How to choose between public and private REITs: IN ONE PICTURE

Readers of this space have been asking us for some time, “Should I invest in public REITs or private REITs?” As with most investing questions, there’s no one-size-fits-all answer.

So, we did a little research and found that a lot has already been said about this question, and yet the question has never been answered. Not clearly, at least. So, without making you wade through the rest of the text, here’s one graphic that will help you make a clear, rational choice:

As you can see, it’s not a single decision. It’s a cascade of decisions. Now let’s walk through them one at a time.

Do you make enough money?

If you’re reading this, you probably make enough money to qualify as an accredited investor. That is, you make $200,000 or more if you’re single, or $300,000 as a married couple filing jointly. You need at least two years’ history in that range, and this gives you clearance from the Securities and Exchange Commission to buy into opportunities that are not appropriate for most retail investors.

Do you have enough money?

Even if you don’t currently have that kind of reportable income, if your personal net worth – excluding the value of your primary residence – exceeds $1 million, you’re probably still an accredited investor.

Regulation D of the Securities Act of 1933 offers other ways besides income or wealth for an individual to qualify for this distinction but, if you meet these requirements, you’re probably rich anyway. One other criterion involves being an insider of the project seeking the funds, so you’d likely already be personally invested.

Note that the Reg D requirements are joined together by the conjunction “or,” not “and”. As long as you clear any of these hurdles, you’re an accredited investor. And you must be an accredited investor in order to invest in private REITs.

And the buy-ins for private REITs can be high. The Corporate Finance Institute reports minimum investments of up to $100,000 for private issues.

Do you prefer regulated markets?

You can’t be an investor without having at least a little bit of a libertarian streak. But you can’t be prosperous enough to consider private REITs without at least a little bit of motivation to preserve your wealth.

The reason why the SEC requires you to demonstrate wealth or financial sophistication before investing in private REITs is the risk. We’ll talk specifically about liquidity risk next, but all manner of things can go wrong with a big-money bet on real estate. Exposure to economic downturns, realty market crashes are all part of the game.

So are exposures to specific geographies, tenants and properties, but there’s not much to be done about those. This, though, is the biggest substantive difference between public and private REITs. Public ones will tend to diversify portfolios across geographies to tamp down exposure to any one property. Private ones tend to laser-focus on a single development or management opportunity, according to Dividend.com. Because they zoom in like that, private REITs tend to have higher risks associated with such concentration. But with greater risks come, one hopes, greater rewards. As of 2024, public REITs average around 4% dividend yields, while private REITs’ yields can be roughly double that, though potentially with higher risk and less liquidity.

What makes public REITs safer than private ones is that regulators mitigate risks associated with the trades to get in and out of the vehicle, as well as those associated with dodgy management. Regulated markets provide assurance that the transactions proceed smoothly, the custodian is responsible and that the issuer’s financial statements reflect economic reality.

Private REITs wouldn’t be breaking any federal law if they never sent out an audited financial statement, so investors in these organizations take a lot on faith.

Do you need instant liquidity?

If liquidity is an issue for you, a public REIT might be the better choice. Of course, if you’re living paycheck to paycheck, liquidity is a central concern. Still, even wealthy people need cash flow.

Your home is probably your most valuable asset, unless your net worth is truly stratospheric – and even then. It might be a smaller proportion of your net worth, but it’ll still be sizable. But you can’t tip the pizza guy with a shingle. You need some liquid holdings.

And you get that from your investment in securities. That’s why you’re in blue chips, indexes, emerging markets, Treasuries, corporate bonds and munis. If you’re using securities for liquidity, REITs might be the last industry-specific holding to add – and public REITs offer far more flexibility.

If you do want to invest in real estate securities, though, and want to stick to the more liquid end, then public REITs are where you might want to start your search. That’s because they’re exchange-traded, same as stocks. Private REITs, on the other hand, trade among a rarified few market players. If you don’t know someone who wants to buy a position, you might encounter difficulty selling yours. Transaction costs, then, will tend to be higher for private REITs because someone has to act as intermediary.

Moment-to-moment or even month-to-month gyrations of the stock market have little effect on private REITS, a benefit that some say offsets the liquidity risk. This is especially true for long-term, buy-and-hold investors who don’t mind lock-up periods which range from three to 10 years.

Do you need more shielding from taxes?

