Many investors are discovering the benefits of diversifying their portfolios by investing in real estate assets. As a result, real estate has all but secured its reputation as the fourth main asset behind cash, stocks, and bonds. However, investors must understand the differences between direct and indirect (or REIT) investing strategies, including the risks and potential returns.
Real Estate Investing Options
There are essentially only a few ways to invest privately in real estate: buying directly, buying indirectly, investing with professional partners in individual projects, or investing via a fund. It is the risk-return profile of the four options that differentiates them. The highest risk profile is in direct ownership. When directly buying a specific property, the investor dedicates their own time and money to the transaction, providing the advantage of direct control over all aspects of the project. If the property does well, the investor can make great returns; however, if there is a downturn, it can mean exposure to the brunt of any losses.
Direct purchase investors are also limited with regard to the size of a transaction—by the amount of their down payment, as well as the amount a bank will lend to them. This limits them to the smaller end of the investment spectrum, where a high number of individual buyers congregate—and where pricing is often driven up accordingly. Further, recognizing that this is the highest risk segment of the market, banks will typically require personal guarantees from borrowers. They factor in an investor’s personal net worth in maximizing the loan they will provide and, in a severe downturn, will pursue losses through the guarantees. The biggest advantage of investing in smaller buildings, the so-called ‘mom-and-pop’ size, is that it provides investors with control over their investment—especially when they take a hands-on approach to the day-to-day management of assisting residents and attending to maintenance issues. For investors who are comfortable with the risk-return profile of direct ownership, this can be a popular choice.
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Direct Real Estate Investments vs. Indirect (REITs)
Direct real estate investing is when an investor purchases a stake in a specific property. In equity investing, this means obtaining an ownership interest in an organization that owns real estate assets like a shopping center, office building, apartment community, etc. In debt investing, it refers to capitalizing on a loan that’s collateralized by real estate, like an existing property or land.
Indirect real estate investing involves purchasing shares in either a fund or a privately or publicly held company. A common first step for investors is to buy shares of real estate investment trust (REIT) stocks. REITs own and manage a portfolio of real estate properties. When it comes to investing in REITs, you’re investing in a landlord’s operating profitability more so than the underlying assets themselves.
Partnering With a Developer
Another option for investors is to invest as a partner with a seasoned real estate professional, a ‘sponsor.’ This downshifts the investment risk profile at the expense of limiting investor control over the daily management of a project. To compensate the investor for their diminished control over how a project is managed, a sponsor will aggregate investor capital and is thus able to handle significantly larger transactions that are less vulnerable to market downturns through their economies of scale.
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The budgets available to sponsors also allow them to employ other specialized professionals to handle individual aspects of the project. This might include everything from general maintenance of a property to renovation and restoration work. In this case, the investment company manager handles all aspects of the transaction, from identifying opportunities to acquisition—including signing on the debt—to responsibility for the day-to-day management of tenants, leases, and maintenance.
Typically, in this investing, investors pay the manager fees for their services and—while accepting no liability for repayment of debt—splits any upside. They do, however, remain exposed to the risk of having capital invested in a single asset. Thus, to de-risk even further, the option to invest in a fund presents itself as the next rung on the risk-return ladder.
Real Estate Funds
A well-structured fund gives investors all the upside of investing in a specific deal, and it mitigates risk. Since funds invest in multiple properties, investors’ capital is spread over several properties that share the same characteristics. As a result, typical funds will be particular concerning the kind of transaction it will invest in—defining asset class, geographic locations, demographics, and a raft of financial criteria.
Therefore, diversification within an asset class uncouples investor capital from exposure to fluctuations within individual locations and property variations. Besides having multiple properties in multiple locations, one of the major benefits that help protect investors from the risks associated with a downturn is in the way the relationship with the fund manager is structured. When investing in individual projects, apart from receiving a preferred return on their equity, investors also incentivize the manager with a bonus share of the profits, known as the ‘promote.’
When a project goes well, the manager will receive this incentive bonus. If the property does not perform well and the sponsor does not receive their promote, investors can at best expect only to receive a proportion of the preferred return they were offered, and at worst, lose part or all of their invested capital.
Related: Real Estate Funds vs. REITs
For example, let’s say you want to invest directly in five individual transactions, spreading a $250,000 investment equally across the properties with $50,000 each. Four of the properties do well, and the fifth—for whatever reason—doesn’t do well. In this scenario, because all investments are tied separately to individual properties, any profit or loss at the property level falls directly back on the investor.
In a fund structure, however, investor risk of loss is reduced because the fund itself takes a piece of the profits, and that is used to offset losses the investors would otherwise bear. It works like this: a well-structured fund will ensure that the profits from the properties that do well are used to cover losses to the investor for the deal that went bad. This is called the cross-promote because the profits benefiting the fund managers are crossed over a pool of properties as opposed to being tied to one property.
This offers investors an additional layer of downside protection that investing in an individual property, either directly or with a sponsor, would not allow. If you are an investor, especially with a larger amount to invest, there are many benefits to investing in a fund, allowing, as it does for a diverse real estate portfolio, lower risk, and downside protection.
Direct and Indirect Real Estate Investing: Understanding Liquidity
Another aspect of direct real estate investing vs. REITs is understanding liquidity. Investing in REITs gives investors the option to easily buy and sell shares whenever they wish. However, direct real estate investing traditionally involves holding the assets for a period of time after the purchase. The longer-term nature of investing in real estate can produce benefits like delivering a steady flow of cash, but it comes with less daily liquidity compared to publicly traded REITs.
Many debt investing offerings will include fixed terms from 12-18 months, while most equity offerings will have targeted terms of 3-7 years.
Looking for more real estate investing advice? Reach out to the investing experts at Trion Properties today!