Investing in real estate can be one of the best ways to accumulate wealth. Wealth grows through compounding, which means putting money into something on the expectation that you will receive more money back later. Historically, real estate has been a consistent compounder for a simple reason: there’s only so much land to build on!
Real estate harnesses the power of supply and demand and channels it into your portfolio. Fundamental rules of supply and demand tell us that a limited supply of something in high demand must result in higher prices. You’ve probably seen the power of supply and demand play out with the value of your primary residence. For example, the US national home price has increased 243% since January 1987 and rebounded 63% since the post-2008 financial crisis low, as of May 2020.
Fortunately, you do not need to be an ultra-high net worth person to get started in real estate investing. Policymakers recognized the potential for real estate as a gateway to wealth accumulation long ago, opening the door to the creation of numerous ways for all investors to put capital to work. This article will briefly introduce seven of the more popular ways to invest in real estate; however, it is in no way an exhaustive list.
1. Invest in a Private Equity Fund
Investing in a private equity real estate fund means trading your capital for an equity position in the company formed to develop, operate, or manage a property or portfolio of properties. Private equity funds offer real estate projects across the development lifecycle. You should be able to find an investment that aligns with your investment objectives, risk tolerance, and time horizon. Generally, private equity real estate funds fall into one of three risk profiles: core/core plus, value-add, and opportunistic.
Core/core-plus private equity deals share characteristics with REITs. These properties already produce income from high-quality tenants, are in the nice parts of town, and typically have low amounts of debt. Core/core-plus may be appropriate if you’re looking for income-generating investments and have lower risk tolerance.
Value-add private equity deals are just another way of saying “renovation jobs.” Basically, the private equity manager uses your capital to fix up a property or portfolio of properties. Then, the manager may choose to keep the property and pass the income from the tenants back to you (called “DPI” or “distribution of paid-in capital”) or sell it and pay out the proceeds of sale according to your equity position (called an “exit multiple”). You trade access to your capital for anywhere from two to five years (or longer) in exchange for DPI or an exit multiple. These deals offer the potential for higher returns—either through income or exit multiple—than core deals but come with higher risk.
Opportunistic private equity deals are ground-up development projects: you trade access to your capital to build something new. These deals can include redevelopment (tear-down jobs), land acquisition, and new builds. Opportunistic deals offer the highest potential exit multiple with the highest potential risk. These deals may be appropriate if you want to complement existing income-generating or low-risk investments with a high risk/high reward growth-oriented investment.
2. Invest eligible capital gains in a Qualified Opportunity zone
The Tax Cuts and Jobs Act of 2017 created Opportunity Zones (“OZs”) to spur real estate development, ideally in underserved or economically disadvantaged areas. Here, you invest unrealized capital gains in opportunistic development deals. In doing so, you can potentially defer, reduce, and eliminate eligible capital gains. Depending on the project, you may also realize a potentially attractive exit multiple upon the sale of the property.
Opportunity Zones are most appropriate for accredited investors with high risk tolerance and a long time horizon. In addition to taking on development risk, you must wait ten years and follow a strict timeline to realize the tax benefits.
3. Invest in a REIT
Real estate investment trusts (REITs) are a popular way to invest in real estate. A REIT is a company that owns, operates, or finances income-generating real estate. Congress created REITs in 1960 to allow investors to buy shares in these companies without getting involved in the day-to-day operations and oversight of the physical properties. Congress modeled REITs on mutual funds, which helped democratize access to the stock and bond market.
The company must meet several requirements to qualify as a REIT. Principally, 75% or more of the portfolio must invest in income-generating real estate, and 90% of the income generated by these properties must be distributed as a dividend to shareholders.
REITs come in two flavors: publicly traded and non-traded.
Publicly traded REITs trade on exchanges like the New York Stock Exchange. Anyone can invest in the REIT. You can either purchase the specific stock yourself or a commingled vehicle like an exchange-traded fund (“ETF”) or mutual fund that owns a basket of stocks. Publicly traded REITs are highly liquid, meaning you can buy or sell the shares quickly on the exchange. Liquidity can be good if you need to quickly access your capital. REIT prices often fluctuate with the general direction of the stock market, regardless of the value of the properties in their portfolio. For example, when the S&P 500 lost 52% of its value during the Financial Crisis of 2008, REIT stocks saw 68% of their value evaporate over that same period.
Non-traded REITs are subject to the same requirements as their public counterparts but are highly illiquid. Investing in a non-traded REIT means locking up your money for two to five years, typically, in exchange for potentially higher dividends. Since non-traded REITs don’t trade on the exchanges, their prices reflect the value of their property portfolio rather than market sentiment. It also means that non-traded REITs appear much less volatile than publicly traded REITs.