All REITs have some tax advantages. Dividends may, by default, be taxed at the ordinary rate, but can often be interpreted as business income, which provides a lower effective rate. Since REITs must distribute a minimum 90% of earnings to shareholders each year, this income can be substantial.

When you sell your stake, of course, you would incur either a capital gain or a capital loss. Losses can reduce your taxable income this year, and carry over into future years. Long-term capital gains get taxed at a rate far below that of ordinary income and, as regular readers of this space know, those incurred from real estate transactions can be deferred for a generation.

Private REITs, though, provide even more tax shielding. Depreciation of a private REIT’s properties – assuming that it’s incorporated as an LLC, as is standard – can be passed through to shareholders. They in turn can deduct that depreciation from their adjusted gross income.

At the close

The public and private REIT markets are each trillion-dollar industries, so perhaps the liquidity risk of the private ones might be a little overblown. Still, there are good reasons why only accredited investors can participate.

Before you decide on which sort of REIT is right for you, take a moment and go through the flowchart above. Still unsure which type of REIT fits your goals? Reach out to one of our investment professionals — we’d be happy to walk you through your options.

Disclosures

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Real Estate Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives including, among other things, profits, distributions, tax benefits, exit strategy, etc.; Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments; Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities; Potential for foreclosure – All financed real estate investments have potential for foreclosure; Illiquidity – These assets are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions; Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits; Stated tax benefits – Any stated tax benefits are not guaranteed and are subject to changes in the tax code. Speak to your tax professional prior to investing.

Securities are offered through Realta Equities, Inc., Member FINRA/SIPC and investment advisory services are offered through Realta Investment Advisors, Inc., co-located at 1201 N. Orange Street, Suite 729, Wilmington, DE 19801. Neither Realta Equities, Inc. nor Realta Investment Advisors, Inc. is affiliated with Perch Wealth.

Realta Wealth is the trade name for the Realta Wealth Companies. The Realta Wealth Companies are Realta Equities, Inc., Realta Investment Advisors, Inc., and Realta Insurance Services, which consist of several affiliated insurance agencies.

Why NOI isn’t the strongest metric for evaluating a REIT’s growth?

The majority of investors often look for investments that offer great benefits without much risk. Individual real estate investments do provide many benefits, but they also expose investors to great financial risks as well. However, a REIT or Real Estate Investment Trust allows investors to own large income-producing properties without the burden of owning or managing the properties. A Real Estate Investment Trust is a company that owns and in most cases, operates income-producing properties. Most REITs receive income in the form of rents by leasing spaces to tenants. A REIT can be divided into two categories –

Equity REITs – Equity REITs are responsible for purchasing, managing, renovating, and administering real estate properties. They lease out spaces to tenants and then receive income in the form of rents.
Mortgage REITs – Unlike Equity REITs, Mortgage REITs (mREITs) invest in mortgages and mortgage-backed securities. A mortgage REIT lends money to real estate developers and earns interests on the mortgages. The profit of a mortgaged REIT is the spread between the interest they earn on the mortgages and the cost of financing the loan.

How Equity and Mortgage REITs make money?

Let’s consider the equity REIT first. Suppose ‘APC’ is an equity REIT. APC owns a couple of large income-producing properties and puts them on lease. Now, the rent received by APC from the rented properties is the company’s profit.

Say PAC is a mortgage REIT. Suppose, PAC raises $10 million from its investors and borrows another $40 million at 2% annual interest. Now, the company invests $50 million in mortgages that pay 5% interest. In this case, the company’s annual interest expense is $0.8 million or 2% of $40 million. Whereas, its annual interest income will be $2.5 million, which is 5% of $50 million.

Therefore,

PAC’s net income = (annual interest income – annual interest expense)
= $(2.5-0.8) million = $1.7 million

How to evaluate a REIT’s growth?

Some investors often use net operating income as a metric to determine a REIT’s potential growth. However, since depreciation expenses are subtracted from net operating income, it isn’t a precise metric for evaluating a REIT’s growth. Qualified Investors use FFO (Funds From Operations) and AFFO (Adjusted Funds From Operations) for evaluating a REIT’s growth. FFO is calculated by adding depreciation expenses and subtracting any gain or loss from the sale of the property. Let’s consider an example.

