For individuals interested in adding commercial real estate assets to their investment portfolio, there are a number of options to choose from both in terms of commercial property type and investment vehicle.
With respect to the commercial property type, investors could choose to focus on one or more of the following: retail, industrial, multifamily, or office. With regard to the investment vehicle, investors could choose to purchase a commercial property directly or indirectly through a private equity firm or REIT.
The real estate type and investment vehicle can be mixed and matched to create a number of different investing options, one of which is a “Retail REIT.” The purpose of this article is to describe what retail REIT investing is, why it can be a good choice, the downside risks, and potential alternatives. Let’s start with a simple definition.
What is a Retail REIT?
To define exactly what a Retail REIT is, it is helpful to break the term down into its two components.
The word “Retail” refers to a specific type of commercial real estate property. A “retail” business conducts direct to consumer sales through a storefront in a shopping center. Retail properties can range in size from “big box” stores like Costco or Home Depot to small, local stores that may only have one or two locations.
The word “REIT” refers to the investment vehicle through which the retail property is purchased. REIT is an acronym for “Real Estate Investment Trust”, which is a specialized type of investment structure that provides individual investors with access to institutional quality assets and their resulting tax benefits as long as they pay out a certain percentage of their income in the form of dividends.
REITs can be publicly traded, which means that their shares can be bought and sold like traditional stocks or exchange traded funds. Or, they can be privately traded, which still means that their shares can be bought and sold, but they aren’t listed on public exchanges, so there is less liquidity.
Equity REITs can specialize in a specific asset class or commercial property type. For example, a mortgage REIT specializes in the purchase and sale of mortgages. Or, a Retail REIT specializes in the purchase and sale of retail properties.
Types of Retail REITs
Even within the Retail REIT investing category, there are sub-categories from which real estate investors can select to match their own individual investment preferences. Two such options are Shopping Mall REITs and Freestanding Retail REITs.
As their name suggests, Shopping Mall REITs invest their capital in traditional retail shopping malls. These are usually located in suburbs of major cities and contain a handful of “anchor” tenants in addition to many supporting retail tenants within an enclosed space.
Freestanding retail REITs follow a similar anchor/supporting tenant concept. However, the physical structure of the commercial property is completely different. Entry to the shops for a freestanding retail property face the outside and are typically fronted by a parking lot. A classic example of a freestanding retail property is a grocery store anchored shopping center.
In addition to the two options above, there are other types of REITs that specialize in retail space. For example, there are also REITs that invest in factory outlets, strip centers, power centers or some combination of all of these. Individuals interested in retail REIT investing, should be able to identify the differences between these retail property type options and choose the one that best suits their own investment preferences.
Who Should Invest in a Retail REIT?
Given their risk/return profile, REITs tend to be a good fit for investors who prioritize income, tax benefits, and diversification. As a generalization, these investors tend to be older individuals who have a sizable investment portfolio from which they use the income to subsidize their living costs.
But, these aren’t the only potential REIT investors. Anyone with a brokerage account can invest in a publicly traded REIT. However, private REITs are typically reserved for wealthy individuals who are certified as “accredited investors” that meet certain income and net worth requirements.
Why Investors Should Consider in Retail REIT Investing
There are a number of important benefits that can be realized from a Retail REIT investment:
- Income: Because REITs must pay out a high percentage of their cash flow as dividends, holders of REIT shares enjoy a stream of income driven by the rents collected on the properties owned. Relative to other investment types like stocks or mutual funds, REITs have high dividends that are beneficial for their investors.
- Diversification: Within a single REIT share, investors have fractional ownership of all properties owned within the entire REIT investment portfolio. This provides a high level of diversification that allows strong properties to offset the weaker performing assets.
- Tax Benefits: In addition to a high dividend payout, REIT investors also receive tax benefits from the interest and depreciation taken for each property in the REIT portfolio. These benefits serve to decrease an investor’s taxable income and reduce overall taxes paid.
- Time Commitment: The properties held within the REIT are managed by a third party. For individual investors, this means that they do not have to spend any time fixing broken toilets or maintaining a commercial property’s landscaping. REITs are a passive investment that provide all the benefits of real estate ownership without the hassle of actually managing it.
While these benefits are compelling, investors should also be aware of the risks of Retail REIT investment.
Risks of Retail REIT Investing
The following sections describe the risks of retail REIT investing.
Interest Rates
Retail investors use a combination of debt and equity to purchase retail shopping centers. As interest rates on debt rise, it becomes more expensive to obtain and can impact the prices that investors are willing to pay for a commercial property. Generally, rising interest rates can impact exit opportunities, creating a headwind for retail properties.
Taxes
To maintain their tax advantaged status, REITs are required to pay out a high percentage of their income in the form of dividends. Investors have come to expect these high dividend yields, but they are a double edged sword. These dividends are taxed as income for each investor and can result in a larger tax bill than expected. In addition, the dividend payout requirement can leave portfolio properties short on operating reserves if not managed correctly.
Furthermore, investors can’t complete a 1031 exchange into a REIT to defer capital gains taxes. REITs don’t qualify as property since they involve purchasing shares in a company which owns real estate.
Liquidity
Shares in publicly traded REITs can be bought and sold on major stock exchanges, which gives them a level of liquidity not normally obtained in real estate investing. However, private REITs do not offer this same benefit. In many cases, they can require a 5-10 year holding period, during which time an investor’s funds are illiquid. If funds are needed during this time, the investor may be forced to sell at a significant discount, if they are able to sell at all.
Market Risk
Changes in market dynamics can have a major impact on retail REIT values. For example, market driven fluctuations in monthly rents or cap rates can be reflected in values that may not always be favorable for the REIT.
Economic Risk
For all REIT owners, there are a certain number of economic variables that are out of their control. These can also impact commercial property values and REIT returns. For example, suppose that the major employer in a given market decides to move to another city. This move results in the loss of 10,000 jobs, which filters through to retailers in the form of lower sales. If a tenant loses business, the risk rises that they won’t be able to pay their rent. Properties with low occupancy, suffer in value.
These risks highlight the fact that retail REIT investment may not be the right choice for everyone. Fortunately, there is an alternative that may be more aligned with individual investment preferences.
Why The Single Deal Private Equity Structure is the Preferred Alternative
In addition to the items cited above, another risk that REIT investors tend to take issue with is that they have no say in how their money is invested. This decision is made by the REIT manager. This may be OK for some, but there is another group of commercial investors who would prefer to know exactly what commercial property their money is going to be used to purchase. For these individuals, the single deal structure may be a better option.
Investing in a private equity sponsored single deal allows an investor to know which property is being purchased, who the tenants are, and where it is located. They can complete their own due diligence and conduct their own site visit if they so choose. For this reason alone, we believe that the single deal structure is likely the better option for most individual investors looking to allocate capital to real estate assets.
Conclusions and Summary
Retail REITs are a specialized type of investment vehicle that allows investors to purchase a fractional share of a portfolio of commercial properties. For the investors who prefer this structure, they can benefit from passive income, rising share prices, and capital gains if the investment is successful.
However, the primary downside to a Retail REIT investment is that the individual has no say in what commercial property their funds are used to purchase. This decision is made by the REIT manager and investors may have limited visibility into their process. For this reason, we believe that the individual deal, sponsored by a private equity firm may be the preferred option for many.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
