We hear over and over again that real estate is a smart investment, but it’s also a big one. For all the complications and options, it’s important to be very clear on what you’re getting into — and how to make the most of your investments. Paying close attention to the experience you want can return dividends in both peace of mind and in the bank.

Publicly traded REIT Investing

Choosing between REITs and private funds requires a clear understanding of each model’s approach to real estate investment. Real estate is a complex and rapidly changing field, especially after COVID, and the deeper your knowledge and preparation, the more likely you are to achieve your goals. In this article we’ll review how these investing options differ and which provides the best experience overall.

What is a publicly traded REIT?

REITs, or real estate investment trusts, are SEC-registered companies trading on major public stock exchanges, representing income-producing real estate. The SEC stamp of approval opens REITs to any interested investor in the same way as acquiring a blue-chip stock like Apple, a mutual fund, or an ETF.

REIT Diversification

The most compelling attraction of REITs is that they generally own huge combinations of an asset category selected from 13 optional verticals as follows:

• Office: This covers a vast field from skyscrapers to office parks, CBD to suburban, and tenant classes like government and biotech)
• Retail: Malls to strip centers, grocery to box outlets, regional to national.
• Industrial: Heavy to light, factories to warehousing and distribution centers.
• Lodging/Resorts: A broad spectrum of hospitality accommodation in hotels, hostels, and Airbnb-type accommodation.
• Residential: Single-family to multifamily, manufactured home to student housing.
• Timberlands: Facilities for harvesting and marketing timber
• Healthcare: Hospitals to hospices; nursing homes to physicians’ office buildings; laboratories to radiology centers.
• Self-Storage: Businesses to individuals.
• Infrastructure: Converging on fiber cable housing, wireless infrastructure buildings, IT towers, and energy pipelines.
• Data Centers: Properties revolving around servers and data storage, including end-to-end power supplies and air-cooled chillers.
• Specialty: Outliers like casinos, day-care centers, and advertising sites.
• Mortgages: Real estate funding instruments (originators to mortgage-backed)
• Diversified: Combinations of all the above.

They go across vast geographic borders (e.g., New York, London, Europe) in the billions of dollars. Conversely, a small investor owning only a few REIT units owns a perfect cross-section of the REIT’s entire portfolio in each acquired unit. Therefore it gives the minor investor a chance to own income-generating units in massive portfolios without lifting a finger to manage or finance the said portfolio.

Thus, it provides:

• Diversification benefits
• Access to property holdings the investor could not hope to acquire for the per unit cost of a few dollars if negotiating directly to own the same assets.

The data indicates that nearly 145 million Americans somehow connect to households invested in REITs through various retirement plans like their 401(k).

REIT income

REITs operate under the auspices of professional teams, demonstrating stellar results in leasing space and collecting rent. REIT managers can leverage assets with a full declaration of their ratios, sticking to rigid SEC rules. One of these is that only 10% of income can be retained for reinvestment, meaning that 90% of net revenue is distributable annually. It leaves little for reinvestment, thus relying on new REIT issues to foster growth.

The primary criteria for evaluating REITs is their dividend yield.

Here’s the thing: The rules allow REITs to declare income tax-free in the company, passed through as a dividend to its unit holders. As a result, investors receive the income as 100% dividend income (untaxed in the REIT) but fully taxable in the investors’ hands. In addition, dividend income (by its nature) cannot access tax allowances or dispensations. Relative to private equity real estate investing (as we’ll show below), it’s a significant disadvantage.

REIT inventors must watch leverage carefully

The expectation is for REITs to deliver around a 4.3% annual dividend. However, return results are significantly higher than this in many instances. Why is that? Most of the time, one can credit it to the leveraging effect. For example:

• Suppose a REIT invests $100 million in offices:
  • Situation #1 – unleveraged: It raised from issuing 1,000,000 units of $100 each with zero leverage to earn an income of $5,000,000 for the year. So, with 1,000,000 REIT units in circulation, income divided by the total REIT units is $5. The current price (we assume) of a REIT unit has remained constant since launch at $100. Thus, the REIT management declares $4.50 (i.e., 90% of $5 per unit) or 4.5% yield based on the unit’s market price.
  • Situation #2 – with leverage: Suppose the same company instead decides to leverage the $100 million portfolio by 2/1, which means that of the $100 million investment, half relied on bank loans at 3% annual interest. Therefore, with only $50 million invested outside the loan, the REIT issued only 500,000 units at $100 each (currently priced unchanged at $100). In addition, the $50 million loan totted up interest of $1.5 million for the year, deducted from the $5 million income (i.e., generated by the same properties as in the unleveraged example above). Thus, it reduces the income eligible for distribution to $3.5 million. Again the managers multiply the latter by 90% – $3,150,000 for distribution. However, it gets spread over 50% less units (i.e., 500,000 vs 1,000,000 for Situation #1 above), creating a dividend of $3,150,000/500,000 = $6.30 per unit. The latter is more than 50% higher than the unleveraged scenario (i.e., (a) above).

