Which are the Better Investment -- REITs or Private Real Estate Funds?

The alto member of the string family, the viola, looks a lot like a violin, its soprano counterpart. Non-string players may be unable to see the difference between a violin and a viola. But violas aren’t just bigger violins.

Full-size violas are typically around 16 inches long compared to the typical 14-inch length of a full-size violin. But violas can also be smaller or larger – as long as 18 inches. Violas also are thicker than violins, which contributes to the viola’s lower pitch and deeper tone. Viola bows also are longer and heavier than violin bows.

Violas also are a perfect fifth lower in pitch than violins. The highest string on a viola, the A string, is the pitch as a violin A string, which is the second highest string on the violin.

Viola music also is written on a different clef than the violin. Violins use the Treble Clef or G Clef, while violas use the Alto Clef, which is a C Clef. The viola and the rarely seen alto trombone are the only instruments that use alto clef.

Among real estate investments, real estate investment trusts (REITs) and real estate funds may look similar to the casual observer. However, although both focus on real estate and real estate-related assets, their structures, accessibility, liquidity, return potential, and risk profiles can differ significantly.

What Are REITs?

A REIT is a legal entity that owns, operates, or finances investment real estate. Modeled after mutual funds, REITs enable individuals to own fractional interests in commercial real estate portfolios.

REITs differ from other real estate investments in that they must strictly comply with specific tax laws. REITs must derive 75% of their income from real estate investment, cash, or government securities. However, REITs may invest in many types of real estate assets, including real estate, real estate securities, leases, and real estate-related businesses such as senior housing. Some REITs engage in real estate development.

Also, REITs must distribute at least 90% of their taxable income to shareholders annually as dividends. So, REIT investors usually can expect a steady income stream.

REITs usually have no stated end date. Rather when they sell an asset, they buy another one to replace it. Therefore, REITs can be considered a perpetual investment for some investors.

REITs can be publicly traded, like mutual funds, or sold privately. Generally, anyone who can invest the minimum investment amount may purchase an interest in a public REIT. However, private REITs frequently are sold only to high-income or high-net-worth accredited investors.

What Are Real Estate Funds?

Like REITs, real estate funds are pooled investment vehicles that enable investors to purchase fractional interests in commercial real estate. Real estate funds traditionally were limited partnerships but now usually are limited liability companies (LLCs).

Although real estate funds might be structured to take advantage of tax benefits, there are not subject to any specific tax laws. Nor are there legal restrictions on what type of assets real estate funds may own or when distributions must be made. However, real estate funds might be subject to investment limitations in their LLC operating agreement (OA).

Most real estate funds aren't structured to provide a significant income stream. Instead, they focus on developing or acquiring real estate, holding it for 7-10 years, and selling it at a profit.

Real estate funds usually are not publicly traded. Like private REITs, they are sold under private placement exemptions from securities laws and, therefore, generally are available only to accredited investors.

 Comparing REITs and Private Real Estate Funds

Assets Owned

REITs must derive 75% of their income from real estate, cash, or government securities.

Real estate funds may invest in any assets permitted by the LLC OA.

Investor Distributions

REITs must distribute at least 90% of their taxable income to shareholders as dividends.

Real estate fund distributions are governed by the OA, rather than tax law. Funds frequently make most or all of their distributions after a real estate investment is sold.

Income Tax

REITs rarely pay tax at the trust level. REIT investors pay taxes on the distributions they receive.

Real estate funds also rarely pay tax at the fund level. However, funds are pass-through entities (partnerships) for income tax purposes. Therefore, fund investors must report fund income on their tax return and pay taxes on that income even if they receive no distributions from the fund. Although fund investors can experience “phantom income” (income they do not receive), usually, funds are structured to provide sufficient depreciation deductions, so investors owe little or no tax on that phantom income.

Both REITs and real estate fund income may consist of cash flow taxed at ordinary income rates, gains on the sale of assets taxed at capital gains rates, or return of capital, which is not subject to taxation.

Liquidity

REITs that are publicly traded provide liquidity for their investors, but private REITs are considered illiquid.

Real estate funds usually are private placements and are illiquid.

Investment Returns

REITs generally must distribute 90% of their income to investors.

Real estate funds may reinvest income, so there is the potential for a larger return on a fund investment than a REIT. However, with that potential comes additional risk.

How Investments Are Sold

Both REITs and real estate funds are considered securities under federal securities laws.

Public REITs are available to all investors with the financial wherewithal to invest the minimum amount established by the REIT. Public REITs will have filed a registration statement with the Securities and Exchange Commission (SEC) and qualified with state securities commissions.

Private REITs and real estate funds both usually are sold pursuant to a private placement exemption from registration with the SEC and do not qualify with state securities commissions. Private REITs and real estate funds usually may only be purchased by accredited investors (with an annual income over $200,000 or $300,000 with a spouse or net worth of $1,000,000 with their spouse)

Conclusion

Both REITs and real estate funds offer investors the opportunity to diversify their investment portfolios with investments in commercial real estate. However, REITs are more likely to provide a steady income stream than private real estate funds, which often are focused on capital appreciation. REITs also tend to be open-ended, whereas real estate funds often have a seven to ten-year duration and may be riskier investments than REITs.

When deciding whether to invest in a REIT or a real estate fund investors should consider their personal financial goals, risk tolerance, and investment horizon. Investors who aren’t accredited may have no option but to invest in REITs since they often aren’t permitted to invest in private REITs or real estate funds.

REITs and real estate funds may present different investment strategies and goals, tax consequences, and risk profiles, so investors have the opportunity to select which option best meets their needs. However, all investors should carefully review the securities offering documents and consult with their financial and tax advisors before investing.

© 2023 by Elizabeth A. Whitman

Any references to clients and their legal situations have been modified to protect client confidentiality.

DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless a written contract is entered into.