With real estate investing becoming more mainstream, some people are left wondering the difference between the many options before them. Should they invest in a real estate investment trust, a real estate fund, as a tenant-in-common, through a Delaware statutory trust, or through a real estate crowdfunding platform like Fundrise? All are co-investment opportunities, but each has its own nuances that may influence how any investor decides to proceed.
Five Common Real Estate Investment Options
In this article, we look at the difference between each of these passive real estate investment vehicles.
1. Real Estate Investment Trusts (REITs)
A REIT, which stands for “Real Estate Investment Trust,” is a corporation that owns and/or manages income-producing commercial real estate. There are many kinds of REITs. Some specialize in specific product types (e.g., multifamily, retail, hospitality, senior housing, self-storage, industrial, etc.) whereas others are more open-ended in terms of product type and instead focus on specific geographies (e.g., commercial real estate in the Southeast or Midwest).
When someone invests in a REIT, they are buying a share of the company that owns and manages the real estate. They are not purchasing an actual property or a share of an actual property. Buying a REIT is similar to buying stock in Apple, Philip Morris, or Berkshire Hathaway. When you invest in these stocks, you are investing in the company – not their specific products. The same concept applies to REITs.
REITs are a popular way of investing in commercial real estate, especially for those who have limited funds to invest. REITs have a low barrier to entry; someone can buy a single share for less than $100. The benefit to REIT investing is that these shares are highly liquid; REIT investments can be purchase and sold with the click of a button just as you would trade other stocks or bonds. The liquidity of REITs makes them particularly attractive for those who want to diversify their portfolios by investing in commercial real estate, but who cannot or do not want to have their capital tied up for extended periods of time.
Unlike traditional real estate, many REITs are publicly traded on the stock exchange. Publicly traded REITs must be registered with the SEC. Others are privately traded, in which case they do not need to be registered with the SEC. Typically, only institutional investors have access to privately traded REITs.
The biggest benefit to investing in a REIT is that it allows investors to preserve liquidity. Their REIT shares can be easily traded just as easily as other stocks, bonds and equities. Conversely, this means that REIT shares are more volatile. They experience ebbs and flows with the market, with shares fluctuating in value often on a day-to-day basis.
2. Real Estate Equity Funds
There are many types of investment funds, including mutual funds, money market funds, and hedge funds. Real estate funds are just another subset of investment funds in which the fund is focused exclusively on investing in income-generating property.
Real estate funds provide an alternative way for people to invest in commercial real estate. Real estate funds will pool capital that has been aggregated from multiple sources and investors. The fund will then invest that capital on behalf of investors depending on the fund’s predefined investment criteria. Like REITs, some funds will set investment parameters based on product type (e.g., multifamily, retail or office) whereas others will concentrate investments in a specific geographic area (e.g., Northeast or Southwest) regardless of product type.
Some real estate funds will also have a strict investment philosophy, such as value-add development or ground-up development. Other funds may be structured to buy-and-hold already stabilized assets.
Real estate funds are usually structured as either a limited liability corporation (LLC) or limited partnership (LP).
In either case, they are generally spearheaded by a sponsor who has years, if not decades, of experience in the real estate industry. The fund manager will analyze all investment opportunities, and then invest in select deals, based on the fund’s parameters, using the pooled capital.
Real estate equity funds are typically attractive to investors who want to be entirely hands-off, turning over all responsibilities to the sponsor. Fund investors should have a long-term mentality, as investments are illiquid and investors’ capital is usually tied up for several years (and if withdrawn early, will be subject to fees and penalties). Funds also tend to have a steep investment minimum, usually no lower than $50,000 to $100,000 and often much more.
In conventional LLC/LP offerings, the sale of a property or portfolio of properties does not allow passive investors to reap the same tax benefits they would if investing in a TIC or DST—namely, a 1031 exchange. The sale of the property triggers a taxable event, with investors on the hook for capital gains and depreciation recapture.
3. Tenants-in-Common (TICs)
Another way to invest in real estate is as a tenant-in-common, or TIC. With a TIC, each co-owner holds a proportionate share of the title to the property based on their total equity investment.
TICs are unique in that decisions, even the most mundane like with whom to refinance, require consent of all participating members. TICs are limited to 35 members (or “co-owners), and while that may seem like a small group, in practice, this can complicate decision making. It also means that investors are more hands on than investors in a REIT, fund or DST – investment vehicles that are more passive in nature.
In the early 2000s, the federal government announced that TIC investments may take advantage of 1031 exchanges. This caused a spike in TIC investments until the Great Recession hit in 2008. When real estate values plummeted, so did TIC popularity. Individual investors found themselves personally liable for the debt on the property (compared to a DST, in which the sponsor is solely liable for debt repayment). TIC investors often struggled to compromise on how best to proceed during the economic downturn, and as a result, many TICs did not make it through to the other side. Several of these properties were lost to foreclosure and investors lost their equity investments altogether.
TICs have shown their flaws, and in turn, have fallen out of favor among most investors. Instead, those looking to co-own real estate will usually invest in a DST instead.
4. Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust, or DST, is another structure often used by those wanting to co-invest in real estate. Most DST programs are sponsored by national real estate companies or are offered through third-party brokers and dealers. In either case, the DST sponsor uses their own capital to acquire the property(s) to be offered within the trust. The DST sponsor then makes the asset(s) available to investors on a fractional ownership basis, and collects a commission and/or annual management fee for overseeing the deal on behalf of investors.
Someone who invests in a DST secure direct beneficial ownership interest in the underlying asset(s), meaning they will list the property in Schedule E of their tax returns.
Because of this direct ownership interest, DST investors benefit from many of the same tax advantages that investors realize if buying property individually. This includes the mortgage interest deduction, depreciation recapture, and the ability to leverage 1031 exchanges. People can invest in and out of DSTs using a 1031 exchange, as long as the 1031 replacement property otherwise meets the IRS’s qualifying criteria. This is often cited as the primary draw to investing in a DST.
5. Crowdfunding Platforms
Crowdfunding has made a splash over the last several years, particularly since 2012 when the federal JOBS Act loosened the regulations for how people can raise capital for commercial real estate deals. Whereas project sponsors once needed to have a personal relationship with those who invested in their deals, now, sponsors could engage in what’s called “general solicitation”. This is what led to the emergence of real estate crowdfunding platforms like RealCrowd, Fundrise and RealtyMogul among others.
In short, real estate crowdfunding is when a project sponsor (usually a real estate corporation, LP or LLC) pools capital from many (dozens, if not hundreds of) investors to invest in their deals.
Crowdfunding platforms like Fundrise are really no different than the equity funds described above. The platforms are simply a tool for raising capital online, into a fund, instead of the sponsor having to host individual meetings to pitch to investors.
Conclusion
As you can see, there are many ways to co-invest in real estate. Each of these investment vehicles has its own pros and cons, including varying tax benefits. Anyone looking to invest in real estate should be sure to consult with their tax advisor first.
