Investors seeking both passive income and exposure to the commercial and industrial real estate sectors have many investment choices. Among them are real estate investment trusts (REIT) and the private equity real estate firm.
Often, private equity firms and REITs are confused with each other because they invest in similar assets. Both also offer investors an alternative to traditional real estate investments. Instead of spending time coordinating general contractors for improvements and negotiating the purchase and sale of the property, investors can passively reap the benefit of their assets. Where private equity firms and REITs differ is in their business models. These are distinctly different, both legally and operationally. They also employ contrasting investment strategies.
Before deciding which is best for you, it would benefit you to learn the difference between REITs and private equity firms.
A real estate investment fund, or REIT, is a company that owns, operates, or finances income-producing real estate. Because most REITs are formed as corporate entities, investors are able to purchase shares in them, which provide access to any potential income or profits produced by the underlying real estate assets. Additionally, a REIT is a tax-advantaged structure.
In order for a company to qualify for REIT status, they must meet the following requirements from the IRS:
Broadly, there are four categories of REITs. Each one also has its own subdivisions that may focus on a specific property type or asset class.
Equity REITs: These are publicly traded companies that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders. The majority of REITs tend to fall into this category and are generally considered attractive to investors because of their liquidity and high dividend yields.
Mortgage REITs: Often called mREITs, these provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities. They earn income from interest on loans and dividends from security investments.
Public Non-Listed REITs: This type, often shortened to PLNRs, are registered with the SEC, but do not trade on national stock exchanges. They do, however, follow the same philosophy of invest in income-producing properties for the purpose of distributing dividends to their shareholders.
Private REITs: These are exempt from SEC registration requirements, and their shares are not traded on national stock exchanges. To invest in a private REIT, investors must meet income or net worth requirements that demonstrate they are knowledgeable enough to understand the risks of investing in non-publicly traded securities.
Though private equity real estate firms and REITs have a similar mandate, the securities offered by private equity real estate firms are not publicly traded, and they are only available to accredited or high-net-worth investors. Private equity firms are not bound by the same regulations as publicly traded REITs, so they have a bit more leeway to invest in a variety of real estate asset classes, which may or may not include potential income-producing properties. Additionally, the legal structure may differ significantly from a REIT, and they are not necessarily required to pay out a high percentage of their income in dividends. Instead, a majority of real estate private equity returns are derived from potentially profitable investments in the form of capital gains and carried interest.
An investment with a private equity firm has higher barriers to entry than a REIT. Those who are considering investing with a private equity sponsor need to be aware of the requirements. First, there is an accreditation requirement that must be met in order to invest with the private equity sponsor. According to the SEC, an accredited investor is any person whose individual net worth, or joint net worth with that person’s spouse (or spousal equivalent), exceeds $1,000,000, excluding their primary residence. It may also include any person who has an annual income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expects the same for the current year.
In addition to this accreditation requirement, private equity funds usually have minimum investment thresholds, which is what makes them suitable and attractive to high net worth investors seeking passive income.
In general, investors tend to like REITs because their shares can be bought and sold with relative ease, providing a degree of liquidity not available in other real estate investments. They also come with other benefits, including:
Income: By definition, REITs must pay out at least 90% of their taxable income as dividends, which are funded by income-producing properties that the REIT owns.
Diversification: Historically, REIT price movements have a low level of correlation with other asset classes, creating diversification in the traditional portfolio.
Governance & Oversight: Operations are usually overseen by a group of independent directors and auditors who publish performance reports on a regular basis, providing investors with a high degree of operational transparency.
Performance: Long-term performance is generally comparable to, or slightly above, that of stocks and bonds.
While the benefits are attractive, REITs can be growth-constrained because they are required to pay at least 90% of their taxable income as dividends. They may also pay out capital even if the asset is underperforming. By contrast, private equity companies pay out only when there is cash flow to do so.
