Public REITs have been a popular way to invest in Real Estate since the 1970s, with around $1.4 trillion in investor cash. But ever since the JOBS Act passed in 2016, we have seen a flood of new real estate investment opportunities enter the mix – in particular, private REITs and private equity. These new opportunities have investors increasingly asking questions about the distinguishing factors and why they might choose to invest in one over the other. Let’s dive into the differences, advantages, and disadvantages of each.
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The Definitive Breakdown Of REITs Vs. Private REITs
In this episode, we got a cool topic. We are going to be exploring the world of REITs, public REITs, private REITs and how they compare to private equity real estate. A lot of times, periodically, we’ll put together some think pieces and white papers on different topics. A lot of it is spawned out of conversations that we’re having with investors and a lot of what we’re seeing in trends in the real estate space that we operate in.
There’s a lot of confusion around the different names of what’s the difference between a public REIT and a private REIT, private equity real estate and syndication and eREIT and mortgage REIT. All these terms can be very confusing because a lot of different sponsors and funds use these terms without using a technical definition. REIT is a technical definition, which we’ll get into but it gets even more confusing as they even make up things like eREIT. That’s not even a real thing other than a branding thing.
What we wanted to do is take some time and break down the differences between public REITs, private REITs and private equity real estate and look at the framework of pros and cons of how they compare to each other. We’re going to do that and hopefully add some clarity to maybe any confusion you may have on this topic.
It’s an important topic because a lot of people want to invest in real estate. Clearly, the prices are going up. How do you invest in real estate when you don’t want to be the cowboy home flipper yourself? It’s an important question to ask. It has gotten very popular. It started in the 1970s. REITs started with around $1.4 trillion in cash.
What has happened ever since the JOBS Act passed in 2016 is we have seen a plethora of new real estate offerings coming to market. It’s creating this opportunity but also this confusion. Make no mistake. It is an opportunity. We want to talk about, “What are public, private and private equity REITs?” We’re going to break it down into pros and cons.
We’re going to start with pretty much what most people or stock investors understand and that is public REITs. A majority of their assets are in real estate assets. They typically borrow money in addition and then they go public and sell shares to the public. It’s a way for you in a public company buying a stock can own real estate. REIT doesn’t mean what people think. It’s an IRS term that means that you can hold real estate in a fund. If you meet these terms, you can avoid paying tax.
Typically, all public companies are what’s called C corporations, which are standard corporations and they pay taxes on their earnings. When they distribute cash to the investors, the investors that receive those cash as dividends also pay taxes. It’s doubly taxed. If they own mostly real estate or mortgages and they distribute 90% of their profits as dividends then they can be classified as a REIT. They get a tax deduction whenever they distribute and hence not be doubly taxed. That’s the whole designation of a REIT.
Not anyone can throw up, “I’m going to be a REIT without doing these technical things that the IRS has codified that you have to abide by.”
It’s a very extensive approval process. It isn’t like you fill out a form and declare yourself a REIT. It’s a massive approval process and pretty onerous.
To be clear, REIT stands for Real Estate Investment Trust.
[bctt tweet=”Public REITs are not buying real estate; they’re buying the stock market.” via=”no”]
There are two classes of Real Estate Investment Trust. The biggest one is equity REITs. This is where you own the equity and real estate. That’s the biggest class and 90% of REITs out there are equity REITs. There’s a less common REIT that’s a mortgage REIT. This is where instead of owning actual real estate, you own mortgages. For example, Annaly Capital Management NLY is a mortgage REIT. Those are less common but it’s very similar. You raise investor cash, buy lots of mortgages and leverage that with debt.
Mortgage REITs can also be abbreviated as mREITS. If you have heard of an mREIT, that’s also a common phrase for mortgage REITs.
We’re going to talk about private REITs. This is where things get confusing because technically, there’s no such thing as a private REIT because most private equity real estate and private equity funds are LLCs, which means they are not C corporations. They pay no taxes themselves but they pass on their tax liability to the owners. It’s called pass-through entities.
