It is a common misconception that the easiest way to invest in a real estate asset is to purchase a property directly. Doing so can yield desirable total returns and excellent tax benefits; however not all real estate investors have the time, expertise, or resources needed for a direct purchase investment. Fortunately, there are alternatives that allow investors to achieve the benefits of real estate ownership, but without the hassle of finding, purchasing, and managing a property. One of these alternatives is known as a REIT.
In this article, we are going to discuss what REITs are, how they operate, and why investors may and may not want to invest in them. By the end, readers will have the information needed to determine if investing in a REIT is a good fit for their own investment objectives.
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What is a REIT?
“REIT” is an acronym for Real Estate Investment Trust, which is a specialized type of investment vehicle that allows individual investors to purchase a fractional share of a portfolio of commercial real estate assets. Real Estate Investment Trusts can be privately held or publicly traded and typically specialize in a particular asset class. As an example, some REITs may invest only in office buildings while others may only invest in multifamily apartment buildings.
There are four types of REITs investors should be familiar with: Equity REITs, Mortgage REITs, Public Non-Listed REITs, and Private REITs. They are described in further detail below:
- Mortgage REITs: Mortgage REITS (mREITs) provide financing for the purchase of real estate assets and typically originate loans associated with residential mortgages, but they can also work with any type of income-producing property.
- Public Non-Listed REITs: Public Non-Listed REITs are registered with the securities and exchange commission (SEC) but are not publicly traded. They may also specialize in certain asset classes; however they lack a high degree of liquidity since they cannot be bought or sold publicly.
- Publicly Traded Equity REITs: Most REITs are Equity REITs which means they offer an equity ownership stake in a diversified portfolio of commercial properties. Thus, investors/shareholders are entitled to their pro rata share of the cash flow and profits produced by the assets. Equity REITs also tend to specialize in specific asset classes like shopping centers, data centers, self-storage, or senior living facilities.
- Private REITs: Private (Non-Traded REITs) REITs are exempt from SEC registration requirements as long as they comply with a certain set of rules – including the requirement to only sell shares to accredited investors who meet certain income and net worth requirements. Because private REITs do not trade on public exchanges, they are far less liquid than publicly traded REITs.
One type of REIT isn’t necessarily better than another, but there are options that are a better fit for an investor’s objectives. For this reason, it is prudent to review the details of each option and choose the one that is the best fit for a given set of objectives. If there is any doubt, it is always a best practice to seek the guidance of a CPA, attorney, or financial advisor.
Why Investors Like REITs
There are a number of potential benefits that investors may realize from a REIT investment. The most notable include:
- Dividend Payout: REITs have a tax advantaged structure, meaning that they are not taxed at the entity level as long as they pay out a certain percentage of their income in the form of dividends. For this reason, they tend to have a high dividend yield, usually somewhere in the 5% – 15% range.
- Taxes: Again, REITs are not taxed at the entity level as long they comply with IRS rules. Instead, income and expenses “flow through” the REIT entity and are distributed to investors, where they are taxed at the individual level. Such an arrangement reduces tax paid, increasing the amount of money available for distributions.
- Liquidity: Publicly traded REITs can be bought and sold on major stock exchanges with ease, making them far more liquid than direct property ownership.
- Time: In a REIT structure, the REIT itself does all the hard work of finding, financing, and managing properties, saving individual investors a tremendous amount of time. REITs are truly a passive investment.
- Fractional Ownership: Commercial properties are incredibly expensive, meaning they are typically out of reach for all but the most well funded individual investors. In the REIT structure, investors can still gain exposure to institutional quality assets, but through a fractional ownership model.
Under the right circ*mstances, a REIT investment can be a compelling option for individual investors seeking to diversify their investment portfolio. But, like any investment opportunity, there are also downsides to consider.
Nine Reasons Not to Invest in REITs
There are nine reasons why investors may not want to invest in a real estate investment trust.
Reason #1: Variable Returns
Investment returns from REITs can vary widely depending on: (1) the trust where the investment is made; (2) the asset class of the investment; (3) market conditions, and (4) the management of the REIT. In addition, publicly traded REITs may be subject to stock market swings that may or may not have anything to do with the fundamentals of the REIT investment portfolio.