Aside from dividend yield, REIT investors also look to sell their units at a favorable price. Ordinarily, the results in (b) above should uplift the REIT unit value. Why? Because a company providing a better dividend yield should see the unit price increase. So, REIT investors can get a double-whammy benefit. History shows that in addition to competitive dividend payments and real estate industry diversification, REIT unit price appreciation has additionally outperformed the S&P 500 on long-term analysis, making them a desirable investment option:

• On the one hand, investors look forward to the dividend yield, which is fully taxable, as explained above.
• On the other hand, there’s the prospect of selling the unit when possibly the market reacts to a better dividend yield percentage (say, $110 or higher.)
• Provided the REIT investor owned the units for over a year, the IRS regards the $10 per unit profit as a capital gain.
  • Notably, capital gains have a reduced tax rate (versus standard tax rates).
  • Indeed, net capital gains tax is no higher than 15% (check with your accountant) versus 50% dividend tax in many states.
• Based on the logic above, it appears that aggressive leveraging is the apparent answer to accelerating profits. Not always, however. Please note:
  • Excessive leverage signifies accelerating risk because interest obligations remain constant even when rental incomes slow or decrease.
  • Alternatively, interest rates are variable and increase unexpectedly with no improvement in rent.
  • The bottom line is that there’s an exaggerated income effect if leveraging works for the REIT. Unfortunately, outsized losses also occur when interest rates increase or/and income decreases (sometimes simultaneously).
• So, when REIT investors see dividend yields of 10% or more, investigate the leveraging ratios to evaluate the health of the REIT long term. Some leverage is helpful, but precisely how much is a vital investor focus.

Private Equity Fund (PEF) Investing in Real Estate

Many investors prefer PEF investing versus REITs, and for many good reasons:

1. Highly taxed income (such as dividends) doesn’t suit them.
2. Likewise, consistent cash flow is unimportant.
3. PEFs are structured differently than an REIT in several ways, aligning with a different investor need set:
   • They are not traded publicly through a corporate structure like an LLC.
   • Like REITs, bottom-line profits before taxation in the LLC pass through directly to all the investors with IRS permission.
   • Unlike REITs, PEFs treat all investors equally with managing partners (the latter equivalent to REIT managers) under an operating agreement. As a result, an LLC distributes the net income to investors as their pre-tax share of profits, but not officially as a dividend.
   • So, the share of profits in investors’ hands enters the tax calculation with the opportunity to take advantage of significant legal tax deductions (unlike dividends). For example, please see an email I received recently from the managing partners of a multifamily private investment portfolio I subscribe to:Dear Partner, Do you like paying taxes? If you don’t, read on: Our latest multifamily investment opportunity not only projects a 117% return on capital over a few years, it provides 107% bonus depreciation to minimize your taxable income. And the best part is that you can carry over any unused portion into the following year until the deal sells.We recommend you talk with your CPA about how much you can save in taxes, but if you want to see a rough analysis of what your investment could look like from a tax standpoint, then contact us for our free tax analysis spreadsheet.REIT dividends can’t even get a look-in to deductions, as in the example above. Moreover, investors can deduct other expenses related to the investment inaccessible to dividend income earners (e.g., investor’s office rent, administration costs, and CPA advice.)
   • Moreover, the big attraction is earning a massive capital gain after getting in on the ground floor, with a low weighting or zero on dividend income. Indeed, many mainstream private funds with reputable managing partners project more than 25% Internal Rate of Return (IRR) over five or six years (potentially higher than most REITs’ dividends and capital appreciation combined). And all of it streams through as capital gain before counting other tax deductions like the example above.
   • Then there’s Section 1031 of the U.S. Internal Revenue Code, which allows private equity fund partners to avoid capital gains taxes on investment A by reinvesting the proceeds into investment B “that’s similar in kind and at least the same value within a prescribed time.” Again, this does not apply to REIT investor accommodations.
4. Like REITs, passive investors rely on the expertise of skilled partners (i.e., inactive members are not hands-on).
5. In many cases, private funds can balloon to a similar size as REITs. For example, Blackrock and some of the country’s other massive hedge fund operators spearhead PEFs in multiple real estate categories (i.e., see above). The’re so popular that entry is by invitation only.

So is there a catch with PEFs?

PEFs do not register with the SEC, thus falling under significantly less regulation. There’s no rule governing PEF dividend policy, reinvestment of retained earnings, and transparency requirements. As a result, managing partners can practically do what they want, sometimes making no distributions to investors for years.

