Publicly Traded REITs vs. Private Real Estate Investments
Both publicly traded REITs and private real estate offerings can present valuable opportunities for an investor looking for real estate exposure. A logical question a client may ask is "what's the difference between investing in REITs and direct real estate"? There are key differences and portfolio implications that should be understood. Here are the top three:
Liquidity.
Of course the most obvious point of difference is liquidity. REITs are securitized, indirect investments in real estate and as such offer public market liquidity. Direct investment, on the other hand, is illiquid with limited options to sell an interest until the underlying property(ies) are sold. The time frame of the illiquid direct investment depends on the strategy employed.
Illiquidity, however, comes with some benefits. To illustrate: a scary thought is if it's possible to sin in Heaven and get kicked out! Eternity is a long time and even if there's a .05% chance of it happening in any year, that means there's a 39% change of it happening in the first 1,000 years, a 92% you'd be gone within 5,000 years, and the odds keep getting worse as more time passes.
Seemingly a silly analogy, this line of thinking is very relevant to public markets. The point being that given enough opportunities to do something dumb, whether its the antsy investor watching minute-by-minute quotes or the tempted heavenly citizen, people will. For direct, private investments, however, once investors own a property, they're not bombarded with daily quotes to sell. This is especially helpful for investors in times when prices are down despite fundamental earning power remaining unchanged or even improving. Despite not having daily liquidity in private investments, we are not, however, precluded from entertaining an excitable buyer who may knock on our door and offer us more than the value we assign to a property.
Diversification.
Since strategic asset allocation is built up by asset class, the decision about how to define those asset classes is an important one. Defining the asset classes also determines the extent to which the investor controls the risk and return characteristics of the eventual investment portfolio.
A well constructed portfolio will offer strategic allocations to distinct assets classes. Asset class definitions follow several criteria with perhaps the most important being correlations. A group of assets are distinct (a separate class) when their correlations with other asset types are substantially lower than those among its own grouping.
When an investor purchases a share in a private real estate fund, they are clearly gaining exposure to real estate. However, when an investor purchases a publicly traded REIT they are gaining, in addition to real estate, equity market exposure to an extent that at times can swamp fundamental real estate exposure. When real estate is publicly traded, it tends to behave more like the rest of the stock market than the real estate market.
The correlation between equity REITs and the stock market has been climbing over the last 30 years.[1] This reality violates the basic test of a distinct asset class. Numerous studies have been performed on what diversification benefits exist among the stock market, publicly traded REITs, and direct real estate. The general consensus is that 1) private real estate provides superior diversification to the stock market relative to REITs; and 2) for the small investor with limited capital, REITs still offer diversification benefits, although less effectively.
Taxes.
Both publicly traded REITs and direct real estate investment produce income, however, that income is taxed differently. A separate essay will dig deeper into tax considerations between REITs and direct real estate and help inform you of the differences.
REITs and direct real estate investment are not mutually exclusive, portfolios will likely benefit from both REITs and private real estate which can be used to complement each other. One example of this is hedging. An investor with long exposure to a certain type of real estate through private, direct investments can utilize public markets to craft a hedge via a short position in a REIT.
Ripe Assets, LLC works with individual investors and RIA's to make private, direct real estate investments available to their clients.
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1. http://scholars.unh.edu/cgi/viewcontent.cgi?article=1186&context=honors