Non-traded REITs aren’t illiquid forever. Eventually, the management company operating the REIT must decide to take the REIT public or dissolve the company and pay shareholders the proceeds. As the expected public conversion grows nearer, investors may receive solicitations to sell their shares in a secondary market transaction before the REIT goes public.
REITs may be a good fit for a dividend-based way to grow your retirement account rather than provide growth via price appreciation. Generally, REIT company’s focus on managing their properties to pay the dividend first and seek to grow their stock price second. While that usually means higher quality properties in the portfolio, that also means a lower potential for price appreciation.
4. Complete a 1031 exchange
Congress amended the Internal Revenue Code to include 1031 exchanges when they passed the Revenue Act of 1921. 1031 exchange is also known as a “like-kind exchange.” It traces its roots to farmers seeking to swap fallow land for land with the potential for crop yield. In the IRS’s view, if the farmer exchanges one tract of land for a similarly valued tract of land, then their economic position has not changed. As a result, the farmer may defer the taxes in perpetuity. When the farmer dies, the farmer’s estate receives a step-up in cost basis, functionally eliminating the accumulated gains. Currently, there is no limit to the number of exchanges an investor may complete.
Completing a 1031 exchange is one of the most popular ways to accumulate wealth using real estate. The regulations require the exchanged property is for investment use only (can’t be your primary residence) and that you exchange for a new property at an equal or greater value.
There’s a web of regulations, timelines, and requirements that accompany a 1031 exchange, so they are far from simple to execute. All those steps aside, the idea is simple: swap one property for another and defer capital gains taxes forever. 1031 exchange properties may be appropriate for someone in a high tax bracket to accumulate wealth for their estate or to expand and diversify an existing real estate portfolio.
5. Invest in a syndicate
Syndication is an established method for raising capital to purchase one property. You trade access to your capital for an equity position in the general partnership formed to purchase an existing property. You are a limited partner who receives passive income and has no oversight or management responsibility.
One of the more famous syndication deals took place in 1961. New York developer Harry Helmsley raised $33 million (approximately $282 million in current dollars) from over 3,000 individual investors to help him purchase the Empire State Building. The average investment was about $10,000.
Like a private debt fund or core/core-plus deal, a syndicate can diversify your current source of income or replace an existing investment for one with a higher yield.
6. Participate in a “mini-IPO”
Title IV of the JOBS Act eliminated the accredited investor requirements previously required for entrepreneurs to solicit outside investment in their company. Now, anyone may invest in a private company in what’s known as a “Reg A+” offering or “mini-IPO.”
Reg A+ permits a private company to raise up to $50 million from the public. Like a traditional IPO (“initial public offering”), the company must file with the SEC to win approval before marketing the Reg A+ offering to the public. Unlike a traditional IPO, the fees and ongoing disclosure requirements the private company would be obligated to complete are much less burdensome under Reg A+.
The JOBS Act legislation is welcome news for investors who want to participate in private real estate deals but do not meet the income or net worth accreditation requirement. Still, approach these investments cautiously as there can be significant risk investing in early-stage companies or real estate development projects.
7. Invest in a private debt fund
Private debt funds pool your capital along with the other LPs in exchange for an equity position in the company formed to lend money to finance real estate projects. Investors in these types of funds are looking to diversify their source of income or replace an existing investment for one with a higher yield. These funds may be more attractive than equity funds if you have a shorter time horizon and a lower risk tolerance.
There are a lot of ways to invest in real estate. The right one should balance your investment objectives, risk tolerance, time horizon, and net worth.
Completing a 1031 exchange may be right for you if you already own an investment property and want to trade up to a different property without realizing capital gains on the exchange. If you have unrealized capital gains, have ten years to wait, and are comfortable with development risk, then Opportunity Zones may be the best fit.
A value-add or opportunistic private equity fund may provide the right blend of growth and income to diversify existing income-oriented investments. A Reg A+ “mini-IPO” may be a better fit if you have a long time horizon and don’t meet the accreditation requirements just yet.
Publicly traded and non-traded REITs, syndicates, private debt funds, and core/core-plus private equity funds each provide a different way to generate passive income from real estate. Your net worth, risk tolerance, and current income-oriented investments are some of the factors that should help guide your choice. Investing in real estate can be an excellent way to grow your net worth. Real estate offers an enviable combination of historically strong returns and passive income, as well as the potential to hedge inflation and the gyrations of the stock market. With only so much land to build on, the opportunity to accumulate and perpetuate wealth should continue to accrue to those who own and invest in real estate.
 Source: author’s calculations based on data derived from the FTSE NAREIT US All-REIT Index and Robert Shiller’s CAPE database. Data covers the period of Dec 1971 through June 2020. Investors cannot invest directly in an index. Third party data deemed to be accurate.