Additionally, these same dividends are taxed as ordinary income for the investors who receive them. To mitigate these risks, investors seeking REIT alternatives often turn to private equity real estate firms.
High Fees: REITs often have a high front-end load, meaning that they will take a certain percentage of the initial investment in the form of fees. For example, many of these structures typically take a minimum 15% of the investment made to pay for offering costs, brokerages, and more. This may translate to smaller potential returns for the investor.
Inefficient: A REIT can be expensive to create and requires a significant amount of staff and costs to manage. Most are also structured as investment companies but outsource a majority of the real estate services. This may lead to projects being delayed and over budget. Additionally, the money constantly coming into REITs may lead to inopportune acquisitions. Managers may spend to complete the deal quickly without doing proper due diligence. Private equity firms do the opposite; they take their time to identify the asset, secure financing, and then raise capital.
Volatility: Publicly traded REIT price movements can also be subject to the whims of the public markets.
Private equity real estate investment comes with some excellent potential benefits.
Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires deep expertise and years of experience, which private equity firms tend to specialize in.
Tax Efficiency: Investments through equity firms are typically structured in a tax-efficient manner, which allows investors to potentially reduce taxable income through depreciation.
Flexibility: Because they are not as heavily regulated as REITs, private equity firms may be more flexible in their investment strategies, giving them the freedom to pursue profitable deals where and when available.
Incentive Alignment: Because the firms are also invested in deals, their incentives tend to align with those of the investor. Both want a profitable outcome. As a result, income and profit splits are often structured in a way that requires the firm to meet certain return milestones before their profit participation kicks in, incentivizing them to manage an asset as profitably as possible.
Exit Plan: Private equity real estate firms usually enter an investment with an exit strategy in mind, giving investors a clear roadmap for how they may achieve a profitable outcome.
Clear Fees and Compensation: The fee and profit participation structure is normally clear from the outset and closely correlated to performance, which means all parties work together toward a profitable outcome.
Like REITs, private equity real estate investments are not necessarily risk-free. Factors such as long holding periods and the lack of liquidity may turn off some investors from participating.
From liquidity to the way investments are made, it is important to understand the key differences between REITs and private equity. This can help an investor determine which is a better fit for their needs.
Liquidity: One key difference between REITs and private real estate investments is the ability to liquidate the investment if needed, i.e. cash out. Liquidity is based on how fast you can get your money back, as cash, when wanted. Publicly traded REITs are liquid, meaning they can be bought and sold quickly. This feature provides investors with a high degree of liquidity that is normally not available in other real estate investments like a direct property purchase scenario.
Private real estate investments are the opposite. They are illiquid, meaning they often have holding periods that stretch out for several years. This means that investors commit to keeping their invested capital with the private equity sponsor for the duration of this holding period before they are able to convert it to cash.
Public Trading: REITs, when publicly traded, offer shares that can be bought and sold on public exchanges by anyone with a brokerage account, much like an exchange traded fund. Keep in mind though, that because most REITs are publicly traded, they are subjected to more stringent regulatory practices and are often prohibited from investing in certain assets. This often means that REITs are more concentrated, so you are purchasing just one specific type of property, such as multi-tenant industrial buildings. For this reason, REITs may potentially generate lower returns when compared to private real estate due to the high cost of these investments on the front end of the purchase and liquidity cost.
If the REIT is not publicly traded, shares may be a bit more difficult to purchase. They are only available to accredited investors and often come with minimum investment requirements. Often, non-publicly traded shares must also be purchased directly from the REIT or through their broker-dealer network.
Investments in private equity real estate firms are non-traded, which means there is no public market for these investments. This allows private real estate firms the opportunity to take their time in choosing an asset, broadens the types of assets they can acquire, and allows for targeting multiple geographic locations. Firms are also not prohibited from investing in assets that need more work or have an efficiency or vacancy issue. This creates more potential and may lead to higher returns than a REIT or the public markets.
