When trying to construct a diversified investment portfolio, one of the challenges that individual investors often face is that there is a finite amount of capital to invest and a nearly infinite number of investment options. This means that choices must be made about how much money to commit to each asset class in the portfolio. Two such investment options are equities (stock) and commercial real estate.
In this article, the pros and cons of REITs vs. stocks are described.
What is Commercial Real Estate?
Commercial real estate is a type of real estate that is purchased with the intent to earn a profit by leasing the space in it to other businesses.
Commercial real estate is a traditionally stable asset class where investors benefit from regular income, price appreciation, and tax advantages. However, it can also be illiquid and often requires a long time horizon to realize a significant gain.
For individual investors, there are a number of ways to gain exposure to commercial real estate. The easiest and most logical is to purchase a commercial property directly. But, they are very expensive to purchase and very time consuming to maintain. For this reason, many investors prefer fractional ownership through a private equity firm or Real Estate Investment Trust (REIT).
What is a REIT?
A REIT is a specialized type of real estate investment company that purchases and manages commercial real estate properties. Because many REITs are publicly traded, individual investors can trade their shares with ease on major stock exchanges. For many individuals, a REIT investment is an excellent entry point into commercial real estate ownership.
Pros and Cons of a REIT Investment
The primary benefit of an equity REIT investment is that investors get the benefit of commercial real estate ownership without the hassle of actually managing a property. In addition, a typical REIT has a high dividend yield, which means a consistent stream of income for investors. Finally, a REIT investment is diversified because it is spread over many properties and locations. Through a combination of dividends and capital appreciation, total returns for REIT stocks can be high relative to other options.
On the downside, REIT investors have no say in how the company’s investment capital is deployed or in the overall investment strategy. Because REITs tend to specialize in certain property types, individual investors may have a general idea (office buildings, multifamily, self-storage, data centers), but they have no say in property specific selections. In addition, a REIT’s dividends represent taxable income for investors and there can be significant price volatility based on changes in publicly traded share prices.
What are Equities/Shares of Stock?
An equity security represents a percentage of ownership in a company. This ownership is held through shares of stock whose price/value is derived from the profitability of the company. There are thousands of publicly traded companies in which investors can purchase shares of stock, ranging from multinational corporations like Apple, Google, and Chevron to small companies like Weis Supermarkets.
Buying a share of stock in a REIT is very similar to buying a share of stock in another publicly traded company with one key difference. REITs focus exclusively on real estate assets and have a tax advantaged structure. Non-REIT shares of stock span all industries and geographies so investors can add diversification to their portfolio by purchasing shares in multiple companies in different industries.
Pros and Cons of Stock Investment
Equity investors benefit from rising prices, low minimum investments, and a wide variety of companies and industries in which they can invest, which allows for the creation of a diversified investment portfolio. In addition, equity investors benefit from a high degree of liquidity because shares of stock can be bought and sold easily with very low transaction/brokerage costs. Finally, there are specialized stock based products like mutual funds and exchange-traded funds (ETFs) that allow investors to buy entire industries (like healthcare) or sectors in one share of stock. These products are similar to REITs.
On the downside, the stock market is well known for periodic price corrections that can wipe 10% – 50% off the price of a share of stock. Although the long term trend has always been up, short term price volatility is a concern. In addition, shares of stock represent the common equity position in the capital stack, which means that investors are last in line to be repaid in the event of a bankruptcy. Although somewhat rare, total loss of capital is a possibility.
REITs vs. Stocks: Comparison of Historical Returns
The primary way to compare the success of a REIT investment against one in stocks is to analyze their historical returns. This can be a difficult task because there are so many REITs and companies in which stock can be purchased. So, to make this comparison, it is best to choose broad indices as a proxy for both REIT and stock performance. For a REIT, a good proxy is the FTSE Nareit U.S. Real Estate Index, which tracks the performance of US-based REITs. For the stock market, the S&P 500, which is a composite of the 500 largest companies, works as a good proxy.
According to historical data, the FTSE Nareit index has returned an average of 11.42% annually since 1972. In its best year, it returned nearly 49%. In its worst year, it lost 42%. Contrast this performance with the S&P 500, which has a historical average annual return of 9.03% over the same time frame. In its best year, it returned 34% and in its worst year it lost 39%. From an average standpoint, the 2.4% annual difference between REITs and stocks may seem negligible, but compounded over many years it can be significant.
So, Which is The Better Investment: REITs or Stocks?
When looking at the difference in historical returns, it can be very tempting to declare that REITs are an objectively better investment. This is a mistake because every investor has their own risk tolerance, time horizon, and return objectives. So, a REIT may offer a better return, but it may not be a good fit for an individual’s preferences. We think the better question to ask is, “which is the better fit?”
For example, an investor who may be older and retired would likely prefer the stability of the dividend payout offered by REITs. Or, on the other end of the spectrum, a younger investor who is chasing growth may be more likely to accept the risk and price volatility associated with a stock investment. So, when trying to decide between the two, each investor should look at the risk/return profile of each investment vehicle and decide for themselves which is a better fit.
But, What About Private Equity Real Estate Investments?
REITs and stocks aren’t the only investment options when constructing a portfolio. There are many other options, one of which is an investment with a private equity commercial real estate firm. Like REITs, these are companies that own and operate income producing real estate for the purpose of delivering a return to their investors.
There are legal and structural differences between a REIT and private equity firm. For example, a REIT investment comes with several tax advantages as long as the firm pays out 90% of their income as dividends. Or, a publicly traded REIT investment does not have a minimum investment and is available to anyone who purchases their shares on a public stock exchange. At the other end of the spectrum, a private equity investment is only available to “accredited investors” and may have a significant minimum investment of $50,000 or $100,000. However, those that meet the requirements may find that these are a good fit for their needs.
To start, private equity investments provide a fractional ownership opportunity in an institutional quality asset and the chance to receive regular dividends derived from the rental income produced by tenant leases. In addition, private equity investors get to leverage the firm’s expertise, relationship network, and operational savvy to gain access to deals that would not normally be available to them. Finally, in an individually syndicated deal, an investor has the chance to pursue an investment in a property, location, and tenant that they know ahead of time and are comfortable with. This sort of customization allows for a better fit between an investor’s needs and the investment vehicle. For this reason, we like this option for many individual investors seeking exposure to commercial real estate assets.
Summary & Conclusion
A REIT is a specialized type of real estate investing company that owns, operates, and/or finances income producing real estate. Publicly traded REITs provide investors with an opportunity to buy and sell shares on major stock exchanges, which also makes them very liquid investments. By buying shares in a REIT, an investor can spread their investment capital across many different properties, operators and locations, which aids in portfolio diversification.
Shares of stock also represent an ownership share in a company, but they are offered across a diverse set of industries from healthcare to financial services and technology. The price of a share of stock reflects the anticipated future profitability and cash flow of the company and tends to fluctuate accordingly. Dividend stocks may behave similarly to REITs in the sense that they can produce a stream of income plus capital gains.
While both of these options are viable investment strategies, they aren’t the only ones. For individuals who aren’t comfortable with the price fluctuations that come with stock investments or the lack of control that comes with a REIT, a private equity investment may be a viable third option. In particular, individually syndicated private equity deals provide investors with a significant amount of advance knowledge about the rental property to be acquired, its occupancy level, and the real estate market in which it is located. This information allows individual investors to make a decision about exactly which property and opportunity is a best fit for their personal investment objectives.
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.
