Passive Real Estate Investments vs REITs

Why screen private real estate investments and deal with sponsors and the paperwork (subscription agreement, operating agreements, etc.) required to invest passively in real estate when you simply buy the shares of a publicly traded real estate investment trust? Here are a few reasons to invest in direct real estate instead (or in addition to) shares of a real estate investment trust.

Private Real Estate Offers Superior Tax Advantages

REITs pay out 90% of their taxable income in the form of dividends. These dividends are classified as ordinary income, capital gains or return of capital. However, the majority of REIT dividends are taxed as ordinary income at a maximum federal tax rate of 43.4% (including a 3.8% surtax for ObamaCare).

OUCH.

Conversely, many direct real estate investments offer investors 100% tax deferred distributions. These deferred taxes are typically paid when an investment is sold (if ever) at a much lower blended tax rate comprised of capital gains and depreciation recapture taxes.

While both REITs and private real estate benefit from depreciation, net operating losses (“NOLs) from REITs are not passed through to investors. Whereas pass thru entities (LLCs) used in private real estate allocate net “paper losses” (thanks to depreciation and interest deductions) directly to the partners. These losses can be used to offset income from other passive investments. This is truly an unbelievable tax benefit and is a major reason why wealthy families love direct real estate investments.

Furthermore, REIT stocks do not qualify as investment property as they are securities not real property. Accordingly, investors cannot utilize a 1031 like-kind exchange to defer taxes upon the sale of REIT shares. The REIT manager can certainly utilize 1031 trades within the portfolio, but when you sell your REIT stock, you have to pay the tax man.

REITs are Typically Poor Cash Flow Investments

While smaller REITs and highly leveraged mortgage REITs offer above average dividend yields, most of the larger REITs are currently only paying 2-5%. The assets my firm currently invest in, mobile home parks, typically return anywhere from 12-20% cash on cash leveraged yields (at current interest rate levels). Is the liquidity of a REIT worth that cash flow delta?

If you have access to cheap debt, you could borrow to boost REIT yields, but this is a risky strategy as REITs employ leverage as well (albeit at lower, sub 50% LTV levels). Personally, I prioritize cash flow over appreciation and need a lot more than 2-5% in cash flow from my investments.

REITs are Nearly Impossible for a Passive Investor to Value

A small portfolio of direct real estate investments is certainly easier to value than a massive, perhaps international portfolio of properties held by a REIT. Furthermore, a REIT adds entity level and GAAP accounting complications that make it difficult for even REIT stock analysts to peg Net Asset Value. Perhaps if you had the time you could value a REIT, but would you want to?

I don’t know about you but I’m much more confident in my ability to fairly value a few private real estate investments. I (like most REIT sell side analysts) would be guessing on the Net Asset Value of a large REIT.

REIT Balance Sheet Complications

During downturns, a REIT’s unsecured debt covenants can create issues as a decline in stock price can trigger forced asset selling at distressed prices. If a distressed REIT elects not to raise capital through asset sales, they might cut the dividend or raise additional equity through new stock issuance, which is dilutive to its current stockholders. This can happen in private real estate, but it would be driven by a specific property’s inability to service its debt, not a fluctuation in a somewhat arbitrary stock price.

Most REITs are highly dependent on the debt markets as they are constantly refinancing existing debt holdings and consequently, are highly susceptible to credit crunches. Case in point, General Growth Properties was forced into bankruptcy despite having the best portfolio of malls in the country.

REITS Behave Like Equities

If you are a passive investor looking to invest in real estate for diversification relative to your stock and bond portfolio, REITs will help, but only over the long term. REIT shares react more to shifts in the capital markets (interest rates, overall market sentiment, etc.) than basic real estate fundamentals (occupancy, rental growth, etc.).

REITS are Volatile Investments

During the credit crisis, REIT prices were drastically more volatile than the value of their underlying real estate holdings. During the worst of the crisis (September 2008 to February 2009) REIT prices fell off a cliff, losing 60% at one point; yet, the NCREIF property index, which tracks the value of private real estate fell only 15 percent.¹

There is certainly a tracking lag in private market valuations; (the NCREIF index is a large set of institutionally owned real estate appraised quarterly) but my underlying point is that it’s much easier for an individual to hold cash flowing real estate through market downturns than than REIT shares that have lost more than half of its value on paper. The short-term correlation of REITs to the overall stock market makes it challenging for investors to “keep their heads” and avoid panic selling when the exit is just a few mouse clicks away via their online broker.

Obviously, the private real estate market had its challenges during the downturn as well. However, owners of multifamily real estate that didn’t overleverage and weren’t forced to sell, continued to collect rent checks, pay down principal and even generated positive cash flow. My business partner even saw the value of one of his mobile home parks increase during the credit crisis as more people looked to reduce housing costs.

Conclusion

Although REITs offer investors a lower entry cost point and higher liquidity vs direct passive real estate investments, I believe REIT shares are better utilized as part of a diversified equity portfolio. If you’re looking to make a passive real estate investment to help hedge you’re stock and bond portfolio you should look to make direct investments with reputable sponsors. Your portfolio should benefit from reduced volatility (without a corresponding decline in potential returns) and meaningfully higher before and after-tax cash flow returns.

Reference: 1. “REIT and Commercial Real Estate Returns: A Post Mortem of the Financial Crisis.” Sheridan Titman and Garry Twite (McCombs School of Business); Libo Sun (California State Polytechnic University). April 2013.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.