REITs vs. Private Equity Real Estate: Differences Explained

Investors seeking both passive income and exposure to the commercial real estate sector have a myriad of investment choices.  Among them is whether to deploy their capital into a Real Estate Investment Trust (REIT) or through a Private Equity Real Estate Firm.

Often, Private Equity Firms and REITs are confused for each other because they invest in similar assets.  In reality, their business models are distinctly different, both legally and operationally, and they employ contrasting investment strategies.  One of the questions that we are frequently asked is, which is the better investment option?

Before answering that question, let’s first define exactly what REITs and Private Equity Real Estate firms are, how they invest, and their pros and cons.

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REITs Defined

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are formed as corporate entities, investors are able to purchase shares in them, which provide access to the income and profits produced by the underlying real estate assets.  In addition, a REIT is a tax advantaged structure and for a company to qualify for REIT status, they must meet the following IRS requirements:   

• Invest at least 75% of total assets in real estate
• Derive at least 75% of gross income from rents on real property, interest on mortgages financing real property, or from sales of real estate
• Pay at least 90% of taxable income in the form of shareholder dividends annually
• Be an entity that is taxable as a corporation
• Be managed by a board of directors or trustees
• Have a minimum of 100 shareholders
• Have no more than 50% of shares held by five or fewer individuals

REIT Types

Broadly, there are four categories of REITs.  However, within each category, there are subdivisions that may focus on a specific property type or asset class. For example, one REIT may specialize in multifamily while another may focus on shopping malls. The REIT types are:

1. Equity REITs: Equity REITs are publicly traded companies that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders.  The majority of REITs fall into this category and are generally considered attractive because of their liquidity and high dividend yields. 
2. Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities.  They earn income from interest on the loans and/or dividends from security investments.  
3. Public Non-Listed REITs: Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges. However, they follow the same philosophy of investing in income-producing properties for the purpose of distributing dividends to their shareholders.
4. Private REITs: Private REITs are exempt from SEC registration requirements and their shares do not trade on national stock exchanges. To invest in a private REIT, an investor must meet income and/or net worth hurdles or demonstrate that they are sophisticated enough to understand the risks of investing in non-publicly traded securities.

Given the number of REIT categories, there are enough options to meet the needs for nearly all investors.

Benefits and Risks of REIT Investing

Primarily, investors like REITs because their shares can be bought and sold with relative ease, providing a degree of liquidity not available in other real estate investments.  However, they also come with a host of other benefits:

• Income: By definition, REITs must pay out at least 90% of their taxable income as dividends, which are funded by the income-producing properties that the REIT owns.  
• Diversification: Historically, REIT price movements have a low level of correlation with other asset classes, creating diversification in the traditional stock/bond portfolio.
• Governance & Oversight: REIT operations are overseen by a group of independent directors and auditors who publish performance reports on a regular basis, providing investors with a high degree of operational transparency.
• Performance: Long term REIT performance is generally commensurate with, or slightly above that of stocks and bonds. For example, the MSCI REIT index – which tracks REIT performance – has returned 927% since January of 1990 vs. 848% for the S&P 500 over the same time period.

While the benefits are attractive, REITs can be growth constrained because they’re required to pay at least 90% of their taxable income as dividends.  And, those same dividends are taxed as ordinary income for the investors who receive them. In addition, publicly traded REIT price movements can be subject to the whims of public markets, which don’t always reflect the fundamentals of the underlying assets.  Finally, REITs often have a high front-end “load”, meaning that they will take 5% – 10% of the initial investment in the form of fees. To mitigate these risks – and others – investors seeking REIT alternatives often turn to Private Equity Real Estate firms.

Private Equity Real Estate Defined

Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it in real estate assets. However, the securities offered by Private Equity Real Estate firms are not publicly traded and they are only available to “accredited” or high net worth investors. 

Because they aren’t bound by the same regulations as publicly-traded REITs, real estate private equity firms have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing properties. In addition, the legal structure may differ significantly from a REIT and they are not required to pay out a high percentage of their income in dividends. Instead, the majority of real estate private equity returns are derived from profitable investment exits in the form of capital gains and carried interest.

There are several key differences between a private equity firm and a REIT.  They include:

• Tax Structure:  Private equity firms are not required to pay out a high percentage of their income to maintain a tax advantaged status.  Their distributions are tied to the income and profits produced by their underlying properties.  In addition, private equity investors benefit from other tax benefits like depreciation and the opportunity for tax deferrals upon sale.
• Fees:  The fee structure between a private equity firm and REIT can vary significantly.  Private equity firms charge small fees for things like asset management and administrative tasks, but derive the bulk of their income from splitting the property’s cash flows with investors.  REITs are commonly sold through financial advisors and brokerages so they can have high upfront fees (up to 15%) that are used to pay for marketing and sales commission expenses.
• Funds vs. Deals:  REITs are similar to mutual funds in the sense that investor dollars go into real estate funds whose cash is deployed into real estate properties.  As such, investors often don’t have direct knowledge of the properties that they are invested in.  On the other hand, private equity real estate investments often allow investors to fund a specific deal.  This way, they know exactly where the property is located, who the tenants are, and how much they pay in rent.
• Dividends:  As mentioned earlier, REITs are required to pay out a high percentage of their earnings in the form of dividends.  In order to show a high yield, these dividends can sometimes be paid from investor capital or debt, not from property income.  This can raise the risk profile of the investment.  Should investor capital or debt dry up, the REIT may be unable to pay the advertised dividends.