What that means is the REIT designation is irrelevant to them. In fact, they can’t even get a REIT designation technically. A lot of companies are still calling themselves private REITs because REITs are well-understood and desirable from an investor point of view. What we’re going to talk about here for clarification purposes and for purposes of this talk is private REITs. They are simply multi-asset private equity real estate funds.
A lot of the private REITs it’s almost a transitory phase as well because there are private REITs. They are not publicly traded on the stock market but they intend to at some point. They will go through this metamorphosis to become a public REIT. It can be used for that. The way we’re going to look at it is this overarching term in the private world. If you have invested in private equity real estate before, it can include private equity real estate funds or private equity syndications.
The difference between those two terms is syndication is generally a single-asset investment vehicle, whereas a private REIT is a multi-asset fund, which is comparable to a public REIT that generally owns multiple assets and a lot of assets. That’s how we’re going to break it down. A private REIT is not technically a thing. It’s a marketing tool. Even if you see someone offer a private REIT, it’s not a technical REIT as defined by the IRS but it can be a helpful way to understand the public versus private.
To summarize, a public REIT raises equity capital from investors, buys real estate assets, borrows money and sends the earnings to investors. Private REITs do the same thing. They generally raise money from investors, borrow money from capital sources, buy assets and distribute the earnings to investors. It’s extremely similar. The only difference is they are not publicly traded and they are usually in LLCs. Our third class is private syndications, which are generally a single asset. A company will go out to buy an apartment complex. They will find some equity and debt for that and then give the results to investors but it’s a single apartment complex.
Another point on this is the way in which these companies raise capital for a public REIT versus a private REIT or private equity real estate is very different. That was the big change in the JOBS Act 2016 that allowed the floodgates to open because a lot of these private investments that were once not available to high-net-worth accredited investors are now available. That’s now a vehicle through Regulation D, which is another topic but allows sponsors to go raise money from investors without having to do a public offering.
The 506 Rule has been around for a long time but in 2016, they added a designation of 506(c) that allowed these companies to raise private equity to market to investors. That was the first. You could invest in this but no one could tell you about it. You couldn’t find out about it except by personal relationship. They changed that and now it’s the Wild West.
We’re going to break down the pros and cons in a couple of areas. The first is taxes. You may think, “Why would you start with taxes?” One of the main advantages of real estate is it is tax advantageous. It’s probably the most tax advantageous investment you can make. Let’s look at this, which lets you keep more of your money.
As you have found out, public REITs are singly taxed. They are fairly efficient in terms of taxes. They don’t pay tax on the profits they distribute and then investors generally pay tax on the dividends. There is a breakdown here of whether they are qualified or unqualified. You pay either capital gains tax rates or ordinary tax rates. Let’s say it’s somewhere in the middle there.
Private REITs are partnerships. Technically, they are LLCs. As you become a partner in the LLC, you get a K-1 at the end of the year. The K-1 is your part of the income as well as the tax breaks. What happens in private equity in real estate is you have a very large depreciation expense typically. A lot of companies are doing even what’s called cost segregation studies to accelerate depreciation.
What that means is, let’s say the distributions to you might be $10,000 a year and because of depreciation, you pay zero taxes on that. It comes in as tax-free income, even though you’re getting cashflow. You have a $10,000 cash distribution but a $10,000 paper tax deduction in addition to that, netting out to zero. That’s a huge plus and that would show up on your K-1. What happens is if you end up getting a K-1, you don’t have a tax liability on that. It’s a huge break.
There are other things like 1031 exchanges and opportunities zones, which we won’t get into on this talk. There are huge tax advantages to opportunity zones and 1031 exchanges where you defer taxation. That would all come through on your K-1s. What happens if you’re a private equity investor, you have a huge amount of advantageous tax treatment. You pretty much wouldn’t have any of the short-term capital gains, depending on how the REIT is structured but there’s far less.
When you’re investing in a private REIT, you’re becoming a part-owner of the assets. As a part-owner, you get the benefits as an owner, which includes the tax benefits that get pushed through that won’t get pushed through in a public REIT.
The bottom line, winner or loser, public REITs or private REITs? In this one, we’re going to give it to private REITs by a long shot because you have to pass through depreciation and you have a host of other tax advantages like 1031 exchanges and opportunities zones. It’s a pretty major win for private REITs to do that.
