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icon February 07, 2020
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REIT Investing vs. Real Estate Funds: What’s the Difference

 

An increasing number of investors are discovering the benefits of diversifying beyond traditional asset classes into real estate. Real estate investment trusts (REITs) and real estate funds both offer easy and affordable ways for investors to gain exposure to diversified real estate investments, and when held for long time periods both investments are capable of producing lucrative returns. Over the 20-year period, 1998 – 2017, REITs and private real estate funds generated average annual returns of 10.9% and 10.1% respectively, compared to approximately 9.8% for US stocks. While they share a number of similarities, some crucial differences exist between REITs and real estate funds that impact risk, returns, and diversification. 

 

What is a REIT?

 

A REIT is a corporation or trust that invests directly in real estate typically through properties but sometimes mortgages. Most REITs trade on public exchanges and are bought and sold like stocks. When investors buy shares of a REIT they are investing in the operating profitability of the REIT, which generates profit by owning and managing a portfolio of underlying real estate assets; they are not investing directly in the properties themselves. REITs appeal to income-oriented investors, as they are required by law to pay at least 90% of their taxable income to shareholders as dividends each year.  

 

How is a real estate fund different from a REIT?

 

Real estate funds come in all shapes and sizes and include mutual funds that invest in publicly traded securities such as REITs and real estate stocks, as well as private investment funds investing directly in property. This article deals primarily with funds offering direct investment opportunities to acquire ownership interests in properties or to capitalize loans collateralized by real estate assets. In addition to providing direct exposure, private real estate funds differ fundamentally from REITs in that they are pooled investment vehicles headed by fund managers that make and manage investments on behalf of clients. Private funds usually operate under a limited liability partnership structure with a management group in charge of operating the fund and who typically invests alongside clients on the same projects. While many funds provide some stable income, funds usually generate the majority of their returns from capital appreciation, realized upon sale of portfolio holdings. 

 

What are the advantages and disadvantages of each?

 

The primary advantage of REITs is their liquidity. The fact that REITs are publicly traded securities makes it easy for investors to exit positions when they please and without having to suffer discounts to find buyers. REITs usually have lower entry costs than private funds since investors can purchase shares of a REIT for much less than what it typically costs to invest with a fund. In addition, REITs offer the benefit of greater transparency: as public companies they are subject to stricter reporting standards than private funds, facilitating a clearer understanding of a company’s policies and procedures and the ways in which it generates profit and invests capital. Mandated dividend distributions make REITs the ideal investment vehicle for investors seeking stable, passive income over a long-term investment horizon. 

 

Like REITs, real estate funds can be a useful tool for helping investors achieve their investment goals, but they come with a different set of pros and cons. Entry barriers to private funds are considerably steeper: many funds carry minimums of $5,000 to $100,000 and are only available to accredited investors who meet specific wealth and income requirements. As is the case with most traditional real estate investments, investments in private funds often lack liquidity since capital can be tied-up in properties for long periods, and it is not uncommon for fund terms to exceed 5 or even 10 years. Both REIT and fund investors are subject to various fees, however, charges tend to run slightly higher with funds.    

 

In exchange for these drawbacks, private funds offer several advantages over REITs, the most prominent being the ability to access unique opportunities and invest alongside managers with expertise in specific market niches offering greater profit potential. By nature, private funds provide closer alignment of interests between managers and investors. Most fund managers are heavily invested in their projects and are compensated through a promote structure that rewards them for strong performance REIT managers, in contrast, rarely invest significant capital into their deals and primarily receive compensation from fixed salaries. Finally, private funds are more tax-efficient than REITs due to their LLC structure, which allows funds to pass tax benefits such as depreciation and amortization through to investors. With REITs, tax benefits are captured at the company level, while dividends are taxed at the income tax rate. 

 

The Bottom Line

 

Both REITs and real estate funds offer convenient ways for investors to gain exposure to diversified real estate investments. Through REITs and funds, investors lacking capital to buy property can access a wide range of opportunities that might otherwise not be feasible. Both vehicles suit passive investors with a long-term focus, offering the potential to profit from stable income streams and capital appreciation over time. Before investing in either it is essential that investors understand the differences between the two, as well as the risks and potential rewards