There are hundreds of types of investments to choose from. Some investors have specific preferences, while others look to build a carefully crafted portfolio of assets to take advantage of diversification and risk mitigation. This blog will discuss the more popular real estate investment vehicles used in portfolios and unique real estate opportunities. Continue Reading our Article the “Investing in REITS and Real Estate Syndications” and learn key facts about REIT and Real Estate Syndications and also the key differences between the two.
Contents
What is a REIT?
U.S. Congress created real estate investment trusts or the acronym “REIT” in 1960. The objective was to allow the small retail investors to invest in one of the most important assets class-Real estate.
Indeed, before the creation of REITs, most larger commercial and residential real estate investments were the territory of wealthy investors and institutions. While those folks still are important real estate investors, there are now over 145million REIT investors.[1]
There are hundreds of publicly traded REIT shares on most stock exchanges that offer a diversified range of real estate investments.
How Do REITs Work
Basically, REITs are companies that raise capital from the public to invest in large real estate related projects. By becoming a registered company with the SEC, these companies are allowed to offer shares to the general public.
Most REITs also manage the properties they own (or subcontract the day-to-day operations).
The REIT owns the assets, while REIT investors own shares in the company. Investors have no control over the assets, but investors have the opportunity to have an impressive total return
All REITs must pay shareholders 90% of pre-tax income in yearly dividends. In addition, the stock itself can appreciate (or depreciate) to provide a total return.
Indeed, total returns for exchange-traded U.S. equity REITs averaged 12.87 percent per year over the last forty years, and by comparison, the general population of stocks averaged 11.64 percent per year over that same period.[2]
Why Invest in REITs
Of course, as with any equity shares in the marketplace, there are no guarantees. In some ways, REITS are similar to bonds with the big exception that neither the coupon rate or return of the investment capital is guaranteed.
Still, because REIT dividend payments are usually well above bond rates and pay regular dividends, REITs are a popular vehicle for generating passive and regular income.
Chatham Partners found that 83% of financial advisors recommended REITs to their clients for retail investors. For portfolios of institutions such as banks and insurance companies are massive consumers of REITs, mainly for portfolio diversification and total return.
When designing a diversified portfolio, a key objective is to hold securities that are not too closely correlated so that they do not move lock-step to market volatility. REITs are not overly correlated to the general market movements.
Three Types of REITs: Equity REITs, Mortgage REITs, and Hybrid REITs
- Equity REITs invest in commercial properties and earn income from rent, property sales, and dividends.
- Mortgage REITs invest in mortgages and mortgage-backed securities (a type of asset secured by a mortgage or a collection of mortgages).
- Hybrid REITs are a combination of both other types.
Benefits of Owning REITs
- Professional Management: As REITs are companies dedicated to making successful investment decisions, the REIT management is actively engaged in the due diligence, selection, operation, and exit strategy for their portfolio of properties; they are supposedly professional money managers and excellent evaluators of real estate opportunities. That said, REIT shareholders pay a management fee for those attributes.
- Liquidity: REIT shares are highly liquid to buy or sell on the secondary markets. This allows average investors to invest in real estate, which is normally not a very liquid asset.
- Portfolio diversification: REITs usually own a stable of diversified and dispersed assets that help reduce risk.
- Steady Income: REITs are required to “pass-through” to investors 90% of their taxable income regularly.
- Transparency: REITs are regulated (by IRS) and audited on a regular basis and the results in published statements for public consumption. In addition, regulations restrict any potentially conflicting interests.
REITs Numbers[3]
Photo Credit: https://www.reit.com/data-research/data/reits-numbers
Housing Shortage
At this exact point in time, the cost of housing is soaring beyond most citizens’ ability to afford to purchase a home or even afford rent. Economists will tell you that it is due to a supply and demand imbalance, and this is nothing new.
Consider the fact that since the end of World War Two, housing construction starts has lagged the demand, and the situation is getting worse.
Consider that the “American Dream” is always centered around owning the most important asset-a home- and we are reaching a crisis point in affordability, and if anything is done about it with a sizeable scope, it will most likely be done through the use of REITs.
If this is true, it implies elevated REIT stocks in the future. Of course, there are no guarantees.
Real Estate Syndication
Before the creation of REITs by Congress in 1960, only the wealthy and institutions could participate in large and profitable real estate ventures through the model of pooling capital funds through the use of syndication.
What is Real Estate Syndication?
A real estate syndicate is when a group of investors pools together their capital to purchase a large real estate property jointly. Apartments, mobile home parks, land, self-storage units, and other real estate assets are some of the investment opportunities available through real estate syndications.[4]
A syndication is still a popular form of investing in mostly local markets. Typically, local investors see the need for developing their local communities….and make a profit in the process. A good return on rentals is about 8% per annum (called “cap rate”). However, that varies depending on many factors such as debt, depreciation, operating costs, etc.
For example, if a group of investors choose to self-finance a project (no mortgage), the returns can be much higher than leveraging debt. But returns on rentals are only part of the total return. As we know, in certain areas, properties have seen impressive valuation appreciation and create sizeable capital gains when the property is sold.
Compare that with a bond that pays regular interest but only returns the investment capital when the bond comes to term.
Well-located real estate can provide an extraordinary return on the initial investment to add to the income stream from rentals. Just recently, after the financial meltdown in 2008, real estate prices (residential and commercial) in most areas went into a deep dive, and mortgage lenders had to deeply discount properties they repossessed.
It was a real opportunity for real estate investors as a decade later, most real estate prices took off and remain high today. But with all investments, there are periods of volatility-both up and down.
However, given the continuing supply-demand imbalance and the need for affordable housing, the future for real estate investments may be reaching another bubble scenario. The demand is still there in spades, but affordability may be reaching a point of re-adjustment again. But who knows the future?