I want to make a side note too. The difference in tax reporting is going to be a K-1 versus 1099 if you’re investing in a public REIT. Some investors maybe get scared of hearing about a K-1 if they have never seen one before. It’s a few-page tax report that all your CPAs will know what it is. It’s not a hurdle where a lot of people think it might be a hurdle because they are not used to it but it’s similar.
[bctt tweet=”You may dip your toe in the public markets, but smart investors end up in the private markets.” via=”no”]
The biggest complaint I had about K-1s from investors is the operators who are late in delivering their K-1s. A lot of times, if you get a lot of these and you don’t have a lot of K-1s coming in, you may have to delay your tax filing.
It’s worth it or wise to always ask the operator when they are delivering their K-1s buying.
You have to delay or extend your filing. To me, that’s no deal-breaker. The second category is liquidity. You have invested your $100,000 in this and now you decide you want your money back. What about that? The greatest feature of public REITs is that you can get your money back. If you go into the stock market and sell your shares, your money is back. There’s an active public market where you can easily cash out your position and access your funds. That is on a moment’s notice with that liquidity.
Private REITs cannot compare to that. Generally, when you put your money in, it is locked up. It’s gone until they release it. Most of the time, you have a lockup period. It’s not uncommon to see a lockup period that’s ten years. Some are as low as three but commonly, it’s 5 to 7 years. You got to decide if that’s worth it or not, although most investors overestimate their need for liquidity. Everybody wants it just in case but no one needs it.
We break this down in an earlier episode. I believe it’s the alternative investment continuum. There’s some pretty interesting research done to where people’s estimate of their liquidity needs is way overboard. There’s not the need for liquidity that most investors expect. You want to have some in a worst-case scenario and maybe in an economic downturn but to the extent that investors think they don’t need that much.
There is a downside to that liquidity, though. In 2008, when the markets were crashing or 2009, you can get liquidity but you may not get it at a price you’re interested in. It’s more fire sale liquidity. I’ll make another side point too. There are some private REITs that do offer liquidity like our flagship funds but that is not common.
Who wins in this category?
By a long shot, public REITs are going to win in this category. Here is a biggie. It’s the value, getting the most bang for your buck. This is the third component we want to look at. Let’s say you’re going to buy $100,000 in real estate and you decide, “Public REITs are so much easier. I’m going to go on my TD Ameritrade, pick a REIT and buy it. It’s all done.” You think you bought $100,000 in real estate. As it turns out, it’s not even close.
I did a breakdown and looked at the largest eight public REITs by market cap, meaning just the largest eight public REITs and looked at their price-to-book value ratios. This means the book value with their real estate versus the price per share for that real estate. You would expect it to be close to one. It means $1 share price bought you $1 worth of real estate value.
To further explain that, the book value is what the operator is carrying the value of these assets on their balance sheet at. What is the value per gap? It’s the generally accepted accounting principle, “What is the value?” The price to book is a ratio that looks at the value.
It’s the value of the shares that you purchased relative to the price of the real estate that they own. You would expect it to be pretty equal.
Maybe it’s a little bit more if you can get liquidity.
As it turns out, it’s not even close. Guess what the range is of the top eight public companies? It goes all the way from 1.7 times.
Meaning, for $170, you can buy $100.
You’re getting $100 worth of real estate. You may feel good about that or 21 times. That’s insane. Your $100,000 investment is buying less than $5,000 in real estate. It’s nuts. If you want to invest in a REIT, wouldn’t you expect to get some real estate? What’s happening in the stock market when these companies go public, the market is beating up their shares way beyond the price of the underlying real estate.
You have to know that when you’re doing that, you’re not buying real estate. Public REITs are not buying real estate. They are buying the stock market. The correlations that you can see are about 70%. Meaning that REITs are correlated 70% of the time with the stock market. You’re buying stocks with all the emotional ups and downs of stocks.
