Investors seeking passive income and exposure to the commercial real estate sector are faced with a myriad of choices for their investment portfolios, one of which is whether to deploy their capital through a Real Estate Investment Trust (REIT) or through a Private Equity Real Estate Firm.
Often, Private Equity Firms and REITs are confused for offering the same type of investment opportunities due to both deriving cash flow from rental income and operating better in environments with lower interest rates, but they are in fact distinctly different, both legally and operationally. They also employ contrasting investment strategies and one of the questions that we’re 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
REITs – Defined
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are companies, investors can purchase shares in them, providing exposure to the income and profits produced by the underlying real estate assets. For a company to qualify as a REIT, they must meet the requirements outlined in the IRS code, including:
- 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
Generally speaking, there are four types of REITs, but within each, there may be an additional 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: The majority of REITs are publicly traded Equity REITs, which own or operate income-producing real estate for the purpose of distributing income to their shareholders in the form of dividends, which generally has a high dividend yield.
- Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from interest on these 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 offerings exempt from SEC registration requirements and whose shares do not trade on national stock exchanges. Often, to invest in a private REIT, an investor must meet an income/net worth hurdle or demonstrate that they are sophisticated enough to understand the risks of investing in a Private REIT.
Pros and Cons of REIT Investing
Investors primarily like REIT investments because their shares can be bought and sold with relative ease, providing a degree of liquidity similar to the stock market that is not available in other real estate investments. They can also be purchased across mutual funds or ETF‘s (Exchange-Traded Funds). REITs, however, also offer a host of other benefits for potential investors:
- Income: Because REIT shares are backed by underlying income-producing properties, they offer a stable stream of dividend income.
- Diversification: Historically, REIT price movements have a low level of correlation with other asset classes, creating diversification for 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 which provide investors with 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. 1
- Past performance does not guarantee future returns. Data compiled from Yahoo Finance, January 1990 to November 2019. MSCI REIT Index ticker is “RMZ.” S&P 500 ticker is “GSPC.”
While the benefits are attractive, REITs can be growth constrained because they’re required to pay at least 90% of their taxable income in the form of 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 and REITs often have a high front-end “load”, meaning that they’ll 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
A Private Equity Real Estate firm has a similar mandate as a REIT, which is to pool investor money and invest it in real estate assets. However, they’re not publicly traded and they’re only available to “accredited” or high net worth investors. Because they aren’t regulated the same way as publicly-traded REITs, private equity firms have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing real estate properties. In addition, the legal structure may differ significantly from a REIT and they’re not required to pay out a high percentage of their income in dividends. Instead, the majority of private equity returns are derived from profitable investment exits in the form of capital gains and carried interest.
Benefits of Private Equity Real Estate
Like REITs, a private equity real estate investment comes with a series of impressive benefits:
- Acquisition and Operational Expertise: To identify, select, acquire, and operate a 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 the use of 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 they’re 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. In addition, income and profits 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: Fees and the profit participation structure are clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.
Also like REITs, a private equity real estate investment isn’t 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 firm. In addition, they’re expensive. Because they’re experts in the field, private equity firms charge asset management fees, acquisition fees, and often take a larger share of the profits once the return hurdle is reached.
Now that we’ve identified the differences between a REIT and Private Equity Real Estate in the commercial property sector, let’s return to the question that opened this article, which is better for passive income investors?
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 exposes them to tax liability through the 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’ll do so knowing that total return may be eroded by fees and that due diligence regarding the firm is critical 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 individual investor’s unique situation.
About First National Realty Partners
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
- Buy it – We acquire high-quality, income-producing assets at discounts to replacement costs
- Fix it – We rapidly and proactively address any capital structure, physical, or operating issues pertaining to the investment
- Exit – Once issues are addressed we refinance the investments and hold them for the long term.
Our average hold period prior to refinancing is slightly more than three years. If passive real estate investing is an option you’re exploring and you have a long term time horizon, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.