REITs, Tenants In Common, Discretionary Funds, and Direct Deals
For passive investors, finding the right way to expose yourself to the real estate asset class can be confusing. You might hear many different terms or buzz words – REITs, TICs, LLCs, Funds, Private Equity, Notes, Debt Funds.
It really can be overbearing, so I’d like to quickly break it down for you over the next series of emails, we’ll start with REITs.
Real Estate Investment Trusts (REITs)
REITs are entities structured as corporations that purchase real estate or interests in real estate. Essentially, these corporations pool money from investors and buy real estate assets.
In order to maintain REIT status (not subject to double taxation), they must pass through 90% of their earnings to their investors.
There are two kinds of REITs – Actual Real Estate and Real Estate Debt (Mortgages) and hybrids of the two.
Investors purchase shares in the REIT corporation. The corporation then purchases real estate assets and then distributes the cash flow from the rents to their passive shareholders.
There are all kinds of varieties of these corporations segmenting even further down from the Mortgage and Real Estate overlying themes. Office, Multifamily, Industrial, Retail, Single Tenant, Triple Net, and so many more including combinations of all the aforementioned asset classes and strategies.
Non Traded vs Public REITs
Some REITs raise money privately, with no active trading market immediately (the worst of all worlds.) And others are already publicly traded companies that trade on major stock exchanges just like a stock.
Personally, I am not a huge fan of REITs. First, you don’t get the direct depreciation to write off associated with real estate ownership. Second, many of these REITs are not opportunistic investors. Sometimes they exist just to give passive investors exposure to the asset class which is fine if you are looking for ordinary returns. And finally, just like in any corporation, you typically have significant levels of management. Other than a property manager or asset manager, why should you have to pay dozens or hundreds of middle managers?
Real estate is best when owned as close to direct as humanly possible in my humble opinion.
Following the theme of different real estate structures for passive investors, let’s talk about Tenants in Common Ownership or TICs.
Tenants in Common Ownership
A TIC is a direct ownership deal structure. It’s similar to an LLC in it’s “pooled, multiple partner” nature, but set up very differently.
In a TIC structure, each “owner” (for lack of a better word) has a divided, potentially unequal interest in a property.
So instead of “123 Smith Street LLC” owning a property as a single entity, up to 35 “owners” may take title to a property as tenants in common.
Remember, every owner’s interest in the property is separate from the other.
How it Works
A sponsor will put together a deal, and then go solicit interests from potential investors, just like any other passive investment opportunity. This is a direct investment, and not a discretionary fund or REIT. TIC investors purchase an interest in one actual piece of real estate.
The key takeaway here is that each owner is completely separate from the other owners. This allows each TIC owner to sell their interest at will to other potential new owners.
The other great aspect to the tenant in common ownership is that due to the separate ownership structure, owners can 1031 exchange in and out of properties at will.
Since 1031 exchanges must adhere to strict IRS rules to avoid capital gains taxes, typical sellers of investment properties with large capital gains will seek out a project a sponsor has made available. This can be much easier than having to shop for a deal on their own in the IRS time frames.
TICs are great for commercial property owners who may have personally owned a piece of real estate for many years and may have depreciated it down to zero and are now facing a large tax bill. Trading into a sponsors deal and collecting passive income on a stabilized institutional piece of real estate may work for some investors.
In my humble opinion, TICs are not geared for opportunistic, value-oriented investors like ourselves. Many times the exit strategy on the overall property level just doesn’t make sense. The additional layer of IRS guidelines and time frames on a transaction also makes the ownership less “nimble.”
You could always sell your interest and take a haircut, but this fact alone makes TIC deals typically more “cash dumps” or stabilized income plays than value add situations.
The next passive real estate investment vehicle I want to tackle is:
Discretionary Real Estate Funds
These are typically referred to as traditional private equity funds. Overall, this is one of my favorite ways to passively invest in real estate.
A sponsor will typically create a fund around a specific strategy (buy and hold, value add, ground up development) or around a specific product type (office, retail, apartments, industrial, mobile homes, etc.)
Due to the “blind” nature of the typical discretionary fund, passive investor success comes down to finding a competent, sophisticated sponsor who can source quality deal flow and execute their strategy. The “blind” nature is ultimately what allows fund managers to create 20%+ annual ROI for their investors as they can be nimble and confident in the acquisition strategies.
Funds are typically set up as LPs or LLCs so you basically get all of the benefits of directly owning the property. You also get the diversification of being involved in multiple deals.
Due to the “blind” nature of the fund, you aren’t 100% sure of exactly which asset you are buying in to.
One of my favorite types of discretionary funds is a broad “value add” fund that utilizes moderate to no leverage. The value add strategy provides for tremendous upside, and the lack of major leverage takes significant risk off of the table.
The final passive real estate investment vehicle to discuss is the “direct” investment. Typically direct “deals” are structured as LLCs or LPs with a managing member or general partner and non-managing members or limited partners.
What’s nice is that unlike the fund structure, with the deal LLC structure, you are investing directly into a particular asset. In other words, you know what you’re “getting”. You can look at the property, the rent roll, the expenses, the proforma, the strategy, etc.
In my opinion, as a passive investor, this makes me feel more comfortable as opposed to a blind pool where you are essentially buying a track record.
As a direct owner of a fractional share of the entity that is purchasing a piece of real estate, you are entitled to all of the direct write-offs and corresponding income and upside. This is pretty much pure ownership without operational control. This is what passive investing is all about.
Closing Off The Series
As you can see from the last few articles, there are many ways for passive investors to get exposure to real estate. There are pros and cons to each structure.
What ultimately makes any program successful is the sponsor of the deal or fund. A successful sponsor can:
1. Source Quality Deal Flow (most important in my opinion)
2. Execute Their Strategy
Since real estate is such a powerful asset class, you should try to get as close to owning the underlying property as humanly possible when it comes to selecting your preferred vehicle. The more “pooling” your investment vehicle does the less risk, but less potential for reward.