On the other hand, private REITs are always sold at book value. I have never seen anything not sold at book value. You could argue that if there’s a load, it would be a slight premium to book value but it’s not much. It’s always one. If you’re investing $1, you’re getting $1 worth of real estate at that time. That is a huge advantage. If you want to own real estate, the only way to do it is through private equity or you go actively buy it yourself. The winner on a value scale is hands down, private REITs.
We’ll see this come into play more when we talk about yields because yields are directly correlated to price.
This is where investors are rightly concerned. The feeling is that a public company is far less risky than a private company. I understand that. As we’re talking about this, I wanted to break it down into, “What are the categories of risk?” If we were to list a public company, what kinds of risk are the public markets protecting you from? These public companies are highly regulated. They are regulated by the SEC, Securities and Exchange Commission. They are very much in the grill of these companies but the only thing that they are mitigating the risk on is fraud.
That’s the thing they can catch, “Are you lying, cheating or stealing? Is it a Ponzi scheme?” They are going to be pretty good at getting that. They do not regulate operational risk. Meaning if you made a goof in your operation or geographic risk, macroeconomic risk, over-leverage risk, market risk or any risk, they don’t regulate for that and it’s pretty hard to. The only thing they can regulate for is, “Did you do all your disclosures right? Did you treat investors the same? Did you lie, cheat or steal?” Those things they are going to catch a lot of that. They are mitigating fraud risk pretty significantly.
The other risk is underestimated but to me, it’s more important. It’s market risk, the risk of the value of your investment dropping. Let’s say there’s a real estate crash. Is it riskier to own public company real estate in a public REIT or private REIT? The winner there is going to be private REITs. If you’re buying real estate, your $100,000 is about $5,000 worth of real estate. The market crashes that it’s going to crash way worse. If the market drops at 35%, you’re going to lose way more in a public market. The market risk far favors private REITs.
There are other kinds of risks like operational risk, geographic risk, macroeconomic risk and leverage risk. All those things are pretty much a tie on the other kinds of risk. You can have bad operators in public companies and private companies. You can have a geographic risk or macroeconomic risk and all of them. They are pretty the same. Overall, if you’re concerned about fraud risk, public companies are the way to go. If you’re concerned about market risk, private REITs are the way to go.
I would even say too on the fraud risk for private REITs is a lot of sponsors and especially the larger sponsors will receive audits from third-party CPA firms, which catches a lot of that and can definitely add some comfort level to the fraud risk.
This is the accountants going in, doing a deep dive and making sure that these numbers look right. It’s what an audit is saying and they are putting their name on it. They are going to catch a lot of that. Investors are maybe a little too cautious, especially with good mid-tier operators. If you have your brother-in-law running a deal, I’m not sure about that. There are a lot of mid-tier operators that do multiple of these kinds of deals. They are running millions of dollars in professional operating teams. These guys are not screwing up. If they are screwing up, it’s here or there and it’s not any worse than a public company screws up, which are plenty too. People overestimate the operational fraud risk.
I would even argue too. When investors invest in REITs, they don’t fully always know what they are investing in. It’s not always clear.
The book-to-value ratio is this case in point.
We have looked at hundreds, if not thousands, of these private equity deals. The reporting is good a lot of times. You see exactly what’s going on at a very granular level. In some ways, I feel like it’s much more clear. It lowers the risk because there’s more transparency.
If you try to read an annual report or quarterly report of a public company, it’s virtually impossible, even for professionals. On the other hand, truly, we didn’t put this in our report but private REITs are far more understandable in all the reporting. Here is the next one. It’s the biggie. It’s the returns, “Where are you going to make more money?” This is hands down the question people care about the most.
As we’re thinking about this, “Where do you make more money?” Let’s break it down into two components, yield and appreciation. Yield is what you’re going to get on a cashflow basis from real estate. Appreciation is what you’re going to make when that real estate is sold. Let’s look at the two of those. The first one is yield. As we pointed out in the value discussion, the values of public REITs are way worse. The bang for your buck is way worse.
