What is the difference between a REIT vs. real estate fund?

In a previous article we discussed various types of funds that real estate investment firms could potentially employ. These were mutual funds, debt funds, private equity funds, and real estate investment trusts (REITs). In this article, we’re going to dig deeper on two of those funds: private equity and REITs. While mutual funds and debt funds both provide a mechanism to invest in real estate related assets, private equity (PE) funds and REITs allow for direct investment in real estate and also a path to scalability.

We’ll start off by briefly discussing the commonalities between PE funds and REITs and then move to some of the differences between them.

Commonalities between real estate private equity funds and real estate investment trusts (REITs)

Both PE funds and REITs provide an alternative way to invest in real estate. Rather than purchase and operate properties directly, investors can pool their money with other investors.

Once these funds have been pooled together, management teams with real estate expertise take an active role in deciding how and where to invest those funds in order to provide the investors with passive income.

Additionally, both types of funds can pursue similar real estate investment strategies, so the distinction between what a PE fund does and what a REIT does can sometimes be confusing. The differences between the two are often more about the legal and operational aspects of the businesses.

Characteristics of real estate private equity funds

Private equity funds, as opposed to publicly traded REITs, are only available to what the IRS calls “accredited” or high net worth investors. The United States Securities and Exchange Commission defines an accredited investor as one who has earned $200,000 or more for the past two years or who has a net worth of at least $1 million.

PE funds are less constrained by legal and tax requirements than REITs are, which gives PE funds much more flexibility in what they can invest in. While REITs generally invest in high-quality, income-producing real estate, PE funds can pursue new development, land, distressed properties, and other investments.

Because of this flexibility to pursue investments that sometimes require long periods of time before a profit is realized, it’s not uncommon for a majority of the investor return in a PE fund to come from capital gains following exits or other capital events.

Pros and cons of private equity funds

While PE funds have more flexibility to pursue investments that could provide a higher yield, they also often come with higher risks.

The higher risk could be attributed to the higher risk of the investment the firm makes or due to the illiquidity of PE fund investments.

Characteristics of real estate investment trusts (REITs)

The definition of a REIT by the Internal Revenue Service (IRS) is long, complex, and not very exciting to read, so we won’t go into every detail associated with obtaining and maintaining a status as a REIT. We will instead list some of the more high-level requirements that a firm must meet in order to be considered a REIT (the definitions below have sometimes been simplified greatly, so make sure you refer to the proper source for the full and complete definitions):

• Must be a corporation, trust, or association

• Must be managed by one or more trustees or directors

• Must have some type of transferable share held by 100 or more persons

• At least 95% of its gross income is derived from dividends, interest, rents from real property, and several other categories

• At least 75% of the value of total assets is represented by real estate assets, cash and cash items, and Government securities

Again, there are a lot of legal requirements to meet and maintain REIT status. The ones above are just some of those requirements. If you have any legal questions about what is or is not a REIT, you should refer to the IRS guidelines or contact an expert.

There are also several types of REITs: publicly traded, public non-traded, and private. Publicly traded REITs have their shares listed on an exchange and tend to much more liquid that non-traded or private REITs.

This means that smaller investors have better access to real estate investments through a REIT than with direct ownership or PE funds. Private REITs are usually sold only to private institutional investors and aren’t listed on any public exchange. One

of the benefits of a private REIT is that the value (shares) of the REIT is not as sensitive to changes in public markets. On the other hand, private REITs are sometimes more difficult to value and are much less liquid than publicly traded REITs.

Pros and cons of real estate investment trusts (REITs)

Like PE funds, REITs provide access to expert management teams that will invest funds for passive investors and liquid markets to trade shares of the REIT.

The tax structure of REITs can also be an advantage, providing regular income to investors due to the mandate that REITs must pay out at least 90% of their income in dividends.

On the other hand, the mandate that 90% of dividends be paid to investors can limit the growth potential of REITs and also means that those dividends are taxed as ordinary income.

Conclusion

Other methods, such as the Internal Rate of Return, are useful when the initial investment is known. The NPV, however, is an essential tool for helping investors determine how much to invest in a property when expected cash flows are more readily available.

Analysts should explore the certainty of both the property cash flows and market conditions to reach a higher level of confidence in the accuracy of the NPV analysis, while also indicating any risks to assumptions that could negatively impact the NPV of the property.