Let’s assume a REIT’s net operating income in the year 2018 was $545,989 and the depreciation expense was $414,565. Whereas, the profit obtained from the sale of the property was $330,450.

FFO = (Net operating income + Depreciation expense – profit on property sale)
= $(545,989 + 414,565 – 330,450)
= $630,104

Now, the company will use this residual income to fund dividend payments. As per the rules, a REIT must distribute 90% of its income among its shareholders as dividends.

Undoubtedly, FFO is more precise metric than net operating income for evaluating a REIT’s growth. However, it doesn’t include capital expenditure, which is also important. Once the tenure of a lease ends and a REIT leases out the property to a new tenant, they need to carry out improvement works in the property. This increases the capital expenditure and the REIT can use a portion of its income for carrying out improvement works. Therefore, qualified investors prefer AFFO over FFO for evaluating a REIT’s growth. Though there is no particular method for calculating AFFO, investors calculate it by subtracting the capital expenditure from FFO. Let’s assume the capital expenditure in this case to be $160,212.

Adjusted Funds From Operation = (Funds From Operation – Capital Expenditure)
= $(630,104 – 160,212)
= $469,892 As you can see, AFFO gives a more precise value, and that’s why it’s used by experts for calculating a REIT’s growth over the years.

Innovative ways to plan a REIT Investment

A REIT generally has large investment properties in their portfolio. A REIT usually leases properties to tenants and earns income in the form of rent, which is then divided among its shareholders. In order to qualify as a REIT, a company must comply with the following rules –

The company must invest 75% of its assets in real estate, cash or treasuries.
It must receive 75% of its income from property rents, sale of its real estate or from the interest on the mortgages.
The company must distribute 90% of its income among its shareholders. The remaining 10% can be reinvested in new properties or assets.
A REIT must have at least 100 shareholders after one year of its existence.
Not more than 50% of the shares are owned by its five or fewer shareholders during the last half of the taxable year.
The company must be taxable as a corporation.
The company must be managed by a board of directors or trustees.

How a REIT generates revenue?

Most REITs lease properties to tenants and make money from the rents, which is then divided among the shareholders as dividends. The majority of REITs trade on the National Stock Exchange and can be easily bought or sold. On the other hand, some REITs lend money to investors and earn interests on the loan. As you can see, a REIT’s source of income varies depending upon the sector in which that particular REIT operates.

Varieties of REITs

Equity REIT – Equity REITs buy, own and sell investment properties. These REITs generate revenue through rents and not by selling real estate properties. They are publicly traded on the stock exchange.
Mortgage REIT – As the name suggests, Mortgage REITs lend money to investors and earn interests on the loan. They also borrow money at low-interest rates and then buy mortgages that could pay a higher return. The spread between the two interest rates is the REIT’s profit. For example, let’s say a REIT raises $20 million through its investors. It borrows another $50 million at an interest of 2% per annum or $1 million, which is the annual interest expense of borrowing. Now, it uses this $70 million for buying mortgages that pay 5% interest or $3.5 million, which is the annual interest income generated from the mortgage. The spread between these two interest rates will be the REIT’s profit, which in this case is –

Profit = (Annual interest income – annual interest expense)
=$(3.5-1) million
= $2.5 million.

Hybrid REIT – Hybrid REITs are the ones that own and lease investment properties as well as fund mortgage loans to real estate investors. Basically, it’s a mixture of Equity and Mortgage REITs.
Publicly Traded REITs – These REITs are listed with the Securities and Exchange Commission (SEC), and trade on the National Stock Exchange. The shares of these REITs can be easily bought and sold. These REITs are regulated by the U.S. Securities and Exchange Commission.
Publicly Non-Traded REITs – These REITs are also registered with Securities and Exchange Commission but don’t trade on the National Stock Exchange. They are more illiquid than publicly traded REITs but could be more stable, as they are not subject to market fluctuations.
Private REITs – These REITs are neither listed with the Securities and Exchange Commission nor do they trade on the National Stock Exchange. They are accessible to only a few selected investors.

The majority of REITs are equity REITs. However, trusts like mortgage REITs or publicly traded REITs also have their own benefits. Therefore, it’s important that you speak to an experienced REIT advisor, who can guide you through each of these REITs more deeply. We do have a team of highly qualified advisors for you. In no time, you could speak to up to three advisors.