Private REITs: Explained

Real Estate Investment Trusts (REITs) were created in 1960 as then President Dwight E. Eisenhower signed Public Law 86-779, which is also known as the Cigar Excise Tax Extension of 1960. The new law provided for REITs to own and finance real estate investments. Later, the Tax Reform Act of 1986 provided REITs with the ability to also manage and operate investment properties. Through the continued evolution of REIT legislation, alternative offering such as UPREITs ultimately came to the market. REITs own about $4.5 trillion of the approximately $14.4 trillion in U.S. commercial real estate or approximately 31 percent of all U.S. commercial real estate.

A REIT is a corporation that invests in real estate directly, either through properties or mortgages, and which is sold as a security. REITs typically raise $1 to $2 billion in capital and purchase a portfolio of properties over a period of several years, with the intention that these properties produce rental income and appreciation. The investment minimums for a REIT may be as low at $2,500 and as discussed later in the chapter they may have a lower accreditation standard for investors. The access to a numerous larger institutional property, lower investment minimums, and lower accreditation requirements make REITs an excellent option for portfolio allocation and building a well-diversified alternative real estate investment portfolio.

REITs are commonly offered privately to accredited or other suitable investors as part of their initial raise. In this phase, these REITs are essentially illiquid. Because of the risk of illiquidity, their smaller relative size, and the risks of investing in the early period of the life cycle of the REIT, private REITs have aggregate capitalization rates significantly higher than publicly traded REITs. This means that an investment in a private REIT can potentially realize significant appreciation simply by the process of becoming publicly traded.

Together with the positive characteristics of illiquid investments, this potential appreciation through transition to public trading is one of the most attractive features of private REITs. Commonly, the goal of these private REITs is to eventually be offered publicly through an initial public offering or to be purchased entirely by a larger REIT. These outcomes, however, cannot be predicted with certainty, and depend upon the performance of the properties in the REIT as well as trends in the real estate market as a whole.

A company must meet the following requirements to be qualified as a REIT:

1. Invest at least 75 percent of its total assets in real estate, cash, or U.S. Treasuries.
2. Receive a minimum of 75 percent of its gross income through rents from real property, interest on mortgages financing real property, or from sales of real estate.
3. Be an entity that is taxable as a corporation.
4. Be managed by a board of directors or trustees.
5. Have a minimum of 100 shareholders.
6. Have no more than 50 percent of its shares held by five or fewer individuals.

Equity REITs invest in and own real property and are measured by the equity or value of their real estate assets. Their revenues come principally from their properties’ rents. Mortgage REITs invest in and own property mortgages, loaning mortgage money to owners of real estate, or purchase existing mortgages or mortgage-backed securities. Their revenues are generated primarily by the interest earned on the mortgage loans. Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages. The advantages and disadvantages of mortgage-based REITs versus equity-based REITs are similar to those of debt-based versus equity-based securities. Mortgage REITs should be considered as more conservative in principle, while equity REITs have greater appreciation potential, albeit with greater risk. However, different from most equity-based securities, equity-based REITs have a strong cash flow component, often ranging from 5 percent to 6 percent of equity invested, usually distributed monthly.

REITS are an excellent way for investors to achieve tremendous diversification across the real estate market. Many REITs invest specifically in one area of real estate. For example, one REIT may concentrate investments in shopping malls, while another may concentrate investments in multifamily. Some REITs concentrate on a specific region, state, or country while others are more diversified. Most REITs raise in excess of a billion dollars of equity and may ultimately hold hundreds of properties. With minimum investments as low as $2,500, investors can easily invest in a cross section of REITs and achieve diversification across properties, asset classes, and geographic locations. Most individual REIT assets are institutional quality properties (like DST properties), professionally managed, often recently constructed in growing markets.

REITs can either be publicly traded or offered as private placement investments to accredited investors. Non-publicly traded REITs are illiquid investments with a typical projected hold period of 5 to 7 years, similar to DSTs, LPs, and LLCs. An illiquid investment is identified as a risk, because an investor is limited in their ability to access their equity prior to the conclusion of the investment. However, this same illiquidity is conversely a significant hedge against the very real risk of market volatility. Practically, this means that the performance of the non-market-correlated REIT depends more directly upon the performance of the assets held by the REIT than upon various market trends, most of which have little or nothing to do with the actual assets held. Private REITs include asset classes such as multifamily properties, single family homes (built to rent), NNN retail stores, industrial warehouses, student housing properties, and government leased properties.

While private REITs are basically illiquid, most have some element of liquidity in the form of limited redemption policies (typically 5 percent per year). While such a limited redemption policy can accommodate the occasional investor needing liquidity unrelated to the performance of the REIT itself, it is exhausted if many investors seek to exit the investment due to its performance. Therefore, it should not be relied upon as a sure liquidity option.

Dividend Reinvestment Program (DRIP) are a structural feature in most REITs that provides an investor an option to buy additional shares of the REIT with dividends rather than take the cash distributions. The DRIP share purchase is with no sales charge and can help the private investor grow equity over time. Some REITs also offer an investor the option of reinvesting dividends at a discount to current share price valuation known as net asset value (NAV).