Investing isn't a one-man show; from deal sponsors, passive investors, and general partners - several people work in cohesion to make an investment possible. Amongst the lot, we also have different investment 'vehicles'.
If you're one to invest in real estate, you're probably familiar with just how high commercial real estate can be valued. This might deter even the richest of investors. However, private investment vehicles; Real Estate Investment Trusts (REITs) and private equity real estate funds can help in securing the initial capital for the investment.
Real estate investing is taking off and investors are turning to private non-traded REITs and private equity real estate funds to avoid the hassle of managing the property on their own. The truth is, they offer a lot of incentives that make them desirable, such as; increased risk-adjustment, tax benefits, lucrative incomes, and a more diverse investment portfolio.
However, there are stark differences between the two in terms of dynamics and management. Which eventually plays a major influence in the investor’s cash on cash returns - the reason you’re investing in the first place.
Which Costs More?
At a glance, non-traded REITs and private equity real estate funds are valued at or about the same. However, a non-traded REIT costs more than a private equity real estate fund when it comes to fees. How? There are sales commissions, broker-dealer management fees, and organizational expenses that take 10-15% off of their value.
According to estimates, private REITs regain only a fifth of the initial capital. Investors are often misled by non-traded REITs that list offering prices at probable costs provided that shares are being sold. To put it simply, the offering price is listed as an estimate from a previous investment. The estimation is based on shares being sold against that investment.
Private equity real estate, on the other hand, has a more stable and predictable fee structure by eliminating unnecessary operator fees. The fund acts as the operator and invests at the investor's discretion.
Avoiding Mismanagement Risks:
The Financial Industry Regulatory Authority (FINRA) now requires private REITs to provide statements to investors of updated share estimates. This helps investors in determining the actual cost of the offering minus the fee. However, private REITs are not under obligation to provide immediate estimates so long as they’re relevant to present circumstances.
FINRA might be the regulating body for both private REITs and equity funds, but it has little to no impact on their operations. The market is an ever-changing entity, and ROI’s are subjected to several factors. REITs and private equity funds can only make calculated guesses at best.
However, private REITs have a very narrow window between when you place an investment and investing. They may offer listings for a diverse pool of properties, but they do not invest in those properties until you've sent them the amount for the investment.
The narrower window creates a larger margin for error with less risk assessment. On the other hand, private equity funds call on investors to invest only after they've procured properties to be invested in. Hence, they've done their due diligence and there's little margin for error.
Where Is Your Capital More Secure?
REITs attract investors with a higher dividend yield. They're also under regulation to pay 90% of their earnings in distributions to investors. However, this may not be in every investor's best interest.
Let’s elaborate on this:
Their higher dividend yield requires REITs to begin distributions earlier on. This may or may not be yield from the property since the CoC or ROIs aren’t reasonably going to be coming in this early on. Thus, REITs begin distributions from other investor’s capital.
The returns you're receiving might not be from the rental income or the property value, but another investor. Hence, your actual share might be diminishing in value.
FINRA passed a rule in 2016 that required non-traded REITs to be more upfront in their operations. As per the regulation, statements begin with the following:
"IMPORTANT — Part of your distribution includes a return of capital. Any distribution that represents a return of capital reduces the estimated per-share value shown on your account statement."
Private equity funds might not seem as attractive with their more far-out dividends, but the patience pays off when investors are paid their profits before the ROI rolls in. Private equity funds have a more strategic plan in place that maximizes growth potential and brings investors better returns against fewer risks.
What About Returns?
Both REIT's and PE Funds provide an investor a passive income from real estate. However, the truth is that the returns you’re receiving in private REIT’s are often not against the property’s share, but against what they were regulated to pay out in dividends.
Your property might be under-performing in the market and the private REIT’s will be keeping that from you by providing returns as promised. How? The REIT’s are waiving off your balance with another investor’s capital.
Is this similar to a Ponzi scheme? Yes. However, this is legal. FINRA might have regulated operations and demanded more transparency from private REIT's, but besides an overhead forewarning in each statement, the practice continues.
Private equity funds are therefore much more stable. Not only are the investments well-researched and returns are calculated, but they wouldn’t be hiding the properties market growth from you.
Over the last 25 years, private REITs have amassed over $160 billion in investments, but the numbers might be $50 billion more than expected. FINRA and SEC might be working on ways to regulate their operations and provide more transparency, but little has changed in how they work.
On the bright side, this investment vehicle has raised only 4.5 billion in 2016 compared to $20 billion in 2013.
Private equity funds are therefore seen as the better option when choosing investment vehicles. The primary reason why an investment vehicle is even considered is to avoid the hassle of managing a property, something REITs take advantage of.
With private equity funds, your investments are secure and returns are valued against the actual properties.