Private Equity Real Estate vs. Publicly Traded REITs

Private Equity Real Estate vs. Publicly Traded REITs

 

In my article “Should You Invest in Stocks or Real Estate?”, I briefly discussed why investing in real estate investment trusts (REITs) is not the same thing as investing in private real estate. Now, let’s take a deeper dive on those differences and examine why classifying them both as real estate investments detracts from the fact that their business models are completely different from a financial, legal, and operational perspective. Essentially, both are investment vehicles, but what’s under the hood of each is completely different.

So let’s take a closer look under the hood.

What Are REITs?

According to Investopedia, an REIT is a company that owns, operates, or finances income- generating real estate. While there are private REITs, most are publicly traded on the stock market. This means that as long as you have a brokerage account set up, you can purchase an REIT and participate in the dividends that the property produces without having to be involved in any of the operational complexities of running the property itself.

In order to be classified as an REIT, the Internal Revenue Code states the following:

  • Pay out at least 90 percent of its taxable income annually in the form of shareholder dividends
  • Be an entity that would be taxable as a corporation but for its REIT status;
  • Be managed by a board of directors or trustees;
  • Have shares that are fully transferable;
  • Have a minimum of 100 shareholders after its first year as a REIT;
  • Have no more than 50 percent of its shares held by five or fewer individuals during the last half of the taxable year;
  • Invest at least 75 percent of its total assets in real estate assets and cash;
  • Derive at least 75 percent of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property;

The distribution requirement of 90% lends itself to a business model that focuses on cash distributions, making REITs an investment best suited for investors who prioritize yield over appreciation. You can’t exactly appreciate too much if you are capped at how much you can reinvest into your business.

The other major requirement that’s noteworthy from an investor’s perspective is the tax treatment of shareholders. The dividends and capital gains are taxed as ordinary income, which can be significant, depending on the income level of the investor.

 

Private Equity Real Estate

 

Private equity (PE) real estate firms raise capital from outside investors, and then use those funds to buy, develop, improve, and operate properties, and then sell them in order to realize a profit.

If you’re new to this space, you might incorrectly assume that these firms are all large organizations that only deal with the ultra-wealthy. In reality, within the commercial real estate industry, they range from one-person operators to multi-billion-dollar organizations and everything in between.

My preference is to deal with smaller PE firms because this allows me to get to know their key team members more personally. These smaller firms, which are more commonly referred to as “syndicators,” “general partners,” or just “operators,” all raise money by issuing securities[1] to investors, and then use that money to purchase various real estate assets. Because these securities are not traded on the public market, investors must meet accredited qualifications or have a pre-existing relationship with the private equity company.

Since they are private securities, these real estate deals are not subject to any of the regulations that an REIT has to comply with, especially the requirement to pay out 90% of taxable income. This lifts the shackles off of the PE firm and allows the operator to structure deals in a more flexible manner (as long as the investor is on board with the plan), making the opportunities endless. Even more importantly, distributions are usually not subject to ordinary income tax (like when you own REITs) and are usually deferred because of depreciations. As an equity investor, you maintain an ownership share of the investment, which gives you an ownership share of the depreciation. This can be a significant advantage to investors.

In most cases, a real estate PE firm will have a special niche in which they have operational experience, such as apartment buildings, mobile home parks, self-storage, retail, etc. This allows the investor in private equity deals to diversify in a manner that is similar to purchasing a diversified basket of REITs.  

A private real estate deal usually comes with a preferred return hurdle. This hurdle aligns the interest of the operator with the interest of the investor by drawing a line in the sand that indicates when profits begin to be distributed to the operator. Up until that point, 100% of the profit distributions remain with the investor. Can you imagine the CEO of a public company making that same promise to their investors?

 

I Do Invest in Real Estate — I Own REITs!

 

 

That was a common refrain I used to repeat when all I knew were assets that traded on Wall Street. At the time, I used a brokerage tool called X-Ray Portfolio, which broke down your portfolio into individual industries and sectors. When I invested in REITs, it clearly showed that I had a decent portion of my assets in real estate—but did I really? After reading this article, the answer should be a clear “no.”

And this brings me to my last point:

The main reason why an investor invests in real estate is to diversify their portfolio into an asset that has a low correlation to the stock market.

In simple terms, just because the stock market goes down 10%—which it regularly does on an annual basis—that doesn’t mean the apartment building you invested in has gone down 10%, as well. The benefits of having an asset with low stock market correlation goes out the window with REITs. Given their high yields, REITs are supposed to weather the market decline relatively well because their yield creates a natural downside buffer. However, sometimes the buffer is more theoretical than REIT advocates might have you believe. During the 2020 COVID decline, stocks—including REITs—saw a correction of 35%, yet most private commercial real estate—except retail—hardly moved (see image below). Most private deals paused, saw an adjustment in their business plan, and moved on. Very few deals traded hands during the COVID sell-off, resulting in an exceptionally calm market during incredibly unknown times compared to the massive price movements that were happening daily on Wall Street. The buffer of the high yield was nowhere to be seen.

At the end of the day, as an investor, only you can decide what is right for you—whether it’s REITs, private real estate, or none of the above. If you would like to discuss the pros, cons, and possibilities of alternative investments further, please reach out to start a conversation.

[1] A financial instrument that represents a monetary interest in a public or private company used to raise capital from investors.

If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my bookThe Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways

Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.

 

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