You already know by adding real estate to your portfolio, you can boost your long-term returns and smooth volatility. Real estate provides steady income, long-term capital appreciation, diversification, inflation protection, all while offering a low correlation to the stock market. You’d like to get involved, but you really want to avoid the nightmare stories you’ve heard of crazy tenants and 2 A.M. overflowing toilets.
Luckily, you have options to gain exposure without direct involvement. Traditionally, that’s been through ownership of real estate investment trusts (REITs). REITs have been around since the 1960’s. They offer investors real estate exposure through publicly traded companies that operate commercial real estate and return the profits they earn to their shareholders.
Through the passage of the Jobs Act in 2012, and a later revision in 2015, the foundation was laid to ease securities law and open up new investment opportunities, once only reserved for an exclusive club. Now, not only are REIT’s available as a passive alternative to owning real estate directly, but also the emergence of crowdfunding and real estate syndications enable smaller investors to participate in the purchase of a single or multiple commercial properties as limited partners.
With quite a few options available to gain real estate exposure in your portfolio, which investment vehicle is the right choice for you? Personal finance is just that….personal. There are some advantages and disadvantages of both REITs and syndications which can help you determine where best to put your money to work.
Type of Asset & Returns
There are two types of REITs: Mortgage REITs and Equity REITs. Mortgage REITs purchase mortgage-backed securities and behave more like debt instruments. Equity REITs actually own physical real estate and are, thereby, more easily comparable to real estate syndications.
The types of real estate equity REITs own runs the gamut…multifamily, industrial, office space, retail, etc. One distinction that’s common, though, is that the assets are typically stabilized – meaning they are either newer or recently updated. They have a stabilized tenant base and don’t have a lot of capital expenses on the horizon. With that, risk is theoretically lower, and returns follow suit. Returns will vary based on a company’s performance, but dividend payouts average around 3-4% with 10-12% overall annualized returns over the long-term.
With real estate syndications, investors have more opportunity to participate in the upside, via value-add improvements. Many syndicators seek assets that have below market rents, have higher vacancies, are dated properties, and have been mismanaged by “mom & pop” owners. Risk is higher but returns are as well. Although not as well known as REITs, real estate syndications have been gaining in popularity in recent years. Currently, preferred returns are in the 6-8% range, depending on the sponsor and asset, with internal rates of return (IRR) in the 15-20%+ range.
When you purchase a REIT, you are purchasing shares of a company that owns real estate, not real estate directly. REIT’s abide by certain regulations:
- 75% of their assets must be in real estate, US treasuries or Cash.
- 75% of profits must be sources from rents, mortgage interest or real estate sales.
- 90% of those profits must be paid out to shareholders in the form of dividends.
- The company must be managed by a board of directors or trustees.
In a private placement syndication, you are investing in a specific property, and become a member of the company, not a shareholder, who owns the asset as a limited partner. This is a key distinction, allowing you not only to underwrite the management team, but also the specific asset that you are investing in. This gives you more control over your investment. You also know that 100% of your money is going towards real estate, versus a REIT, where percentages of your investment could be held in bonds or cash.
For the reason just discussed, when you invest in one specific asset, you are inherently not diversified (unless you are investing in a syndicated fund). REITs typically are invested in specific types of properties (ie commercial office, retail, agriculture, etc.), but can offer both diversification through volume, as well as geography.
Achieving diversification with syndications can be difficult, as minimums are typically $25,000 or more.
REITs allow anyone with a brokerage account to participate. There is not a net-worth or income requirement to buy and typically you can purchase as little as $100 worth of shares.
Many real-estate syndications are only available to “accredited” investors. There are nuances, but in its simplest definition an accredited investor is one who’s net-worth is greater than $1 million, excluding their primary residence One may also qualify based on income of $200,000 or more for the last two years ($300,000 combined if married), with the expectation to make at least that much the next year. While some offers are open, or have limited slots available, for non-accredited investors, finding access to these deals can be more difficult. Couple that with the aforementioned high minimum investments required to get in the game and many are left on the sidelines.
REITs are taxed like stocks. REITs do benefit from depreciation write-offs, but that’s prior to it reaching the investor in the form of dividends. Unfortunately, the IRS taxes dividends at ordinary income tax rates. For that reason, REITs perform best through compounding interest in an IRA.
Investing as a limited partner in a syndication can offer major tax benefits. A syndication is set up as a pass-through entity. The business will pass their income to their owners, who then will pay taxes on that income via their personal return. This income can be sheltered nicely with the power of the depreciation write-off expense. Many syndicators employ cost segregation studies and bonus depreciation to accelerate the allowable depreciation in the first years of ownership. This paper loss can be used not only to write-off income from the property owned, but also capital gains incurred by the individual investor from other investments.
REITs, having characteristics more similar to stocks, are highly liquid. A few clicks on your broker’s website can get you in and out of positions.
Syndications are one of the least liquid investments you can make. While some deals look to return their investors’ initial capital quickly through a refinance or sale of the asset, it comes down to the general partner’s decision when the best time is to exit the asset, maximizing returns for their investors. You should go in expecting to lock your money up for 5-10 years.
When you invest in Facebook, you don’t get to spend thirty minutes on the phone with Mark Zuckerberg, hearing his direction on where the company is headed and why his shares are being sold at a value. REITs are similar. You can read income statements, listen in on quarterly earnings calls, and measure historical returns, but it’s not a personal relationship.
When you invest with a sponsor of a syndication, you have likely spoken to this person and understand their philosophy and drive. You can ask specific questions regarding their investments based on what’s important to you. You may have their cell phone and direct email. The opportunity to build a long-term, personal relationship exists with a sponsor. You are only one call away from the individual making the decisions. Trusting someone with your money is critical to sleeping well at night.
Note that there are platforms that “crowdfund” by bringing together investors to raise money for sponsor’s deals. The platform does due diligence on the sponsor for you, per se. By adding this middle-man, you are one step farther from the operator. You should perform due diligence on both the platform and the operator. Understand that the platform is charging a fee to the sponsor of the deal, but that fee is likely coming out of your returns.
There is a lot to consider when deciding between a REIT and a passive syndication, and there is not a one-size fits all answer as to what vehicle is right for you. You really don’t have to commit to one or the other. Because REITs trade more like stocks, they can become volatile, and occasionally offer deep discounts to book-value. For example, at the time of this writing we are battling a pandemic that has decimated retail and office REITs. A contrarian may want to look at REITs offering discounts to book value, potential earning outsized returns in years to come.
In general, If you have limited funds to put towards real estate, are looking for the most passive option, and want to be able to get out of your investment quickly, REITs are likely your vehicle of choice.
However, if you can commit capital for a longer stretch, have an income and net worth that allows spreading your bets across a number of sponsor’s offerings, then you likely could also benefit from the tax advantages syndications offer, not to mention the upside potential of higher returns. Isn’t that what we are all after?
Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications. Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room. After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019. Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties. He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.