Requirements to Invest in Private Equity Real Estate

An investment with a private equity firm has higher barriers to entry than a REIT. Investors who are considering investing with a private equity sponsor need to be aware of the requirements.

First, there is an accreditation requirement that must be met in order to invest with a private equity sponsor. The definition of an accredited investor according to the Securities and Exchange Commission is as “any person who comes within any  of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of securities to that person:

1. Any bank; savings and loan association; broker or dealer; insurance company; investment company; Small Business Investment Company licensed by the U.S. Small Business Administration; plan established and maintained by a state; or employee benefit plan with total assets in excess of $5,000,000 
2. Any private business development company
3. Any organization described in section 501(c)(3) of the Internal Revenue Code, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold
5. Any natural person whose individual net worth, or joint net worth with that person’s spouse (or spousal equivalent), exceeds $1,000,000 (NOTE:  The person’s primary residence shall not be included as an asset)
6. Any natural person who has individual annual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person 
8. Any entity in which all of the equity owners are accredited investors

In addition to the accreditation requirement, private equity funds have minimum investments, which makes them most suitable for high net worth investors seeking passive income. The minimum investment usually starts around $25,000 and can rise to $100,000 or higher in some cases.

Benefits of Private Equity Real Estate

Like REITs, a private equity real estate investment comes with impressive benefits:

• Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires deep expertise and significant experience, which a private equity real estate firm specializes in.
• Tax Efficiency: Private Equity Real Estate investments are structured in a tax-efficient manner allowing investors to reduce taxable income through depreciation.
• Flexibility: Because they aren’t as heavily regulated, private equity firms can be nimble and flexible in their investment strategy, giving them the freedom to pursue profitable deals where available.
• Incentive Alignment: Because private equity firms are also invested in the deals, their incentives align with those of the investor, they both want a profitable outcome. As a result, income and profit splits are often structured in a way that requires the firm to meet certain return “hurdles” before their profit participation kicks in, incentivizing them to manage the asset profitably.
• Exit Plan: Private Equity Real Estate firms enter an investment with the exit in mind giving investors a roadmap to a successful outcome.
• Clear Fees and Compensation: The fee and profit participation structure is clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.

Like REITs, private equity real estate investments are not risk-free. They often require long holding periods, aren’t liquid, and their success is closely correlated with the experience, expertise, and track record of the investment manager. In addition, they can be expensive because real estate private equity firms charge asset management fees, acquisition fees, and participate in the profits once certain return hurdles are met.

Major Differences Between REITs vs Private Equity Real Estate

Before determining which is the better investment, investors need to understand some of the key differences between REITs and private equity investment vehicles.

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.

Private real estate investments are exactly the opposite. They are illiquid, and as we will see below, they often have holding periods that stretch out for several years. This means that investors commit to keep their invested capital with the private equity sponsor for the duration of the holding period before they are able to convert it back to cash.

Public Trading

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).

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.

Investments in private equity real estate firms are non-traded, which means there is no market for these investments to change hands. A typical private equity commercial real estate investment has a predefined holding period, usually somewhere in the three to ten year range. Broadly, investments with shorter hold times tend to have a lower return than those with longer holding periods. This is because there is a longer period of time from which to collect cash from the property. The business plan and hold time for every rental property is unique so investors should study it prior to allocating capital to make sure they are comfortable with it.

Ownership

Whether an investor chooses to purchase REIT shares or invest with a private equity firm, they will have equity stakes in the underlying real estate assets. In a REIT, the investor is one among many who pool their capital together and give the management team the responsibility of managing the capital. The investor usually ends up owning a small stake in a diversified portfolio of real estate assets.

In private equity real estate syndications, there are two fund structures that provide different types of ownership options for investors.

In a fund structure, a fund sponsor leads a fundraising effort for a specific fund in which capital will be deployed under a specific investment strategy. In other words, investors allocate capital, but only for the purpose of general real estate investment. Specific properties are purchased in the future and investors generally have no say in which ones are pursued. For example, a private equity firm may raise funds for multifamily investment under the idea that they will use the capital to purchase apartment buildings in the future.

In a syndicated deal structure, the deal sponsor raises capital to purchase a specific property. In this case, investors know exactly which property is going to be purchased with their equity investment.

Investment Minimums

Minimum investments between REITs and private equity firms can differ greatly.

Public 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.

As we saw above, the minimum investment in a private equity sponsor usually starts around $25,000 and can rise to $100,000 or higher in some cases.

Returns

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.

In the world of private equity, there is some general agreement about what constitutes a “good” ROE (~10% – 15% annually), it is also a somewhat subjective metric because each individual real estate investor’s needs and objectives are different.  A 5% ROE may be perfectly acceptable for a conservative investor who prioritizes preservation of capital, but may not be enough for another investor who seeks growth.

Determining Which is the Better Investment

The short answer is it depends on an investor’s time horizon, risk tolerance, liquidity preference, net worth, and investment strategy. The key is finding the right fit for each investor’s individual situation. For non-accredited investors with a short-term to medium-term time horizon and a desire for a high degree of liquidity, then a REIT is probably the most suitable investment choice. However, this option has the potential to expose the investor to price volatility and tax liability from REIT dividends.

Conversely, accredited investors with a long term time horizon, higher risk tolerance, and no need for immediate liquidity may find that a private equity real estate investment is more suitable. However, in making the investment they do so knowing that total return may be eroded by fees and that sufficient due diligence must be performed on the investment manager to ensure that they have a track record of successful outcomes.

So, when attempting to choose between a REIT and a private equity real estate firm, the question shouldn’t be, which is better, it should be which option is more suitable for the investor’s unique situation.

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.