After writing about PeerStreet, the benefits of hard money lending and exposure to the real estate market, a couple of people have asked how REITs fit into an asset allocation and whether it’s worth getting involved in smaller real estate deals when you can use index funds to invest in REITS.
For those that don’t know, a REIT is a Real Estate Investment Trust. In some ways, they are comparable to a mutual fund since they allow both small and large investors to pool resources for the purpose of acquiring ownership interest. Most REITs own and operate large commercial properties like apartment complexes, hospital, office buildings, warehouses, etc. You can invest in individual REITs traded on the public stock markets or you could invest in a REIT index fund from a company like Vanguard if you wanted exposure to the entire public REIT market.
If you’re not interested in being a landlord and can’t afford to purchase a $100,000,000 commercial building in NYC, REITs offer you the opportunity to own a slice of this market and the resulting appreciation and revenue from operation.
For dividend investors, REITs are often attractive because they are required by law to pay out at least 90% of their income each year (after expenses). That means a portion of those rent checks find a way back to your pocket each month.
Three main kinds of REITs
There are four main type of REITs in the United States:
1. Equity REITs. Equity REITs are the type discussed above. Investors pool their resources and acquire property throughout the United States and world. Revenue typically comes from leasing space to tenants. Rent is then distributed to the owners of the REITs as a dividend to shareholders. Sometimes an Equity REIT will sell a property and pass on the capital appreciation to its investors. Equity REITs are probably the most common type of REIT you will find in the market.
2. Mortgage/Debt REITs. If you’re not interested in being involved in the equity stack, mortgage/debt REITs loan money for mortgages to real estate owners or purchase existing mortgages or mortgage-backed securities in the open market. As you can imagine, these REITs were particularly hammered during the financial crises since they heavily invested in collatarelized debt objects (CDOs) composed of mortgage backed securities. That doesn’t mean they are toxic assets but mortgage/debt REITs are only as good as the quality of the underlying mortgage (just as Equity REITs are only as good as the underling properties). Mortgage REITs generate income based on the spread between the interest paid by the mortgage borrowers and the cost of funds for the REIT. This makes them sensitive to interest rate changes.
3. Hybrid REITs. Some REITs try to pick and choose between the equity and debt markets to find the right balance.
Public vs private REITs
In addition to the type of REITs discussed above, REITs come in two flavors: public or private.
Public REITs trade on the public stock markets where investors can buy their securities directly. If an investor wants to focus in on a particular market or type of property, you can invest in a single REIT in the same way that you could pick an individual stock.
One example would be something like the the American Tower Corporation (AMT) which is described as a real estate investment trust that owns, operates and develops multi-tenant communication real estate (i.e. cell phone towers).
If you’re not interested in picking individual stocks (like me), you might consider something like the Vanguard REIT Index Fund which has $64 billion spread out across the entire REIT market.
Private REITs aren’t available on the public stock market. An example would be the Fundrise eREIT. Fundrise is one of the many real estate crowdfunding platforms. It’s taken the approach of focusing on the REIT market, rather than sourcing individual deals. As such, they’ve put together a professional managed portfolio of commercial real estate assets that are available to accredited investors on the platform.
The argument for private REITs over public REITs (as told to me by the Fundrise rep) is that private REITs have significantly lower fees, less liquidity since they aren’t publicly traded and a corresponding lower correlation to the broader public market.
It’s impossible for me to tell for sure if private REITs have lower fees but REITs in general seem opaque when it comes to fees. There are many opportunities for fees to be layered throughout real estate transactions (broker fees, management fees, property maintenance fees, origination fees, finder fees, etc.) and so it’s natural to assume that the farther away you are from the underlying real estate transaction the more fees you’ll end up paying.
For that reason, public REITs as a whole don’t have the best performance record. Rather than generating large returns, they seem to be considered a steady and predictable income stream.
REIT correlation to the stock market
Another supposed benefit to REITs is that they should generally not be correlated with the broader stock market. Since REITs are composed of real estate assets throughout the company, they should track the broader real estate market as prices move up and down. Further, since equity REITs generate income via rent, they shouldn’t see as much volatility even if tough markets because rent has to be paid regardless of the market turmoil.
For that reason, it’s a bit surprising when you compare the Vanguard REIT Index Fund (VGSIX) vs the Vanguard Total Stock Market (VTSAX). As you can see, they seem to move in tandem. There are a lot of theories as to why this is the case. Obviously, the 2007-2008 financial crises had a lot to do with the housing market but that doesn’t explain the near exact volatility of the broader stock market. One theory is that since public REITs are traded in the stock market, they behave more like securities in general than real estate, which means that in times financial crises public REITs face the same flight of capital as investors look to park their money in safer investments.
If you’re not benefiting from the lack of correlation in an asset class, I’m not sure it makes sense to accept the volatility when overall returns will still be tied to the performance of the broader real estate market.
Further thoughts on private REITs
When I think of unlisted or non-public REITs, I think of the real estate crowdfunding platforms that are trying to change the public REIT market. However, I’m also told that private REITs are a common tactic used by commissioned salespeople looking to sell you an investment. I’d be skeptical of any person that is trying to sell you on the concept of an unlisted REIT.
They may tell you that there are many benefits to investing in an unlisted REIT, such as a stable share price, income that won’t be taxable, a higher return and the possibility that the REIT will go “public” at some point.
Of course, a private company can arbitrarily keep its share price stable but that has nothing to do with the underlying value of the assets. It doesn’t make any sense to assume that a price is stable just because a company wishes it to be so.
Many times someone will try to tell you that investment returns aren’t taxable to you. That’s because it’s called a “return of capital” (i.e. the first dollars out are returning your capital back to yourself). You’ll get taxed on those earnings eventually. There’s no such thing as a free lunch. If I wanted to give some capital and then let them return it to me, I’d use my checking account.
As for waiting for something to go public, don’t fall victim to the greater fool theory. Sure, there may be a greater fool out there but that’s no way to make an investment.
Should you invest in REITs?
As mentioned when I wrote about PeerStreet, currently I have very few of my assets in real estate (although once I tried Personal Capital, I realized I had more assets in real estate than I thought thanks to their excellent asset allocation tool).
Since I live in NYC and rent, I can’t even count my personal home as part of my real estate holdings (although there’s plenty of differing opinions about whether your home should be considered a real estate investment). For that reason, I’m actively exploring making real estate investments. I’ve put $10,000 to work on the PeerStreet platform, but that’s hard-money lending and not an equity investment.
At this point, I’m more interested in making an equity investment directly into a property through a real estate crowdfunding platform as part of a small percentage of my overall asset allocation (definitely less than 10% and probably more like 5%).
I’m not comfortable with REITs mainly because I don’t understand how the fee structure works and I’m not sure that anyone can see through the entire investment to understand how much of the returns are “lost” to various expenses. Real estate has too many opportunities for money to be siphoned out of the system (brokers, maintenance, managers, etc.).
Of course I won’t completely avoid that if I invest in a specific real estate project. It should just be easier to identify the expenses related to the actual project. On the flip side, I’d obviously lose the diversity. If you invest in a college dorm in Houston, Texas and a hurricane comes along, you’ll be lucky to get a return of the equity. So there’s that to consider too. You’ll be the first to know if/when I decide to invest in a real estate project.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.