The one SEC stipulation is that PEFs are only open to accredited investors – persons or entities who qualify to invest in Regulation D (“Reg.D”) unregistered securities as financially sophisticated investors.

What is a “Sophisticated Investor”?

Dodd-Frank Wall Street Reform and Consumer Protection Act dictates accredited investors must have the intellectual capacity to demonstrate financial insight. Thus, they can evaluate complex investment situations and, most crucially, the integrity behind them. In addition, sponsors who go for Reg.D. projects don’t want strict regimentation or compliance with strict dividend declarations because it stifles flexibility. So the steps investors interested in PEFs must take are as follows:

• First, discover opportunities that call for accredited investor protocols.
• Second, submit your accredited credentials to the investment sponsors for those opportunities you desire the most.
• Third, once they accept them, go ahead and invest.

Qualifying as an accredited investor (AI)

Here’s the thing: Neither the sponsor nor the investor has to report AI approval to the SEC. Indeed, the general partners carry the approval responsibility, which they should take seriously in case anything goes wrong down the line and their due diligence falls under the microscope (in retrospect).

The Most Seamless Way To Achieve Accredited Investor Status – The 3rd Party Letter

It’s enough for SEC/FINRA registered broker-dealers, investment advisors, attorneys, and licensed CPAs who provide a signed letter dated within the month of AI application confirming the candidate’s AI credentials. All it takes is a single page saying the applicant meets one of the required benchmarks (see below.) It doesn’t involve a precise explanation or validation. Instead, it’s short, sweet, and simple – the signor’s say-so opens the door to PEFs, no more questions asked.

Next, let’s look at the more burdensome methods.

Income Qualification:

• As an individual, you must submit your last two W-2 returns showing a minimum $200,000 income for the year. Moreover, submit documentation that the current year is on track.
• As a couple applying, the same applies, except the minimum is $300,000.

The Net Worth Qualification:

Proving you have a net worth of $1 million (not counting one’s primary residence) also works. However, the task isn’t simple, requiring presenting a combination of audited assets and liabilities statements that should include:

• Credit reports for you and your spouse.
• Recognized consumer credit reports.
• Property deeds with the latest appraisals.
• CPA verified equity valuations.
• The income IRS documents under the income qualification above (even if less than the required minimums for that option).

Other Qualifications

• Sponsor company’s directors, executive officers, or general partners are AI-based “insider investors.”
• Same as (a) above in a similar entity to the investment sponsor’s based on being a “knowledgeable employee.”
• Showing that you possess SEC-specified or FINRA professional certifications such as Series 7, 62, or 82.
• Demonstrating via public acclaim that you’re a famously rich person (e.g., Bill Gates or Justin Bieber).
• Aside from AIs, there are also Qualified Purchasers, like pension and endowment funds (i.e., often referred to as super-accredited investors). The latter slots into the PEF channel with no contentious issues. Indeed, institutional investors in REITs routinely seek a percentage of their portfolio vested in PEFs as a calculated diversification. Why? Because SEC rulings cut out direct partnerships in REIT investments, resulting in droves of people interested in adding the PEF category to their portfolio to boost their bottom line.

In short, B to D above involve onerous “tests.” Online assistance can help would-be AIs navigate the system to find a way in.

To review…

When you’re a qualifying AI committed to securing unique PEF opportunities; there are undoubtedly many private funds with compelling propositions that match Reg.D. protocols. Getting in on the ground level to travel up to the 100th floor (so to speak) can be exciting after substantial due diligence. This article does not say that REITs or PEFs are good or bad. It’s prudent to say they can co-exist in one portfolio, giving investors the best of two worlds. The dividing line is that entering PEFs takes much more pack drill than accessing REITs on stock exchanges. Finally, appreciate that if a PEF goes south (i.e., in the opposite direction of your hopes and expectations), don’t expect the SEC or FINRA (i.e., the regulators) to help much. So therefore:

• Avoid sponsors with a suspect history: Dig into general partners’ past performance and scan as many investor reviews as possible. There’s no such thing as over-evaluation (or too much analysis) before joining your funds with other PEF members.
• Understand the exit strategies that are frequently unclear. Getting in is one thing; extracting your capital with gains is quite another. REITs have a public forum of thousands of investors for seamless and instantaneous exiting – not so PEFs. Question the sponsors on this score, and if in doubt, leave it out. The last thing you need is the inability to extract rewards in a reasonable time.
• The private fund ROI traditionally exceeds REIT returns, given all the taxation loopholes. Give it a miss if you don’t see these after careful review.

In summary, becoming an AI in a PEF can be immensely rewarding if you check all the right boxes in your analysis.