What is Private Equity vs REITs Investments
Private Equity vs REITs Investments
One of the most important considerations for choosing to invest capital in commercial real estate is with the goal of minimizing risk while optimizing investment returns. Two of the most popular investment choices are through a Private Equity Real Estate (PE) firm or a Real Estate Investment Trust (REIT). The question is… which one suits the specific investor best?
The two are often mistaken for one another not only because their titles sound similar, but also, they both invest in similar assets – Real Estate.
That is where however, their similarities end, and the differences between REITs and PE investments become apparent – in the methods in which they invest, the risks involved, and potential growth of the investment are drastic. First, let’s define REITs and Private Equity Real Estate, and then discuss the differences between them, as well as detail the circumstances when one is more beneficial than the other.
A REIT is a corporate entity …
that invests in real estate with opportunity for profit production, and finances these real estate properties to investors. These properties generally focus on “income-producing” real estate, such as apartment buildings, mobile parks or storage units where tenants pays rent. Sometimes, the real estate can be invested in on an individual basis, but largely the strength and uniqueness of a REIT comes from the fact that it provides the investors the opportunity to purchase its shares. Usually, investors will purchase shares of a REIT and gain access to the profits attained by the real estate as an entity. Furthermore, the ease of which investors can buy and sell shares of the REIT is considered to be one of the stronger points of REIT ownership. In simple terms, REIT is a Mutual Fund with a concentration on real estate.
In order for a company to qualify for REIT status by the IRS, it must meet a set of requirements.
A REIT must …
- invest at least three quarters of its total funds in real estate.
- derive at least three quarters of its gross income from rents on real property, interest on mortgages financing real property, or from sales of real estate.
- pay at least 90% of taxable income in the form of shareholder dividends annually, and must be an entity that is taxable as a corporation and managed by a board of directors or trustees.
- have a minimum of 100 shareholders and no more than half of their shares held by five or fewer individuals.
Similar to REIT, PE firms are also companies that pool funds to invest in real estate.
Unlike REITs, Private Equity firms do not restrict their investors to the purchasing of shares involving profitable real estate properties.
Rather, PE firms allow to invest in real estate asset classes, which are variable groups of investment types that have similar characteristics, and categories that include equity, cash equivalents, fixed income, and commodities. And while REITs fall into the category of the real estate asset class, REIT investments do not expand outward towards other real estate types, such as those that might not involve income-producing properties.
Additionally, the procedure of investing in a PE firm is very different from that of a REIT. Unlike a REIT, where the investor must purchase shares of the corporation as a whole and then make profit from the growth of value in the company, an investment with a PE firm is not an investment in the firm itself, but rather an investment in the firm’s project. Where a REIT owns a property and makes money solely from the income produced by the property, a PE firm buys properties and operates them to improve them in many ways, with the goal of selling them at a profit. The difference between a REIT and a PE firm is synonymous to a landlord that makes a profit from the rent collected from the tenants, and flipping a property, which involves making the property more desirable before selling for a profit.
Private Equity firm buys properties and operates them to improve them in many ways, with the goal of selling them at a profit.
Now, what part does the investor play on both sides of this analogy? Essentially, while the REIT investor represents a share of the landlord, and when the landlord makes money the investor gets a portion of it; an investor in a PE firm acts similarly, but not quite identically to a bank that provides the capital necessary to purchase the property and make it more desirable. The reason that the investor with a PE firm is not identical to a bank is because the investor’s profit is not based on the interest derived from the capital payment. Instead a PE investor funds someone else’s project, allowing the sponsors, or general partners in that project do the work required to make a profit, and then paying them a fixed rate of fees for their services. Using yet another example: an investment in a PE firm would be similar to hiring someone to replace an outdated kitchen in their own house, and the investor is expected to pay the hired worker to do the work that they can’t or don’t want to. This economic principle is very standard, yet effective at a high level – the investor loans money to many firms at once while personally doing none or very little of the “hands on” work. On top of this, a large portion of the profit a PE firm will make usually comes from promoted interest. That is why PE firms will typically structure the investment returns in a waterfall fashion, which will allow to have various levels of returns split between the investors and the general partners in a deal.
The question, “Which is better – REIT or PE?” has probably come up quite a few times, and the short answer is – it depends!
An investor’s decision depends on how much that that individual plans to invest, as well as the investment timeline. With a REIT, the goal is similar to that of the stock market, where someone can buy a certain number of shares, and then sell them at any time. For someone looking for a simple way to make some money without a long term commitment, with high liquidity in the process of purchasing and selling shares, investing in a REIT might be the best option. On the other hand, PE projects are usually long term projects to allow to generate more significant returns, while offering tax benefits that are not available through REITs investing. Furthermore, the minimum investment in PE firm’s projects is typically much higher than that via REIT. In order to protect the investor, SEC regulations in most cases require each investor to be accredited.
Which is better – Real Estate Investment Trust or Private Equity?
In summary, quick in-and-out investments without long term commitments can typically be achieved via REITs investing. Conversely, investors that prefer to generate greater returns, multiply their wealth, save on taxes, and are willing to park their funds for longer terms, should consider PE investments, which is a more viable option for the above criteria.
Note, this article is written in collaboration with Zach Digirolamo.
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