Why Invest in Real Estate Investment Trusts

Real Estate Investment Trusts (REITs) have emerged as a powerful tool for real estate fund managers looking to diversify portfolios, generate steady income, and mitigate risk.

What is a Real Estate Investment Trust (REIT)?

A REIT is an investment vehicle created to own, operate, or finance income-producing real estate properties. Most REIT investment strategies focus on generating a steady stream of income for investors and are not focused on the appreciation of the underlying real estate assets. To have a REIT and maintain good standing, the entity is required to distribute a minimum of 90% of its taxable income to its shareholders, along with satisfying income, asset, and organizational requirements.

Typically, a REIT is capitalized by selling its shares in either a public or private offering. Investors considering where to invest should know that publicly traded REITs offer a more liquid option since their shares are traded on a public exchange.

Conversely, private REITs issue their shares through a private placement geared toward more accredited or institutional investors. In addition, a REIT provides the benefit of being able to deduct dividends paid to shareholders from its taxable income and thus avoids income tax liabilities at the corporate level as long as it is able to satisfy certain qualifying requirements. This makes REITs an appealing structure and investment product offering of fund managers to investors.

How Publicly Traded REITs Differ from Real Estate Private Equity (REPE) Funds

When investing in real estate products, two of the more common options are REITs and REPE funds. Both offer investors an alternative to investing directly in real estate. However, REITs differ in structure, investment strategy, and risk profile compared to REPE funds.

While both investment vehicles provide access to real estate markets, they cater to different investor profiles and have distinct operational frameworks.

Privately offered REITs, also sometimes called placement REITs, possess the same core characteristics, requirements, benefits, and tax implications as publicly traded REITs, but their nature, purpose, and investors differ. Privately offered REITs can be part of REPE fund structures used by fund managers for their ultimate tax advantages to REPE fund investors. Their shares are issued to accredited or institutional investors and are not publicly traded.

For purposes of this article, the REPE fund reference is for a non-REIT REPE fund.

Benefits and Tax Implications

Both publicly traded and private REITs can offer significant tax advantages to U.S. and foreign investors.

REITs are typically structured to provide beneficial tax treatment, often avoiding corporate taxes altogether. Investment income and earnings are passed on to the REIT shareholders through the dividends they receive. REPE funds, on the other hand, are often taxed as partnerships, and various income/loss items are passed through to the investors, which are not in the form of a “dividend.”

One of the biggest benefits for U.S. investors in REITs is the 199A QBI deduction, which effectively reduces the highest federal individual tax rate of 37% to 29.6%.

See Benefits of Choosing REITs for Your Real Estate Private Equity Fund Structure for additional information.

Liquidity

Publicly traded REITs invest in real estate the same way people invest in stocks or bonds. Instead of buying and managing properties directly, investors can buy shares of a publicly traded REIT. Publicly traded REITs also allow investors with smaller capital amounts to pool their resources together to invest in real estate.

Unlike publicly traded REITs, REPE funds are investment funds that pool money from investors to buy, develop, or manage real estate properties and assets. They do not trade on public markets.

Publicly traded REITs are highly liquid since they trade on stock exchanges. Investors can buy or sell shares on demand in an open market. REPE funds are typically illiquid investments. Investors must commit capital for a fixed period, often 5-10 years, before the fund exits its investments, and capital can be returned to investors.

Private REITs can offer some liquidity options, but there may be limitations. They typically operate the same way as a REPE fund.

Risk Profile

Publicly traded REITs are typically less risky and provide consistent but usually moderate dividend returns. However, they can be affected by market fluctuations since they trade like stocks. REPE funds and private REITs aim for higher returns but also come with higher risk because they often take on large real estate projects or development deals. There is the potential for greater rewards if things go well or larger losses if they don’t.

Management

Typically, publicly traded REIT investors have no say in property selection and are more passive investors. Alternatively, in REPE funds and private REITs, large investors come into the fund as limited partners and have the potential to exert influence on the fund manager.

Management of REITs differs from that of REPE funds in that REITs are generally managed by a professional management team that is typically approved by the board of directors of an investment management company. On the other hand, a REPE fund is typically managed by a general partner/fund manager, providing a more hands-on management style.

Choosing the Right Investment Option

REITs and REPE funds offer distinct opportunities for investors to gain exposure to real estate markets. However, they differ in structure, investment strategy, liquidity, and risk profiles. Public-REITs provide a more accessible, liquid, and passive investment vehicle, allowing small investors to diversify their portfolios through publicly traded shares and receive steady income through dividends. They are generally less risky, but their returns are moderate and subject to market fluctuations. In contrast, REPE funds and private REITs target high-net-worth individuals and institutional investors, offering higher potential returns but with increased risk due to their focus on long-term investment horizons; as such, REPE funds are illiquid and require a longer commitment period.

Moreover, while REPE funds may have similarities with private REITs, they differ drastically for tax purposes. A REIT provides many tax advantages for U.S., foreign, and tax-exempt investors and allows investors to diversify their portfolios without costly and heavy compliance burdens.

Real estate fund managers can effectively incorporate REITs into their portfolios by understanding their nuances and carefully considering their implications. Our team of experienced professionals can provide tailored advice on REIT investment strategies. Contact us today to learn more, or check out our recent e-book, REIT Strategies: A Practical Guide.