Real Estate Investing Comes in More Than One Package

Many people think real estate investing means personally buying a property, acquiring tenants, and collecting rent. That is one possible path, and with good reason.

Directly owning commercial real estate (CRE) can offer a reliable source of income and other benefits. However, it also tends to require significant sacrifice, whether in finances, effort, or time. Usually all three.

Add to that a necessary level of expertise and it’s safe to say that directly owning CRE isn’t for everyone. That’s why it was a rich man’s game for millennia.

Fortunately for us, there are new ways to invest in CRE through real estate investment trusts (REITs) and other fund structures. Publicly traded REITs are real estate-oriented companies listed on stock exchanges. In most instances, these corporations directly own properties that they rent out to tenants.

Private real estate funds are another popular option. They also invest in real properties and investors like you and me can own shares or units of the fund. But unlike publicly traded REITs, they often have investment minimums and suitability restrictions. On the plus side, the reported value of an investment in a private fund is generally less volatile than the same strategy applied by a publicly traded REIT. That’s because private real estate funds change in value primarily based on how the properties perform. Public REITs, on the other hand, are more correlated with the broader stock market.

As such, when investors buy into a REIT or a private fund, they buy into real properties. Moreover, they get real payments from tenants in the form of dividend checks – all without the hassle of researching individual properties… securing and maintaining tenants… and familiarizing themselves on federal, state, and local real estate law.

That means real estate funds, whether public or private, can be a powerful part of the average investor’s portfolio. Some investors own both types for greater potential diversification. Private funds are valued on their net asset value (total value of their properties minus debt) while all public stocks, including REITs, are valued by the market. This gives investors a different level of volatility and risk even if the underlying assets are similar. In addition, dividing capital between more public and private real estate investments usually results in greater geographical diversification compared to owning a few number.

As with any other investment category, to make the most of them, you have to understand their pros and cons.

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Liquidity

One of the biggest advantages of investing in publicly traded REITs is liquidity.

Since they’re traded on stock exchanges, entering or exiting an investment is quick, simple, and depending on your broker, free. Investors can quickly deploy funds to take advantage of opportunities that come up as they see fit because all they have to do is buy more shares. And when they need those funds for some other investment or a personal expense, they can just as easily sell their stakes (although the price may be lower).

Investments in private real estate funds vary in the liquidity they offer. Some offer investors the ability to sell a small percentage of their holding quarterly. Others offer no liquidity until the investment manager decides to sell. As an investor in private funds, it’s critical to understand the liquidity terms before making an investment.

Like public REITs, private funds generally offer a way for investors to exit their investment without occurring significant transaction expenses. In contrast, direct real estate investments often move at a much, much slower pace. It might take a person several months – even years – to gather enough funds to purchase a property.

And once the transaction is complete, that money is often locked up for quite a while. Don’t forget closing and broker expenses, which can really add up.  

It also takes much more than a few computer clicks or a quick call to one’s stock broker to sell a CRE property. As with buying, that process can take a while. And while a wealthy person can own more than one building, it’ll usually be far less diversification than owning shares in a publicly traded REIT or diversified private real estate fund.

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Volatility

For every upside, there’s always a downside. The key is to know them beforehand so you can make the best decision.

So while it’s much, much easier for individual investors to buy and sell shares of public REITs…

It’s also much, much easier for other investors to buy and sell shares. Which means that share prices of public REITs tend to be more volatile than other ways of owning real estate.

This only makes sense.

Stock prices can quickly respond to changes in investor sentiment and market conditions. Private real estate valuations, however, are typically slower to change because they’re based on recent comparable transactions and appraisals.  A publicly traded stock may be valued thousands of times a day. Each property in a private real estate fund is usually appraised four times or less a year.

Consider the research from industry advocate Nareit summed up in the chart below. It shows how different short-term returns from public REITs (dark blue) and private real estate (light blue) can be.

In short, while both public REITs and private real estate investors participate in the real estate sector, they’re prone to behaving like different asset classes in the short- and medium-term. This is why some people use both types of real estate investment to diversify and potentially smooth out their performance. Investors still need to be cognizant of the sector types and geographical exposures of their real estate allocation, as using a combination of private and public real estate investments doesn’t guarantee optimal diversification in those key areas.

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Specialty Sectors

CRE has historically been a powerful diversification tool versus stocks and bonds. Within CRE, there are also numerous property classifications beyond traditional categories such as apartments, offices, retail, lodging, or industrials. Each offers a unique risk and return profile, so there is significant diversification potential within CRE too.

