Investing in commercial real estate has become a popular way for people to diversify their portfolios and otherwise hedge against market volatility. There are many ways to invest in commercial real estate, both actively and passively. Among the ways to invest passively are through a real estate investment trust (REIT) and real estate fund.
REITs and real estate funds are both exceptional ways to invest in commercial real estate, but function much differently. REITs provide tremendous liquidity, whereas investing in a real estate fund requires someone’s capital to be tied up, often for several years. They also have much different barriers to entry: REITs can be easily purchased with low share prices and are often tradable, whereas real estate funds often have minimum investment thresholds costing tens of thousands of dollars (or more) and cannot be exited.
In today’s article, we look at the key differences between REITs and real estate funds to help investors determine which avenue might be best for them.
What is a REIT?
A REIT, which stands for “Real Estate Investment Trust,” is a corporation that owns and/or manages income-producing commercial real estate. There are many kinds of REITs. Some specialize in specific product types (e.g., multifamily, retail, hospitality, senior housing, self-storage, industrial, etc.) whereas others are more open-ended in terms of product type and instead focus on specific geographies (e.g., commercial real estate in the Southeast or Midwest).
When someone invests in a REIT, they are buying a share of the company that owns and manages the real estate. They are not purchasing an actual property or a share of an actual property. Buying a REIT is similar to buying stock in Apple, Philip Morris, or Berkshire Hathaway. When you invest in these stocks, you are investing in the company – not their specific products. The same concept applies to REITs.
REITs are a popular way of investing in commercial real estate, especially for those who have limited funds to invest. REITs have a low barrier to entry; someone can buy a single share for less than $100. The benefit to REIT investing is that these shares are highly liquid; REIT investments can be purchase and sold with the click of a button just as you would trade other stocks or bonds. The liquidity of REITs makes them particularly attractive for those who want to diversify their portfolios by investing in commercial real estate, but who cannot or do not want to have their capital tied up for extended periods of time.
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What are REIT’s requirements?
In order to qualify as a REIT, a company must meet the following criteria:
- Real estate must comprise at least 75 percent of the company’s total assets;
- At least 75 percent of the company’s gross income must come from that rental portfolio, which may include both rents and the sale of property;
- At least 95 percent of gross income must be generated passively;
- At least 90 percent of the company’s taxable income earned must be returned to shareholders on a consistent basis in the form of dividends;
- The company must have at least 100 shareholders after its first year of operation, with no more than 50 percent of total shares being held by five or fewer investors; and
- The company must be structured as a taxable entity that is overseen by a board of directors or trustees.
The requirement to have at least 100 shareholders is often one of the biggest hurdles companies face when trying to obtain status as a REIT.
Unlike traditional real estate, many REITs are publicly traded on the stock exchange. Publicly traded REITs must be registered with the SEC. Others are privately traded, in which case they do not need to be registered with the SEC. Typically, only institutional investors have access to privately traded REITs.
What Are Real Estate Funds?
There are many types of investment funds, including mutual funds, money market funds, and hedge funds. Real estate funds are just another subset of investment funds in which the fund is focused exclusively on investing in income-generating property.
Real estate funds provide an alternative way for people to invest in commercial real estate. Real estate funds will pool capital that has been aggregated from multiple sources and investors. The fund will then invest that capital on behalf of investors depending on the fund’s predefined investment criteria. Like REITs, some funds will set investment parameters based on product type (e.g., multifamily, retail or office) whereas others will concentrate investments in a specific geographic area (e.g., Northeast or Southwest) regardless of product type.
Some real estate funds will also have a strict investment philosophy, such as value-add development or ground-up development. Other funds may be structured to buy-and-hold already stabilized assets.
Real estate funds are generally spearheaded by a sponsor who has years, if not decades, of experience in the real estate industry. The fund manager will analyze all investment opportunities and then invest in select deals, based on the fund’s parameters, using the pooled capital.
Are you still wondering whether a REIT or Real Estate Fund is the better investment for you? Reach out to Smartland today to learn more.
REIT vs Real Estate Fund: What’s The Difference?
There are several differences between REITs and real estate investment funds. The two most notable, which we will describe in more detail below, pertain to liquidity and the actual investment product.
