Crowdfunding vs. REITs for Real Estate Diversification

The recent trend toward online “crowdfunding” has begun to make some private real estate investment opportunities more accessible to investors, at relatively small minimum investment amounts. Diversification remains a …

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The recent trend toward online “crowdfunding” has begun to make some private real estate investment opportunities more accessible to investors, at relatively small minimum investment amounts. Diversification remains a key concern, however, and the real estate investment trusts (REITs) that would seem to solve that problem for “average” investors continue to be given short shrift by the larger financial institutions. What gives?

REITs operate pools of many different properties and their shares offer at least a degree of liquidity. Yet recent surveys estimate that institutional investors continue to place between 80% to 95% of their real estate allocations into private real estate investments, rather than publicly traded REITs.  Crowdfunding sites tend to similarly focus on private opportunities.

Many market participants insist that there are simply some things that private real estate investments can do better than public REITs. Some of these purported advantages are:

  • Public REITs are driven partly by underlying market sentiment, rather than real values
  • REITS are limited by asset class or geography; but cycles don’t always track either of those groups, so private opportunistic buying makes more sense
  • Private equity is better managed and investor-aligned because sponsors are highly invested, and so focused on achieving high returns
  • Private equity is disciplined by its focus on achieving a successful exit
  • The liquidity of public REITs is illusory (only the biggest REITs are liquid)
  • Private equity can be nimble, with more ability to buy at the bottom of the market and sell at the top
  • Private transactions use a bit more leverage, so should be able to outperform public funds

It seems that part of the issue with REITs lies with their essential nature. Basically a creation of the Internal Revenue Code, a REIT is a real estate company or trust that has elected to qualify under certain tax provisions to become a pass-through entity that distributes to its shareholders substantially all of its taxable earnings, in addition to any capital gains generated from the sale or disposition of its properties. To qualify for this tax treatment, a REIT must follow several legal requirements, probably the most significant of which is that distributions to shareholders must equal or exceed 90% of the REIT’s taxable income.

This requirement would seem to be beneficial to investors, but it can prove to be a handicap. Because they must distribute nearly all of their income, both mortgage and property REITs must regularly sell equity in order to grow, i.e. acquire more assets. Institutional investors holding REIT shares are continually being approached to increase their existing positions, a circumstance that can worsen liquidity issues at smaller REITs whose shares are already largely held by just a few institutional holders.

Refinancing risk includes not only the risk associated with the cost of debt, but also that relating to the availability of capital. In 2008, the subprime mortgage crisis resulted in a very severe credit crunch in which many REITs were unable to refinance corporate or property-level debt when it came due, regardless of operating performance. The focus of discussion became “survivability,” and there was a massive sell-off in REIT shares. One very high-profile REIT, General Growth Properties — which had been one of the largest REITs in existence — sought bankruptcy protection.

REITs also face other issues that tend to reduce their attractiveness to some investors. They tend to focus only on the highest “Class A” assets, and are often unable to take advantage of “core-plus” or “value-added” properties needing some remodeling or more extensive renovation to get their cash flows up to desired levels — but which also offer greater potential returns. Another drawback is that the value of REIT shares can fluctuate constantly, just like any other stock. If one purpose of real estate is to provide true asset class diversification, some people argue that REITs fail that test simply by being publicly traded. Private real estate investments are somewhat insulated from — or at least not closely correlated with – the equity markets. 

The debate over whether private real estate investments or publicly-traded REITs are better overall investments will surely rage for some time. REITs suffered greatly during the recent recession but have come back strongly recently, with many institutional investors taking a greater stake in them than in earlier years. Nevertheless, most large institutions – and crowdfunding sites – remain focused on private investments, for reasons of reduced volatility, exposure to a broader range of opportunities, and true asset class diversification.

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