One of the most important considerations for choosing to invest capital in commercial real estate is with the goal of minimizing risk while optimizing investment returns. Two of the most popular investment choices are through a Private Equity Real Estate (PE) firm or a Real Estate Investment Trust (REIT).
The questions are: which one suits the specific investor best? And where do you get the funds if you are low on cash?
The answer to the second question may be simpler than you think.
Do you have an IRA account that you rolled over from your prior employer? Well, guess what: your IRA account can be easily converted into a self-directed IRA with a qualified custodian, and you can invest the funds into an investment outside of the stock market including REIT or private equity real estate offering.
The two are often mistaken for one another not only because their titles sound terribly similar, but also, they both invest in similar assets. That is where, however, their similarities end, and the differences between REITs and PE investments become apparent—the methods in which they invest, the risks involved, and the potential growth of the investment are drastic.
First, let’s define REITs and Private Equity Real Estate, and then discuss the differences between them, as well as detail the circumstances when one is more beneficial than the other.
A REIT is a corporate entity that invests in real estate with the opportunity for profit production and finances these real estate properties to investors. These properties generally focus on “income-producing” real estate, such as apartment buildings, mobile parks or storage units where tenants pay rent.
Sometimes, the real estate can be invested in on an individual basis, but largely the uniqueness of a REIT comes from the fact that it provides the investors the opportunity to purchase its shares.
Usually, investors will purchase shares of a REIT and gain access to the profits attained by the real estate as an entity. REITs can be traded (meaning they trade on a public stock exchange) and are by nature liquid or they can be non-traded (meaning they do not offer shares on a public stock exchange) and are by nature highly illiquid.
Also, nontraded REITs have additional requirements for investors to be allowed to invest in them including, but not limited to, be accredited as well as some income requirements.
In order for a company to qualify for REIT status by the IRS, it must meet a set of requirements.
1. Firstly, a REIT must invest at least three-quarters of its total funds in real estate.
2. Secondly, a REIT must derive at least three-quarters of its gross income from rents on real property, interest on mortgages financing real property, or from sales of real estate.
3. Furthermore, a REIT must pay at least 90% of taxable income in the form of shareholder dividends annually and must be an entity that is taxable as a corporation and managed by a board of directors or trustees.
4. Lastly, it must have a minimum of 100 shareholders, and no more than half of its shares held by five or fewer individuals.
Like REITs, PE firms are also companies that pool funds to invest in real estate. However, unlike REITs, PE firms do not restrict their investors to the purchasing of shares involving profitable real estate properties.
Rather, PE firms allow investing in real estate asset classes, which are variable groups of investment types that have similar characteristics, and categories that include equity, cash equivalents, fixed income, and commodities.
And while REITs fall into the category of the real estate asset class, REIT investments do not expand outward towards other real estate types, such as those that might not involve income-producing properties.
Additionally, the procedure of investing in a PE firm is very different from that of REITs.
Unlike a REIT, where the investor must purchase shares of the corporation as a whole and then make a profit from the growth of value in the company, an investment with a PE firm is not an investment in the firm itself, but rather an investment in the firm’s project.
Where a REIT owns a property and makes money solely from the income produced by the property, a PE firm buys properties and operates them to improve them in many ways, with the goal of selling them at a profit.
The difference between a REIT and a PE firm is synonymous with a landlord that makes a profit from the rent collected from the tenants, and flipping a property, which involves making the property more desirable before selling for a profit.
Now, what part does the investor play on both sides of this analogy?
Essentially, while the REIT investor represents a share of the landlord, and when the landlord makes money the investor gets a portion of it; an investor in a PE firm acts similarly, but not quite identically to a bank that provides the capital necessary to purchase the property and make it more desirable.
The reason that the investor in a PE firm is not identical to a bank is that the investor’s profit is not based on the interest derived from the capital payment. Instead, a PE investor funds someone else’s project, allowing the sponsors or general partners in that project to do the work required to make a profit, and then paying them a fixed rate of fees for their services.
Mind you, such projects can be funded by investing cash or opening up a self-directed IRA account and diversifying your retirement funds into it.
Using yet another example: an investment in a PE firm would be like hiring someone to replace an outdated kitchen in their own house, and the investor is expected to pay the hired worker to do the work that they can’t or don’t want to. This economic principle is very standard, yet effective at a high level – the investor loans money to many firms at once while personally doing none or very little of the “hands-on” work.
On top of this, a large portion of the profit a PE firm will make usually comes from promoted interest. That is why PE firms will typically structure the investment returns in a waterfall fashion, which will allow having various levels of returns split between the investors and the general partners in a deal.
The question, “Which is better – REIT or PE?” has probably come up quite a few times, and the short answer is that it depends on how much are you planning to invest and what is your timeline.
With a REIT, the goal is similar to that of the stock market, where someone can buy a certain number of shares, and then sell them at any time. For someone looking for a simple way to make some money without a long-term commitment, with high liquidity in the process of purchasing and selling shares, investing in a REIT might be the best option.
On the other hand, a PE firm usually requires each investor to be accredited. The minimum investment in PE firm’s projects is typically much higher than that via REIT. PE projects are usually long-term projects that are very suitable for retirement accounts and hence present a viable option for someone with SDIRA or Checkbook Control IRA account to allow to generate more significant returns over time, while offering tax benefits that are not available via REITs investing.
To answer the original question of the article which is better: REIT or private equity investment, the answer is… it depends!
Quick in and out investments without long term commitments can typically be achieved via REITs investing, while for investors looking to generate greater returns, multiply their wealth, save on taxes, and willing to park their funds (cash or self-directed IRA) for longer terms, PE investments may be a more viable option.
Alina is the founder and Managing Partner of SAMO Financial. It’s a boutique private equity firm specializing in helping busy business owners and IT professionals passively invest in commercial real estate. Alina's business motto has been articulated well by Warren Buffett’s quote; “Someone is sitting in the shade today because someone planted a tree a long time ago". Her passion is to teach others how to build wealth by investing passively.
*Mainstar’s role as custodian of self-directed accounts is nondiscretionary and/or administrative in nature. This information is for educational purposes only, and should not be construed as investment, legal, tax or financial advice or as a guarantee, endorsement, or certification of any investments. Mainstar encourages individuals to consult a financial or legal professional when making investment decisions.