Both REITs and private equity real estate firms give investors an alternative to traditional real estate investing. Instead of spending time managing tenants, coordinating general contractors for improvements and negotiating the purchase and sale of the property, investors can passively reap the benefits of this historically wealth-building asset class.
A real estate investment trust (REIT) is a type of company that owns, operates or finances income-producing commercial real estate properties. Established by Congress in 1960, REITs are asset vehicles in which investors can purchase shares and gain exposure to the potential income and profits generated by the underlying real estate assets.
A private equity real estate firm like Caliber also pools investor capital into real estate assets, but the two are legally and operationally different. Private equity real estate firms’ funds are not publicly traded and only available to accredited or high net-worth investors. This may offer certain advantages, which we will explore in-depth later.
To qualify as a REIT, companies must follow specific laws established and implemented by the IRS:
- 90% of taxable income must be paid back to shareholders on a consistent basis. This is tax advantaged at the REIT level and not at the investor level.
- 75% of gross income must be acquired from real estate-related origins
- 95% of gross income must be passive
- Be structured like a mutual fund where investments are pooled together and overseen by a fund manager
- Must be held primarily by shareholders (a minimum of 100 after its first year operating)
- Be treated as a corporation by Internal Revenue Code for tax purposes
Company listings and REITs:
Publicly traded – Investors purchase and sell REITs using a SEC-regulated national securities exchange. Publicly traded REITs also tend to be more liquid.
Public non-traded – While registered with the SEC, these REITs aren’t listed on national securities exchanges. The benefit of this listing is that the REITs aren’t wounded by market fluctuations and are generally more stable.
Private – Shares of private REITs are generally sold to institutional investors and aren’t listed on the national securities exchange or registered with the SEC.
Why Private Equity?
If you are a high net-worth investor with a long-term time horizon, private equity real estate funds might be an attractive option, as they allow passive investment in real estate with more direct ownership of the actual properties. Additionally, a private equity firm takes the burden of management off of the investor’s plate and has the added benefit of in-house expertise on the investment cycle.
Private equity real estate is, however, less liquid. Unlike REITs, which are publicly traded like stocks, real estate cannot be easily converted to cash at its fair market value. Selling an apartment complex or office building, for example, may take months or years to secure the optimum market rate.
But in exchange for this lack of flexibility and to mitigate the risk of locking up funds for a longer period, investors demand what is called an “illiquidity premium”— a higher rate of return. These excess returns do not exist in public, highly liquid markets, and could mean better ROI over time.
The Disadvantages of REITS
Limited growth potential – REITS are required to pay at least 90% of their taxable income to investors in the form of dividends, which can truncate the company’s growth. They may also pay out capital even if the asset is underperforming. This does not bode well for the asset or the investment. By contrast, private equity real estate companies pay out only when there is cash flow to do so.
High fees – Both traded and non-traded REITs often have a minimum target of $1 billion in capital. These structures are typically “fee-heavy” with a minimum of 15% of the investment made being utilized to pay offering costs, brokerages, etc. This may translate to less return for the investor.
Inefficient – A REIT can be expensive to create and requires a significant amount of staff and costs to manage. Most REITs are also structured as investment companies but outsource a majority of the real estate services. This can lead to projects that are delayed and over budget. Additionally, the money constantly coming into REITs can lead to inopportune acquisitions. Managers may spend to complete the deal quickly without doing proper due diligence. Private equity firms do the opposite: Identify the asset, secure financing, then raise capital.
Volatility – Since publicly traded REITs are exchanged on the stock market, they are subject to fluctuations in value.
Private equity Advantages
Leaner and more efficient– Private equity real estate funds are designed to be large enough to take advantage of real estate investment opportunities but small enough not to require an army of employees and brokers to manage. Less overhead means a stronger focus on the success of the asset and generating returns for investors. Private equity funds make more of their money on the back end after certain performance metrics are hit rather than the front-end fees associated with REITs.
Real property ownership – Instead of relying on the day-to-day value of a piece of paper created by Wall Street as with a REIT, investors actually own real property and can generate income based on their profitability.
Incentivized for success – Private equity real estate firms specialize in the acquisition, development, operations and sale of a property. It is in their best interests to actively seek favorable investment opportunities based factors like cash flow, location, and job growth. This in-house expertise also allows private equity firms to optimize the property—by investing in improvements to management, operations, design, architecture, etc.—and to find the right buyer at the right time maximize returns. Incentives are aligned for private equity to not only raise money, but also perform.
Tax benefits – Private equity investments may present tax benefits to the investor.
If you are an accredited investor with a longer time horizon, higher risk tolerance, and no need for immediate liquidity, you may find private equity to be a more suitable and cost-effective alternative investment option for your portfolio.
Before you invest:
Just like with any major financial decision, it’s essential to research and understand all components before investing. Disclosure filings and prospectus documents are available through the sec.gov website and are good sources of information surrounding the investment security.
Contact us for more information about Caliber’s offerings and investments.