Price and yield are inversely related. If the value of the price you’re paying is way high, your yields are going to be way low. If I paid $5,000 for a piece of real estate that’s earning $1,000 a year, it’s a great yield. If I paid $50,000 for that same piece of real estate that’s earning the same $1,000, it’s not a good yield. That’s the point here. Because public REITs are priced so high, their yields are much lower than private REITs. It’s common to see public REITs in a 3.5% dividend. You’re earning three and a half times.
In private REITs, it’s not uncommon to see yields approaching 10%. It’s quite a bit better. That makes sense. Yields are going to be a big win for private REITs. What about appreciation? Since public REITs are priced like stocks, it’s hard to determine that because if the stock market is frothy then you’re going to make a lot of money. If the stock market is not frothy, you’re not going to make money. Where private REITs appreciate is with the appreciation of real estate.
In fact, I looked over in the last twenty-year period. What turns out is they are not that dissimilar with appreciation. The public REITs grew about 15% per year. The private REITs, based on commercial real estate, averaged about 13% per year. They are both incredibly good, although I will point out that that’s been a bull market since 2009. You got to take that into account. Who knows if that’s going to be sustainable? You can’t say that’s going to be sustainable but because of the yield win, I’m going to have to give this to the private REITs. Volatility is the next one. This is a biggie. Volatility is something we have talked about quite a bit. Talk about volatility.
[bctt tweet=”Know what you’re buying. ” via=”no”]
When a REIT is publicly traded, it trades on the stock market and because of that, there is volatility. Depending on what the market sentiment is, how the economy is doing. Depending on the whims of emotions of some of the investors at that point, the price can change and sometimes very dramatically. One of the things that you don’t have in private REITs is much volatility because these are locked in.
These are investments you make one time and you usually hold it for 3 to 10 years. You can’t get in and out of them. There’s not a market sentiment driving the value of those. In public REITs, liquidity is a double-edged sword. The liquidity is great because if you have an emergency or whenever you need your cash, you can get it out.
If you want your liquidity at the same time when everybody else wants their liquidity, it’s not a pretty picture.
One of the things we had broken down in other articles before is that volatility is the ultimate killer of compounding over time. If you want to compound it, you have heard about the Eighth Wonder of the World, which is compound interest. Volatility will completely subvert your goal in attaining that because, every time you have a drawdown, you have to earn usually more than what your drawdown was to get back to par. As you keep having this volatility, which is the variance in price over time and how big is that variance, it gets very difficult. Even though an average return might be okay, your actual compounding and absolute return will be lower.
For instance, the public REIT EQR, which is an office real estate yielding 3.5% yields is not too exciting. Since 2000, I have looked at the drawdowns of 20% or more. This means where the stock price dropped by 20% or more. It’s seven times since the year 2000, including one time that you lost 45%. Meaning almost half of the value went down. If you’re $100,000, it went down to $55,000. In another time, it’s 68%. It’s where your $100,000 dropped to $32,000. How does that feel? In order to earn this 3.5% yield, you’re taking an enormous volatility risk. That’s a non-starter for me.
I can’t even bring myself to buy a public REIT because of the volatility risk. The public markets trade primarily on emotions. A lot of investors will tell you that public markets are traded on the information. In fact, it’s traded much more on emotion than the actual mathematics or information. We’re going to have to give this one, volatility, to private REITs because they are based on a non-volatile. Leverage is the next little component we’re going to use, which is how much debt you put on. Leverage is a double-edged sword. Leverage can boost your returns but it can also be dangerous. You can burn your house down.
I feel like this is one that, in my mind, should be one of the top things that we evaluate riskiness and quality on is how much leverage.
You underwrite a lot of deals as a banker and leverage is a very big deal. It’s something bankers pay a lot of attention to and investors should know as well.
A lot of retail investors don’t know how much it can impact, both positively and negatively, an investment. It’s important to look at what is the leverage that is driving the returns that you’re getting because if it’s 90% or 95% leverage, that’s extremely high.
You can choose your returns but if that thing goes against you, you’re White. Leverage in private REITs is typically what?
In private REITs, you’re going to see anything depending on the asset class 60% to 80% as a general rule.
