When it comes to real estate investing (REI), there are a many different REI facets to choose from. Investors can actively fix-and-flip properties or buy and hold real estate to generate rental income.
There are also more “passive” ways of investing in real estate. Investors can purchase mortgage notes or do private money lending to other investors, for example.
Two of the more popular types of passive investments in the REI space are private equity funds and REITs. But what’s the difference between them?
Let’s dig deeper into this matchup of real estate private equity vs REITs.
What is a Private Equity Real Estate Fund
Private equity, as a term, covers a wide range of different types of investments. These can include everything from investing into businesses to single-family homes.
A real estate fund is one such type of private equity investment.
Real estate funds pool investor dollars to invest into real estate. This could be loans on fix-and-flip properties, residential rentals, or commercial property that generates returns through rents.
Usually, these funds have a focus or niche they serve in their real estate investment strategy.
The Use of Crowdfunding
Real estate funds have gained in popularity over the last few years thanks to the introduction of “crowdfunding.” Crowdfunding allows groups of individuals to pool their money together to take advantage of investments that might be out of reach for many of these individual investors.
It also allows investors to take advantage of alternative real estate investments that historically we’re only available to accredited investors.
These investors share in the profits and losses of a specific property. In these types of investments, investors are typically looking for capital gains or maybe income to supplement their retirement.
Advantages of Investing in a Private Equity Fund
More Control
When it comes to choices, fund investors typically have more control over their investment than those who invest in REITs. Investors usually have a say in the management and purchase of properties. Because of transparency between management and investor, investors are more likely to have a voice in the direction of the management of properties within the portfolio of the fund.
Tax Advantages
They can also benefit from tax breaks that may not be available to those who invest in REITs. For example, the investor’s marginal income tax rate may be lower than the capital gains tax rate that would apply to dividends from REITs.
Potential for Higher Returns
Another potential advantage of funds is that it can provide a higher return on investment than REITs. This is because investors typically share in the profits of the property, while REITs must distribute most of their profits to shareholders in the form of dividends. Fees for REITs can also cut into investors’ net returns.
Lower Correlation to the Market
Investing into real estate funds offers you a hedge against the stock market’s volatility. This is due to the fact that these types of real estate investments are not tied directly to the market.
The real estate market experiences its fair share of ups and downs, but historically these are not as extreme as what is seen in the stock market.
Transparency in Investments
These funds are based on “real” properties. Your investment dollars don’t go into a general pool in which you simply receive “shares” in properties. Fund managers and organization are usually accessible to investor questions and strategy insights on the investments that are being made.
What is a REIT?
Real Estate Investment Trusts, or REITs, are a type of security that represents ownership in a pool of properties.
When you buy shares in a REIT, you become a part owner of a portfolio of commercial or residential properties.
REIT shareholders typically receive regular income from the dividends paid out by the trust.
However, REITs also offer the potential for capital gains when the value of the underlying properties increases and is sold.
Three Types of REITs
Publicly Traded REITs
Publicly traded REITs are traded on major exchanges (just like stocks) and are subject to the same disclosure requirements as other publicly-traded stock. They have to register with the SEC and trade under SEC guidelines. Instead of buying property inside the REITs, investors get “shares.” Share values for public REITs are directly tied to the stock market.
Non-traded REITs
Non-traded REITs have to register with the SEC but do not fall under the strict trading guidelines as public REITs. These investments are not subject to the same disclosure requirements as a publicly traded REIT. Investors receive shares in a pool of property or only one. For example, a non-traded REIT could invest into a multi-family apartment complex that returns a portion of rent payments back to investors in the form of a dividend.
Private REITs
Private REITs are only available to institutional/accredited investors. These investors need to meet certain income requirements to gain access to these types of investments. Private REITs are are not subject to the registration requirements of the SEC and do not trade in the stock market.
For comparison purposes, this article focuses on Non-Traded REITs in comparison to funds.
Advantages of Investing in a Non-traded REIT
Investing in non-traded REITs offers a number of advantages, including:
Diversification
By buying shares in a REIT, you can gain exposure to a large portfolio of properties without having to purchase any of them yourself. Diversification is a cornerstone of good investing practice. By putting your money into multiple properties you spread out your exposure to risk. If one real estate investment property falters and doesn’t produce a good return, all of your funds aren’t subject to the same loss.
