com for more information.