I would say 2 to 1. It’s $2 of debt for every $1 of equity. That’s generally the range you’re going to see and sometimes they are 1 to 1. You’ll see $1 of debt for every $1 of equity and these are pretty safe. Meaning that if the value of that equity goes down, you’re not at risk of owing more than it’s worth. That means you can hopefully sustain that property through whatever this downturn is and not have to sell it out.
Public REITs are well-known to be much more highly leveraged. It’s not uncommon to see 10 to 1. Meaning they only have 10% equity and the rest is all debt. Because debt is so cheap to these public companies, they can leverage to the hilt. It’s not uncommon to be leveraged 5 to 1. For example, the apartment’s REIT that we looked at was a multiple of five times the book value. You’re paying five times the price of the real estate in order to buy a share of this apartment REIT. It’s also five times leverage. It’s super risky. Pay attention to the leverage. The winner is going to be private REITs.
The last category we want to look at is transparency. This is knowing what you’re buying. In public companies, it’s almost impossible to find out what actual homes or apartment complexes are owned. It’s very difficult. Sometimes there’s some little bit of data. You can figure that out but it’s generally not that easy to understand. There’s a little bit more transparency in private REITs. It’s easier to find the actual properties that you own but even there, it’s not as transparent as someone would like.
If you want to know what do I own exactly and I want to go visit it and knock on the doors and whatever then you want to do neither of these. You want to do private syndication, “Here’s the apartment complex.” For transparency, I would give a slight edge to private REITs but we’re going to call that a tie officially. The final thing to consider is your strategy, “What kind of assets are they typically on?” Talk through the REITs, which typically go after the Class A properties versus the private REITs.
Because public REITs are so large from a market capitalization standpoint, they are going after scale and that’s the appeal that they have. The way to scale is to go to class A because these are usually much bigger apartment complexes and they are much pricier. They cost more. The public REITs are generally buying Class A properties. We see some Class A offerings and think that there is some value that can be created there but generally, it is harder to move the needle in creating value in a Class A apartment building because these are newer construction.
A lot of times, they are coming in where they are bringing rents to market already. Another thing that you can do to drive value is you’re generally going to be paying a premium for Class A. You’re a part of that that does drive the return profile that you see in the public REITs. Whereas private REITs, private syndications and private funds, as we’re lumping these all together, generally focus more on the Class B and Class C properties. Usually, it’s older properties that are in good areas.
It may not sound as good but it can make more money. They have a greater ability to appreciate the value through value-added programs.
This is a general classification of what types of assets the REITs are buying. From a portfolio standpoint, as an investor, we think diversification is good. It’s good to have exposure to different asset classes but there are a lot of private REITs as well that do invest in Class A apartments and will have some advantages over a public REIT.
Let’s wrap it up. Our overall winner is?
The data is pretty clear. That’s why we’re seeing this huge movement of investors being excited and seeing what’s out there and what’s available to them in these private syndications, private funds and private REITs. We’re still at the beginning stages.
The private REITs are clear winners in several areas. The public REITs are clear winners in liquidity and ties in others. An objective observer needs to give the advantage to the private REITs, looking at things investors should be concerned about. It’s something that you want to be looking at in private real estate. Most people, once they start to get into private REITs, they don’t go back and no one does. No one is interested in that. Dip your toe in the public markets but the smart investors are going to end up in the private markets.
To those newer to the world of private equity, real estate investing and private REITs, you’re concerned about the fraud risks. There are some great episodes. We have done interviews with a few individuals, Lance Pederson and Jim Pfeifer, in previous episodes where they talked about how to do due diligence on these sponsors and what to look for and how to find the best-in-class operators.
There are a lot of great operators out there. When you find them, you know you’re going to have great results with these guys. Everybody makes mistakes but these are honest, hardworking and smart people. That’s where you’re going to end up going.
There’s a lot of information. Maybe your head is spinning a little bit in trying to remember some of the things we said. We’re going to have this where you can download it. You can share it with your friends and family. Hopefully, this will be a good useful tool as you’re evaluating your options. I hope this was helpful and cleared up some questions that you had. Thanks for joining us.
Important Links:
- Alternative Investment Continuum – Previous episode
- Lance Pederson – Previous episode
- Jim Pfeifer – Previous episode
