What is a REIT?
By Adam Gower Ph.D.
A common question that arises when investors first discover the option of investing in syndications via online crowdfunding websites is how they differ from Real Estate Investment Trusts, or REITs.
One of the best comparisons to a REIT is a mutual fund; specifically, an equity mutual fund.
With an equity mutual fund, you save yourself the trouble of having to compare and pick individual stocks by paying money to a mutual fund manager to make those decisions and who will pick out a portfolio of investments for you.
REITs function similarly in that they are a collection of real estate properties controlled and operated by a dedicated, professional management team into which you can invest directly.
In contrast to having to choose an individual property to invest in, by selecting a REIT investors can diversify their capital across a broad range of properties, and paying the management team a fee for their services, can realize passive income from real estate without any of the direct hand-on management responsibility.
REITs are usually structured to specialize in a particular type of real estate; from multi-family housing, to office buildings, cell-phone towers and everything in between.
All the investor does is to decide what kind of real estate they have an interest in, look into their brokerage account and choose what REITs specialize in that asset class and to invest in that.
In essence, investors buy into a portfolio of office buildings, apartment buildings, or any type of commercial real estate they deem viable.
Traded vs. Untraded REITs
There are two kinds of REITS, traded and untraded.
Publicly traded REITs are registered with the SEC and can be bought and sold on the stock market through brokers and are subject to usual brokerage fees.
Different kinds of investments can be made in REITs ranging from common or preferred stock, or debt.
Untraded REITs are different from publicly traded REITs in that there is a lack of liquidity; once an investor places their capital, there may be no way to sell those shares.
That said, some non-traded REITs do have share buy-back provisions, but these programs are often offered at the discretion of the REITs management, can be rescinded at any time, and therefore cannot be counted on for liquidity.
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One concern often expressed when it comes to REITs, as opposed to crowdfunding or similar options, is the extent to which they incur fees relative to each other.
For REITs the soundest comparison to make is that fees are typically going to be the same as paying a normal fee to any broker for other stock investments.
In non-traded REITs these fees can be substantial totally 9-10% which immediately and significantly reduces the value of the investment.
That said, it is difficult to compare fees associated with REIT versus those associated with crowdfunded real estate deals because crowdfunding is still in its infancy, making it harder to compare fees to something like REITs which are more established.
Fees in real estate crowdfunded deals can be extensive also and in both cases, investors often need to dig deep into offering documents to uncover their true extent.
Advantages and Disadvantages
While there will be unique circumstances for each investor and each REIT, there are a few common things to keep in mind.
First, REITs offer the opportunity for investors to solidify their foothold in many specialized and nontraditional types of real estate.
One of the largest REITs on the market, for example, specializes in owning cell towers.
Others include billboards, prisons, senior housing, etc.; you’d be surprised by the variety of properties represented.
Many of these kind of investments are otherwise unavailable to investors.
This also goes hand-in-hand with another advantage of REITs: helping small investors access a strong, diversified portfolio.
Another factor that drives the decision to invest in a REIT is what is known as the “liquidity premium.”
The Liquidity Premium is the amount above the actual value of a non-liquid asset i.e. real estate, that the investor is willing to pay in return for converting that investment into a liquid asset.
Put another way, commercial real estate is illiquid – it can takes months to sell a building – but a share of a REIT is a liquid asset that can be bought and sold instantly. This is a great advantage of investing in real estate through a REIT.
But the liquidity premium can also be seen as a disadvantage depending on who you ask.
Why, for example, would long term investors want to pay a liquidity premium for real estate, if they don’t actually need liquidity?
REITs Behave Like Stocks
Another difference between investing in REITs and investing in a syndicated real estate crowdfunded deal is that REITs trade on the stock market and are subject to market volatility, whereas a direct investment in a real estate project is not.
With stocks, day by day, month by month, prices fluctuate.
In some cases, prices may increase or decrease more than the true value of the underlying assets due to the nature of the market - something that you wouldn’t see with actual physical properties.
This could lead to a sort of “double whammy” where if the market goes down, not only does your stock go down, but your dividend goes down as well.
We saw this play out on a massive scale in the 2009 financial crisis, with the REIT index dropping over 80% at one point.
Hindsight is, of course 20:20, and a lot of what happened during the financial crisis was due to panic, which drove down the values of REITs way too far.
For investors at the time the reality of the collapse in REIT values was exacerbated by the bear on the stock market and their ability to sell their shares super quickly.
While there was a drop in the underlying values of actual properties, it wasn’t responsible for the full 80% plummet.
Since people had the ability to sell so quickly, they used that freedom to sell faster than they needed to and this placed disproportionate downward pressure on publicly traded REIT pricing.
REITs offer an alternative to investing to either direct acquisition and management of real estate or investing in a syndication via a crowdfunded deal, and vary in these three distinct ways:
1. They can behave more like stocks than real estate in terms of pricing fluctuations
2. there is likely a liquidity premium for converting an inherently non-liquid asset (commercial real estate) into a liquid asset, and,
3. especially with non-traded REITs investors should pay close attention to REIT management fees.
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