REIT investments, as noted above, are highly liquid. REIT shares can be purchased and sold as easily as any other stock or bond. Real estate fund investments, meanwhile, are significantly more illiquid. Most funds have a 3- to 7-year lifecycle, in which the investor’s capital can be tied up. This is known as the liquidity/illiquidity premium as follows:
The Liquidity Premium
When an investor buys stocks, the transaction is virtually instantaneous. The investor clicks a button and the transaction is executed almost immediately. Stocks are, therefore, almost as liquid as having cash.
Commercial real estate, by contrast, is inherently illiquid. When an investor looks to buy real estate, there is a lengthy period from the moment they make the decision to purchase, to when they actually close on a transaction. That period is prolonged to accommodate due diligence, contract negotiation, debt placement and other factors associated with commercial real estate transactions and, in some cases can take months to conclude.
The way a REIT works, therefore, by creating an investment instrument that can be traded instantaneously, you are converting something inherently illiquid (commercial real estate) and making it liquid and with this comes a premium – a cost, if you will. That premium is the cost an investor incurs in buying real estate through a REIT and is typically levied through fees – transactional fees, management fees, broker fees etc.
This is the liquidity premium – buying real estate through a REIT costs more than buying it directly because the investor is enjoying the added benefit of liquidity.
The Illiquidity Premium
The illiquidity premium is the additional wealth and income that investors enjoy from investing in real estate assets that are illiquid such as those in a fund. When an investor places their capital in a fund, there is an expectation that they will not receive back their capital for a significant period of time, typically several years. Similarly, they are unable to trade their shares in a fund to other investors. They are, in other words, locked in with very limited options, if any, for how to get their money out in the short term.
To compensate them for the inconvenience of investing in an asset that is illiquid like this, investors are rewarded with significantly higher returns. Not only will they enjoy preferred returns (dividends) that are either paid current or accrued, but they typically also expect some multiple of their initial investment to be returned to them.
Investments in funds are, therefore, significantly more lucrative than investments in REITs and this is known as the “illiquidity premium.”
Below is a more comprehensive overview of the differences between REITs and real estate funds.
REITs and Real Estate Funds Have Different Investment Minimums
When buying a REIT, you are buying a share of the company that owns or manages investment properties. The shares of the company can cost just a few dollars and will rarely cost more than a few hundred dollars. As such, REITs have a much lower barrier to entry for those looking to invest in commercial real estate.
Real estate funds tend to have much more substantial investment minimums. Oftentimes, a fund will require a minimum investment of at least $50,000 and sometimes, much more. Some funds are only open to accredited investors, while others are open more broadly as long as the investor has the capital to meet that minimum investment threshold.
REITs goes with stocks and ETFs, but Real Estate Funds Go with Traditional Mutual Fund
One of the primary benefits to investing in commercial real estate is that, given its illiquid nature, it does not experience the same volatility that one might expect in the stock market. That said, because most REITs are publicly traded, they perform more like stocks than they do traditional commercial real estate.
REITs, for example, can experience the same type of volatility as other stocks – even on a daily basis. This means that REITs are more likely to experience significant highs and lows as opposed to other forms of commercial real estate, such as direct ownership or investing through a real estate fund.
REITs also pay out dividends to their shareholders on a consistent basis, just as stocks and ETFs tend to do. Real estate funds, meanwhile, perform more like traditional mutual funds. Real estate funds generally increase in value through appreciation, or the increase in value of the fund’s assets. They do not provide the same short-term gains or dividends to investors as do REITs though some real estate funds will distribute dividends in the form of preferred returns, on a current basis provided the underlying assets in the fund are generating enough cash flow to allow them to do that.
Related: Smartland: About Us
REITs and Real Estate Funds Offer Different Tax Benefits
One of the unique attributes of REITs is that they must return at least 90 percent of their taxable income to shareholders. As such, they are considered “pass through” companies and do not pay any corporate taxes. Because of this, REIT dividends tend to be higher than those paid by the average S&P 500 stock. What is more, the IRS made a change to its regulations so that, beginning in 2018, income distributions from REITs held in mutual funds became eligible for a new 20 percent pass-through deduction known as the Qualified Business Income (QBI). The QBI deduction is available to all individuals regardless of their income level, which means that those who would have otherwise had their gains taxed at the highest rate of 37 percent will now top out at 29.6 percent – a major tax benefit for REIT investors.