Professional Management
Real estate investment trusts are managed by professionals who have extensive experience in the real estate market. These organizations might consist of a few people or be a large organization.
Potential for High Returns
REITs offer the potential for both high income as well as capital gains. REITs are required to pay 90% or their returns to investors in the form of dividends. This makes REITs attractive to investors seeking high yields.
Stable Returns
Since these types of REITs are not traded on the stock market, they offer some stability from the volatility that can occur in public trading. Since REITs are tied to investments in real properties, this is also another advantage that lends itself to stability.
The real estate market, as a whole, is not as subject to the intense rise and fall of the stock markets. Though fluctuations in the market reverberate throughout the economy, affecting even real estate, these “hills and valleys” are typically not as sharp.
Disadvantages of Investing in Non-Traded REITs
There are some notable disadvantages to investing in non-traded REITs that should be considered before making an investment.
High fees
REITs often charge high fees, which can eat into your returns. These fees include high upfront and transaction fees and can range upwards of 15% against the share price. It’s critical for an investor going in to any investment to do proper due diligence on the investment and operator.
Get a copy of SIC’s Due Diligence Checklist for a list of questions to ask when you perform your due diligence
REIT managers make their money on transactions, so buyers beware. This can be an investment niche subject to fraud, as managers can pick investments just based on the fees that it generates. As these investments are not traded publicly, they fall outside of SEC regulations on traded investments. The topic of non-traded REITs is serious enough that the SEC issued a bulletin on the subject.
Lack of control
As a shareholder, you will have little to no say in how the REIT is managed. Investments are chosen by managers.
Lack of Liquidity
Typically, REITs are longer term investments. Some of these can have terms of 10 years in some cases. For the investor, this means making a long-term commitment on tying up investment dollars. Without the ability to be liquid, some investors might miss out on other potential opportunities with their money.
Lack of Visibility on Investment Performance
Since shares in these REITs are not traded, it’s hard to know what the value of a share is because there is no market price. Reporting on share values will be periodic—possibly quarterly or on an annual basis. Because of the infrequency of reporting, shareholders might not have a clear picture of the historical performance of their investment.
Third-party Management
According to the SEC, most non-traded REITs are run by third parties and don’t employ employees of their own. This can create a conflict of interest, as these managers can work for other REITs with competing interests. Another risk with third party managers is a potential for excessive fees through acquisitions that benefit the managers more (through fees) than the actual shareholders.
Taxes
REITs are subject to special tax rules that may not be favorable to all investors.
REIT dividends can be taxed as ordinary income, or in some cases as capital gains in the case that the property is sold.
Capital gains can be taxed at different levels depending on the investor’s income for that year. There are other cases in which a portion of the dividend can listed as a Nontaxable Return of Capital, not subject to taxation the year it is distributed, but taxed later.
Overall, the tax picture for REITs is much more complicated than other investment types.
REITs vs Funds Comparison Table
| REITs | Private Equity Funds | |
| Overview | Non-traded REITs that file with the SEC but whose shares do not trade on national stock exchanges. | Pooled investor funds go to fund investments that provide returns |
| Liquidity | Redemption programs vary by company and are limited. Generally a minimum holding period for investment exists. Investor exit strategy is generally linked to a required liquidation after some period of time (often 10 years). | Can be up to a 12 month divestment to receive complete liquidity |
| Fees | Typically, fees of 10-15 percent of the investment are charged for broker-dealer commissions. Fees are typically accessed up front. Ongoing management fees and expenses are also assessed. | No upfront fees. Low management fees. Investors are typically paid before managers of the fund. |
| Management | Typically externally advised and managed. | In-house managers and staff accessible to investors. |
| Minimum Investment | Anywhere from $1,000 – $5,000. | Investments can begin at a few hundred dollars. |
| Performance | No independent source of performance data available. | Regular reporting to investors. |
| Taxes | Complicated taxation, including ordinary income and capital gains. | Taxes accessed as ordinary income in most cases. |
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