Access to Syndicates
In the case of REIT shares, anybody can afford most REIT shares and can purchase and sell those shares almost instantaneously. However, in the case of syndications, investors usually are invited to invest.
On a local level, banks and accountants have a good idea of who has the capital to invest and can play an important role in the formation of real estate syndication. However, there is a very big difference between a REIT and a syndicate: liquidity.
Investors can buy or sell their positions into the massive secondary securities markets with a REIT. Not so for members of most syndicates. It is not impossible to sell syndicate shares, but it usually takes an extended time to liquidate.
However, risk-reward can favor syndicate investing if the investors have no real need for liquidity. In fact, syndicates can provide a higher return on investment (ROI) but need to be held for extended periods of time. Anecdotally, syndications can produce about 5% higher ROI. But they lack the liquidity of REITs.
In fact, with both types of real estate investing, real estate should be considered as a long-term hold. The current popularity of short-term ‘flipping’ is a unique opportunity usually following a significant dip in real estate prices.
Today, however, skyrocketing construction costs make it harder to get a solid return on the flipping of renovated properties. But, as with all things investing, situations can and will change. It’s just a matter of time…and awareness.
Should you invest in a REIT or a Syndicate?
Investing and risk-reward depend primarily on the individual goals and financial situation. That said, there are some fundamental differences between investing in REITs and syndicates.
- Diversification: REITs typically buy a portfolio of properties, providing the risk mitigation of diversification of assets.
- Professional & Regulated Management: REITs are regulated investment companies. To be able to offer shares to the public, they are required to meet specific requirements that are aimed to protect the consumer. Audited financial reports and activity reporting help reduce mismanagement.
- Passive income: REITs own and operate their properties and are totally passive investors. On the other hand, syndicates are required to manage their properties, including active investor participation. Also, private syndicates are not required to have regular audited financial statements.
- Transparency: As noted, REITs are regulated and help provide a more credible level of information to investors. Also, if there are any suspected problems with a REIT, the Internal Revenue Service (IRS) is the regulator of REITs and can impose severe fines and legal action. Syndications by nature are less transparent.
- Ownership: Investors in syndicates actually own a portion of the asset. REIT investors only own shares of the REIT.
- Pricing: Shares of REITs are affordable for just about anyone. However, syndicates normally require significant capital investments.
- Access: REITs are available to the public for both buy and sell. Syndication investors are normally allowed to purchase by invitation of the organizer. Shares of REITs cost very little in comparison to Syndicate requirements.
- Liquidity: REITs can purchase or sell shares in the public markets with almost immediate execution. Syndicates do not have such liquidity. As a result, syndicates are much more of a longer-term hold investment.
- Taxation: Income from REITs is taxed as normal income. Syndicates have much more flexibility with taxation, such as the use of depreciation and operational expenses, which can have a positive impact on cashflows. As REITs are required to pass through 90% of pre-tax profits, those pre-tax profits can be affected by the efficiencies of REIT management.
- Hold Strategy: REITs and their liquidity offer investors more control as it regards to hold period. Typically, syndicate investing is for a long-term hold.
Both REITs and syndicates are important vehicles for investing in the multi-trillion-dollar U.S. real estate market.
“Little guy” real estate ownership strategy
With the increasing use of retirement plans for retirement planning, being able to own real estate in your IRA or 401K is becoming a popular vehicle for the long-term investment in real estate.
While you can’t invest in real estate directly through an employer-sponsored 401k, you can choose to roll a former employer’s 401k account into an individual retirement account or IRA.
While many IRA custodians don’t offer the ability to buy real estate, some offer an account type known as a self-directed IRA or Solo 401K
It is crucial to remember that there are some specific rules for owning real estate in retirement accounts. Failure to work within the rules can result in expensive fines and disqualification from tax deferment status.
Some basic rules to observe[5]
- You can’t mortgage the property.
- You can’t work on the property yourself—you must pay for an independent person to do any repairs.
- You don’t get the tax breaks if the property operates at a loss, nor can you claim depreciation.
- You must pay all costs associated with the property out of the IRA and deposit all rental or other related income into the IRA. If you don’t have enough cash in your IRA and if a major property expense comes up, that can put you in a bad situation.
- You cannot receive any personal benefit from the property—you can’t live in it or use it in any way. The real estate owned by your IRA must be strictly for investment purposes.
Custodians
As IRAs have unique tax benefits, an IRA must have a custodian who keeps track of and reports to the IRS on deposits, withdrawals, and year-end balances.
Many custodians will allow you to open what is called a “Self-directed IRA.” They charge an annual or quarterly fee to provide the necessary reporting. Many of these custodians provide literature and links to the IRS rules that apply, but most of them will not give you legal or tax advice, meaning that it’s up to you to make sure you are following the rules.
If you don’t follow the IRS rules, you are taking the risk that your entire IRA account will be considered taxable income.
Disclaimer: When investing in Real Estate or other investments, it is suggested there be some input from professional and certified investment knowledge considered before making any investment. Just internet due diligence is not sufficient.
Learn More
Mortgage Brokers vs. Loan Officers: What’s the Difference?
What Is Step-Up Basis? The Complete Guide (to Legal Loophole)
Tax Advantages of Rental Property
LLC for Rental Property in California
Sources
[1] https://www.cnbc.com/select/what-to-know-about-reits/
[2] [2] https://goodegginvestments.com/blog/reit-vs-syndication
[3] https://www.reit.com/data-research/data/reits-numbers
[4] [4] https://www.realtymogul.com/knowledge-center/article/real-estate-syndication
[5] https://www.thebalance.com/rules-of-buying-real-estate-in-an-ira-2388761
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