A typical commercial real estate investment has a pre-defined holding period, anywhere from three years to much longer. Investments with shorter hold times tend to have a lower return than those with longer holding periods, but it depends on the property type. This is because longer periods may allow the investor to collect cash from the property. Each business plan and hold time is unique, so investors would benefit from studying it prior to allocating capital to make sure they are comfortable with it.
Ownership: Whether an investor chooses to invest with a REIT or private equity firm, they will have equity stakes in the underlying real estate assets. In a REIT, the investor is one among many who pool their capital together and give the management team the responsibility of managing this capital. Investors usually end up owning a small stake in a diversified portfolio.
REITs are similar to mutual funds in the sense that investor dollars go into real estate funds whose cash is deployed into real estate properties. This means that investors often do not have direct knowledge of the properties that they are investing in. On the other hand, private equity real estate investments often allow investors to fund a specific deal. This way, they know information such as where the property is located, who the prospective tenants are, and how much they are expected to pay in rent.
In private equity firms, there are two fund structures that provide different types of ownership options for investors. In a fund structure, a fund sponsor leads a fundraising effort for a specific fund in which capital will be deployed under a specific investment strategy. Basically, investors allocate capital, but only for the purpose of general real estate investment. Specific properties are purchased in the future and investors generally have no say in which ones are pursued.
In a syndicated deal structure, the deal sponsor raises capital to purchase a specific property. In this case, investors know exactly which property is going to be purchased with their equity investment.
Investment Minimums: Minimum investments between REITs and private equity firms can also differ greatly. Public REITs are available to any investor, large or small, as long as they have a brokerage account and enough cash on hand to purchase at least one share of a publicly traded REIT. For retail investors who have limited capital to invest, REITs can be a great way to get exposure to the real estate market and earn passive investment returns.
Targeted Returns: Returns are very dependent on the firm or REIT you have decided to invest with and their approach to generating returns for their investors. Like other types of real estate investments, REITs have the potential to see capital appreciation over time and to generate returns for shareholders. For many REITs, 8-10% is a high expectation for returns on your investment.
In private equity, there is some general agreement about what constitutes a good return on equity, but it is usually somewhat subjective because each individual real estate investor’s needs and objectives are different. Returns also tend to fluctuate greatly depending on how the firm chooses to invest. For example, a 5% ROE may be acceptable for a conservative investor who prioritizes preservation of capital, but it may not be enough for another investor who seeks growth.
Another thing to keep in mind: because REITs are required to pay out a high percentage of their earnings in the form of dividends, these are sometimes paid from investor capital or debt, not from the property’s potential income. This may raise the risk profile of the investment. Should investor capital or debt dry up, the REIT may be unable to pay the advertised dividends.
Other key differences between private equity firms and REITs include:
Tax Structure: Private equity firms are not required to pay out a high percentage of their income to maintain a tax-advantaged status. Their distributions are tied to the potential income and profits produced by their underlying properties. In addition, private equity investors benefit from other tax benefits like depreciation and the opportunity for tax deferrals upon sale.
Fees: The fee structure between a private equity firm and a REIT may vary significantly. Private equity firms may charge small fees for certain things, such as asset management and administrative tasks, while deriving the bulk of their income from splitting the property’s potential cash flows with investors. Because REITs are commonly sold through financial advisors and brokerages, they can have high upfront fees used to pay for marketing and sales commission expenses.
Since its founding in 2013, Avistone has acquired and managed more than 4 million square feet of flex industrial properties located across the nation in California, Georgia, Ohio, Virginia, Texas, and Florida. Our executive management team has years of experience in acquisitions, dispositions, operations, structured finance, appraisal, land use, and portfolio management.
We have the unique ability to integrate extensive capital market knowledge with a boots-on-the-ground approach to successfully acquire and operate a variety of properties that offer our investors attractive potential yields and strong potential total returns with relatively low risk. If you are interested in investing in industrial commercial real estate, contact us today to learn more about our current offerings!
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