Two Ways to Invest in Commercial Real Estate: REIT and PRE

By Hightower Bethesda on October 29, 2021

Real estate investing can be an important addition to any investor’s toolkit. Rather than purchasing a property and renting it out yourself (an onerous process for many), real estate investment vehicles make it easier for investors to access the benefits of investing in real estate, without the burden of managing a property. Investors conceptually feel comfortable with tangible real estate because it’s something they can see, it generates income, and typically maintains some type of floor in terms of value.

Here, we’ll discuss two methods of passively investing in commercial real estate: Real Estate Investment Trusts (REITs) and Private Real Estate funds (PRE). A REIT is a type of company that owns and operates income-producing commercial real estate properties. A PRE fund is a broader category, covering any non-traded fund that invests in commercial real estate, and could focus on developing properties, renovating them for future sale, or producing income.

Commercial real estate, not to be confused with residential, includes underlying investments where costs are prohibitively high for most individual investors to obtain exposure. These types of commercial real estate investments include, but are not limited to, multi-family housing, office, retail, industrial, storage, medical office, senior and student housing and data centers. From an investment perspective, these investments look and behave differently than traditional residential real estate.

REITs and PRE funds are asset vehicles that allow an investor to purchases exposure to the potential income and profits generated by underlying real estate assets. Both REITS and PRE funds provide the same core advantage: adding real estate (a non-traditional asset) to a portfolio of traditional stocks and bonds to help diversify a portfolio, and thereby decrease overall volatility, if done correctly. Beyond these points, there are very few commonalities between the two asset types, and each comes with its own set of advantages and disadvantages outlined below.

REIT Advantages:

• Income: Because REITs are required by law to distribute 90% of their taxable income, these investments can provide an attractive income stream to the investor. For example, the FTSE Nareit All REITs Index, a broad US-based REIT index, is yielding 3.2%, which is about 2.5 times the dividend yield of the S&P 500 as of last quarter end.
• Liquidity: Because tradable (not all) REITs are listed on national public exchanges, they are fairly liquid, meaning investors can easily buy or sell these assets on any given trading day. This liquidity can be very important to those investors who might need quick access to cash.
o Private REITs tend to be less liquid, but still offer some level of liquidity. This might mean restrictions on how much an investor can sell or limiting sales to specific timeframes (typically once a month or quarter).
• Accessibility: Tradeable REITs typically (but not always) have relatively low minimum investment thresholds, and typically have no income requirements.

REIT Disadvantages:

• Correlation and Volatility: Though both provide some level of diversification, REITs are generally more correlated to the stock market than PREs. Because many REITs are traded on public national exchanges, they can be susceptible to the whims of the broader market. If, for example, a downturn in the broader market happens, REIT values may be dragged down as well, even if the underlying issue does not affect commercial real estate as much. Individual investors requesting their money back when the general economy is not as strong, may force the REIT to have to liquidate commercial real estate at an inopportune time, affecting returns adversely. As a result, REITs typically have higher volatility than PRE.
• Limited Growth Potential: Because REITs are required by law to distribute most of their income, the funds do not have the opportunity to reinvest those earnings in potentially lucrative investments. In some situations, this can limit long-term growth.

PRE Advantages:

• Greater Flexibility: Because PRE investments may have a broader investment mandate, they tend to have greater flexibility in their investment methods and goals. Rather than being restricted to mostly passive income producing properties like a REIT, PRE can more easily pursue new construction or renovation projects, that may not yield immediate income, but could result in future capital appreciation.
• Diversification Potential: Because PREs are not publicly traded, fund values tend to be less correlated with stock markets. If done correctly, holding less-correlated PRE assets can add diversity to a well-constructed portfolio and can lower the overall volatility of an investor’s holdings.
• Illiquidity: At Hightower Bethesda we believe the illiquid nature of PRE investments is a huge advantage for long term investment returns. Because the underlying commercial real estate investments do not have daily liquidity, they can only be sold solely at the managers discretion, thus reducing the risk of forced-selling that might afflict REITs (as discussed above).

PRE Disadvantages:

• Investment Restrictions: Because of their greater risk, PREs frequently have income or wealth thresholds for investors, and often have sizable minimum investment requirements. This limits the investment opportunity to higher net worth (or income) investors.
• Illiquidity: PREs are not publicly traded, and typically limited in their ability to buy and sell. In some cases, this means investors need to commit to fund the investment in a narrow time frame. This capital raising period can be as short as 3 months, particularly for funds that have investors eager to commit capital. However, the time to call the capital committed (when the investor actually sends money to the fund) can vary from 1 to 3 years for the PRE fund to be fully invested. Importantly, investors need to understand they should not anticipate selling for the life of the fund (which could be as long as 12 years) and these decisions are at the fund managers discretion.
• Due Diligence: Because PREs are less regulated, there is an increased due diligence burden. Before investing in a PRE, an investor will need to thoroughly understand the caliber of the management team, historical performance, and other risks. At the same time, because of greater flexibility in investment strategies, it is necessary for an investor to completely understand the goals and targets of the fund before investing. For example, it would be foolish for an investor seeking immediate income to invest in a PRE pursuing mostly development projects, where income would not be expected for years.

Which is Better?
The question remains: between REITs and PRE, which is better? As with most investment questions, the answer is not clear-cut. Both REITs and PRE can be useful additions to a portfolio. It ultimately comes down to the needs and goals of the investor. For those investors who do not meet the income/wealth thresholds of PRE or need to maintain more liquidity, REITs are probably better suited for their portfolio. However, for those investors who can bear the illiquidity and due diligence burdens, PRE can be a useful addition to a well-constructed portfolio and provide attractive long term returns and income.

We’ve highlighted the high-level differences but explaining all the nuances of each investment vehicle is difficult in a short-form blog. If you have any questions about real estate investing in general or specifics about the different flavors of vehicles, please reach out to your financial advisor, who can provide more insight and discuss the appropriateness of each investment.

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