Investors can use both private real estate funds and REITs as tools for diversifying a long-term investment portfolio. You can invest in real estate as a hedge against inflation and as a source of stable income. The factors dictating whether to invest in real estate via REITs or private real estate funds should be based on factors including liquidity needs, tax considerations, risk tolerance and investment time horizon.
Publicly traded REITs must meet requirements set forth by the exchange they trade on and must also make regular disclosures to the Securities and Exchange Commission. To qualify as an REIT, a long list of requirements must be met. REITs must distribute at least 90 percent of taxable income to shareholders, derive no less than 75 percent of gross income from real estate related sources and derive at least 95 percent of gross income from real estate sources along with dividends or interests from any source. Private real estate funds are not subject to these restrictions, but larger private real estate funds are subject to the Consumer Protection Act, stemming from the Dodd-Frank reforms of the late 2000s.
Investors prize liquidity for a wide variety of reasons, and publicly traded REITs are far more liquid than interests in most private real estate firms. Liquidity in private real estate firms is dictated by the operating agreement created to form the firm and often include onerous restrictions on transfers. REIT holdings can be bought and sold anytime on exchanges via broker-dealers, or they can be redeemed directly by the REIT. REITs must also have at least 100 shareholders, and no more than 50 percent of its shares can be held by five or fewer individuals, which increases liquidity by expanding the shareholder base. REITs pay a high level of distributions -- one of the most important factors offsetting the liquidity risk for investors. All this is contrary to the way private real estate firms operate.
Most of the larger private real estate funds have high standards for admission of new partners, typically including minimum net worth requirements and the ability to commit to making future capital contributions. These funds are generally the domain of institutional investors such as pension funds, endowments and other qualified investors. REITs have outperformed private real estate funds by nearly 5 percent during the past three decades through early 2013, but institutional investors still allocate approximately 80 percent of their real estate investments to private real estate funds. This is reportedly due to concerns over pricing and volatility. The minimum requirement for investing in an REIT is the price of one share.
Transparency in Disclosures
Both REITs and private real estate funds may hold a wide variety of investments, including mortgages, mortgage-backed securities and real estate equity. Publicly traded REITs and nontraded REITs must both make regular disclosures to the SEC, including quarterly and annual financial statements. Private real estate funds generally disclose annual results to partners and are not required to fully disclose all operating results. REITs are formed as “regular” C corporations, while private funds are set up as partnerships and limited liability companies. Share value transparency is higher with REITs, because the market prices them daily, which is not the case with private funds. Private funds are also more likely to invest in more illiquid real estate investments because they're not required to distribute such a high percentage of their income.
- Securities and Exchange Commission: Real Estate Investment Trusts (REITs)
- Securities and Exchange Commission: Investor Bulletin -- Real Estate Investment Trusts (REITs)
- Investment Law Group of Davis, Gillett, Mottern & Sims, LLC: Structuring Private Real Estate Funds
- Institutional Investor: Despite REITs' Virtues, Institutions Still Favor Private Real Estate Funds