The varied returns are a reason why some Investors may want to consider REITs alternatives.
Reason #2: Interest Rates
In most cases, REITs utilize a combination of debt and equity to purchase a property. As such, they are more sensitive than other asset classes to changes in interest rates., particularly those that use variable rate debt. When interest rates rise, REITs share prices can be prone to volatility.
Reason #3: Tax Implications
While the REIT itself has a favorable tax structure, the IRS considers REIT dividends to be taxable income, which means they are taxed as ordinary income. Investors must account for this when completing their REIT research.
Reason #4: Liquidity
While publicly traded REITs are highly liquid, private and non-public REIT shares are not. In these cases, the REIT may require a hold period of somewhere in the range of 5-10 years, during which time shares cannot be sold. If shares must be sold in an emergency, there may be significant penalties or discounts applied to the investor’s principal.
Reason #5: Timeline
In general, commercial real estate returns are earned over the long run, which is why privately held REITs require a significant commitment of time on behalf of their investors. Investors in privately held REITs must be able to commit capital for 5-10 years to allow enough time for appreciation.
Reason #6: Low Growth Potential
REITs are not like an operating business who can reinvest their rental income and profits to grow. Instead, IRS rules require REITs to distribute 90% of the annual earnings to investors. Thus, REITs are left with only a small percentage to reinvest.
Reason #7: Fees
REIT managers do not work for free. To fund their operations and stewardship of the property portfolio, they charge fees ranging from acquisition fees to asset management fees and property disposition fees. In some cases, these fees can account for 10%-15% of earnings annually.
Reason #8: Management
A REIT’s manager can have a significant impact on portfolio performance, meaning that choosing the wrong one can lead to negative returns or returns that underperform the broader market or REIT index. For this reason, it is important that investors work with REITs that have an established track record of delivering consistent returns over a long period of time.
Reason #9: Less Ideal for Experienced Investors
REIT investors do not have a say in real estate property purchase or management decisions, which makes them a good fit for investors who don’t have the time or expertise to do it on their own. For experienced investors, this structure may not be ideal as they may want more control over major investment decisions.
Alternatives to Investing in REITs
A REIT is not the only way to gain fractional ownership of commercial real estate assets. Another common way is to invest in a real estate syndication – which is the type of investment opportunity that we (and other private equity firms) typically offer.
In many ways, the types of syndications that we offer are similar to a REIT, but there are a few key differences:
- Syndications are not publicly traded. They are privately held investments that are subject to the same type of liquidity constraints as a privately held REIT.
- Our syndications are for one property, whereas shares in a REIT are for an entire portfolio of assets. There are both pros and cons to this type of strategy.
- Returns from a syndication are split with the transaction sponsor based on the performance of the property. This helps incentivize them to drive returns and capital appreciation.
- Syndicated deals are available to accredited investors only. Thus, they must meet certain income or net worth requirements.
- Finally, since syndicated investments are not publicly traded, they cannot be purchased on an exchange. They are typically purchased directly from the syndicator or through the real estate companies that run them.
Investing in both a REIT or a syndication can yield a profitable outcome so real estate investors must determine which is the better fit for their unique circ*mstances. In general, syndications tend to be a better fit for high-net-worth investors who have a long term time horizon and a moderate risk tolerance.
Summary of Why Investors May Not Want to Invest in REITs
A Real Estate Investment Trust – REIT for short – is a special type of real estate company that owns, operates, and/or finances commercial real estate assets. They invest in all property types and in some cases mortgage backed securities.
Investors like REITs for their high yield, dividend income, potential for capital gains, and the diversification that they can add to a real estate portfolio.
But, REITs are not risk free. They may have highly variable returns, are sensitive to changes in interest rates, have income tax implications, may not be liquid, and fees can impact total returns.
For investors looking for alternatives to the REIT structure, mutual funds, ETFs (exchange-traded funds) and private equity syndications may be compelling options.
Investors should weigh the pros and cons of a REIT investment, along with their own personal preferences to determine the best investment vehicle is the best for their own investment strategy.
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.
If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