This change notwithstanding, anyone who buys and sells REIT shares on a consistent basis will be subject to short-term capital gains tax. Proceeds from real estate funds, on the other hand, tend to be subject to the lower long-term capital gains tax rate given the duration of most funds, unless they are being paid current on their preferred returns in which case it is taxed at regular income tax rates. Investors in a real estate fund may also benefit from the pass-through depreciation equivalent to a 20 percent deduction on their tax returns, depending on how the fund is structured.
Real Estate Funds Tend to Be More Highly Levered
Real estate funds will generally pool investor capital and then pair it with bank loans, or leverage, to invest in commercial real estate. Most private funds will use between 50- to 80% leverage when investing in real estate. REITs tend to be more conservative and average only 30- to 50% leverage. The reason REITs are more conservative has a lot to do with their lifecycle: REITs are structured to be around for the long-term, well beyond any market cycle. Having low leverage allows REITs to better weather economic downturns, which in turn, helps to protect shareholders’ capital.
Funds are generally structured for a finite period, usually three to seven years, at which point the fund dissolves and investors are repaid their capital. Funds can take on greater leverage based on where we are in any market cycle, knowing that the fund will not generally last beyond one market cycle.
Real Estate Funds Offer Investors More Control
A key criticism of REITs is that investors are just one of hundreds, if not thousands or tens of thousands, of investors. As such, individual investors have virtually no say in how or when investments are made, what type of investments are made, or other key decisions. Those who invest in REITs have essentially no control, except for control over the purchase and sale of their own shares.
Those who invest in real estate funds are much closer to the decision-makers. Most funds limit the number of people who invest, and therefore, the sponsor can have a closer relationship with each individual investor. Many fund documents are even structured to give LP investors certain voting rights, such as the ability to approve or deny a major change to the sponsor’s business plan. Funds will also sometimes provide other investor controls, such as the ability for the LPs to buy out a share of the sponsor’s equity in the event of the sponsor’s gross negligence or other significant mismanagement of the fund. This degree of control, even if limited, tends to be a middle ground for passive investors: they aren’t as passive as those who invest in REITs, but are not truly active investors, either. They are passive investors who have some degree of authority related to the fund and its performance.
REIT Diversification Helps to Mitigate Investor Risk
One of the appeals to investing in a REIT is that a REIT usually owns dozens, if not hundreds or thousands, of investment properties. This diversification helps to mitigate investors’ risk compared to real estate funds, which depending on the size of the fund, may only include a few investments. This concentrates investors’ risk into fewer deals, and if any one of those deals underperforms, that one deal can drag down the performance of the entire fund.
That said, some REITs are exclusively focused on investing in only one product type – such as retail or hospitality. This creates a different kind of exposure for investors; if that product type is underperforming, the REIT might struggle as well. Of course, this is also true for funds that invest in only one product type.
Real estate funds are more attractive for buy-and-hold investors.
Unlike REITs, which are federally mandated to distribute most profits to investors on an annual basis, real estate funds are generally structured to remain in the fund until the assets are refinanced or sold. Real estate funds rely more heavily on portfolio appreciation than cash flow, which makes real estate funds particularly attractive for buy-and-hold investors. Those looking for smaller but faster, more consistent distributions are better suited to invest in REITs.
Bottom Line on REIT Vs Real Estate Fund
REITs and real estate funds are both excellent avenues for those looking to diversify their portfolios by adding an alternative investment such as commercial real estate. That said, the differences between REITs and real estate funds are significant. Deciding which is right for you will depend largely on how much capital you have to invest, your risk tolerance, liquidity needs, and your investment time horizon.
At Smartland, we raise capital to invest in ground-up development and value-add multifamily real estate deals located in both the Southeast and Midwest. Importantly, we share in the risk to ensure our interests are aligned. The four principals at Smartland invest their personal funds into each deal we do, which highlights how confident we are in our investment strategy and ability to execute. When you invest in a Smartland fund, you know that our own money is at stake, too.
Are you interested in investing in a real estate fund? Contact us at Smartland today and let us show you how our experience is unparalleled, and in turn, allows us to deliver exceptional results.