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
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:
- 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.
- 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.
- 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.
- 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.
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.
Which is Better?
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.
Through our decades of experience, we’ve established a consistent and repeatable three-step investment approach:
- Buy It: We acquire high-quality, income-producing assets at a discount to replacement costs
- Fix It: We rapidly and proactively address any capital structure, physical, or operating issues pertaining to the investment
- Exit: Once the issues are addressed we refinance the debt and hold the asset for the long term.
To learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.