Today, both REITs and private real estate funds alike can consider owning data centers, self-storage, healthcare, gaming, research facilities, farms, timberland, and even cell towers. However, because public REITs don’t have investment minimums (besides the price of 1 share) they make it easier to diversify across these real estate “food groups”.

Think about it: Most real estate managers understand their own sectors inside and out. But that doesn’t make them experts on some other CRE category.

Data centers, for example, are in high demand due to the rising use of artificial intelligence (AI) and cloud computing. However, not just anyone can successfully develop and lease a data center.

They require specific knowledge of customer requirements for large amounts of reliable electricity, as well as enhanced cooling solutions and high bandwidth internet connections. They also need a lot of money.

While an individual investor can buy and rent out a single-family home, or maybe even afford a small apartment complex, it’s unlikely they’ll be able to build and lease out a data center on their own. Google (GOOG) and Facebook (META) use data centers that average $250 million to $500 million to construct.

Yet investors can get a piece of that with just a few hundred down (or less) into a publicly traded data center REIT, or a little more to make the investment minimum in some private real estate funds… likely leaving them with funds to also buy into retail, self-storage, casinos, or whatever combination of real estate they deem best.

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Diversification and Scale

Another potential diversification benefit available through a public REIT or private real estate fund is the stage in an asset’s life cycle. There are potential benefits to investing in ground-up construction, like the possibility of a quick capital gain when a new building is sold. That’s often the case in real estate bull markets or if demand in a single area significantly outstrips demand.

But there are also risks. What if you can’t find a tenant quickly or the cost of construction goes way over budget? If a recession occurs right when trying to lease a brand-new building, it could become a real challenge. And no one can predict when the next recession will arrive. Buying an existing property with a tenant already in place mitigates those risks.

With direct real estate, it’s more difficult to get exposure to properties at different points in their lifecycles. That’s a result of having a lower number of real estate properties in your portfolio compared to investing the same capital across diversified funds.  

Speaking of diversification, larger public REITs and private funds can have truly sizeable portfolios.

Many of the largest public REITs have market capitalizations over $50 billion and hundreds – or even thousands – of properties to their names. Some have also accumulated real estate assets outside the U.S., adding another layer of geographic diversification.

The largest private real estate fund, Blackstone Real Estate Income Trust, ended 2023 with $60.7 billion in properties and stakes in over 260,000 properties.

This scale can come with the corporate benefit of adding operational leverage. As a REIT’s portfolio grows, its fixed general and administrative costs are spread out over more assets.

In contrast, private real estate funds often employ highly specific strategies designed to meet their targeted risk and return profiles. So their fees and expenses relative to assets under management are generally higher.

With that said, they may be able to focus more on obtaining the best outcomes from their assets. Many managers are paid an incentive or performance fee, which only kicks in if the fund performs well. That incentive doesn’t apply the same way to public REITs. At best, management might own a lot of common stock. But since they can’t control the share price, it’s not the same alignment of interest as the typical private fund.

Once again, there’s a give and take.

Long-term, a private real estate fund run by a great manager is likely to produce a better outcome for investors than a public REIT with a sub-par management team. At the end of the day, it’s about intelligently buying, operating, and selling real estate no matter the type of investment vehicle.

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Tax Considerations

REITs don’t pay any corporate taxes… with the stipulation that they distribute at least 90% of their taxable income to shareholders. This is a clear win-win situation for both investors and investees.

However, investors do have to pay taxes on their REIT income unless it’s held in certain tax-advantaged accounts. Currently, the tax treatment on REIT income is greater than the same income received from a typical C-Corp, which is how most publicly traded companies are structured.  

Private real estate, in contrast, does offer tax exceptions. (Though whether you qualify for them is something you need to discuss with a tax expert.)

For instance, private real estate funds are often structured as limited partnerships. They can therefore pass depreciation through to the limited partners, which can then be used to shield their income. For some investors, this is a big benefit.

There are also potential perks when selling a property. Capital gains taxes can be deferred through a 1031 exchange – if the proceeds from the sale are reinvested into a new property and all the IRS rules are abided by.

Really, these and other potential tax benefits on direct or private real estate funds can make even nominally low returns more attractive.

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Public REITs Can Complement Private Real Estate

In short, public REITs and private real estate each have different strengths and weaknesses.

Public REITs, for their part, offer better liquidity, access to more types of real estate with the same dollar amount, and may have larger, more diversified portfolios. Private real estate, meanwhile, usually offers lower volatility, more focused strategies, and greater tax benefits.

That’s why each individual investor should consider a comprehensive real estate strategy. Depending on their exact financial situation, goals, and temperament, that could include private and public real estate.

Especially since both types have performed well against the stock market long-term and provide potential inflation protection.

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