Real estate investing is a popular wealth-generating strategy. Investors can capitalize on price appreciation and cash flow. While you can buy properties, taking the helm can lead to financial stress. You may have to put all of your savings into the down payment, and expanding your portfolio can get difficult. Diversifying and capitalizing on new opportunities is harder when you invest by yourself. Property management will also take up more time, and any legal battles can devastate your finances early in your real estate career. Some people incur these risks because historical real estate returns are too much to ignore.
REITs and real estate funds make it easier for anyone to enter real estate. These assets provide real estate diversification without any work on your end. These choices turn you into a passive investor. You don’t have to worry about property management, filling up units, finding great deals, or hiring a construction team. While REITs and real estate funds offer great advantages, every investor has finite funds. So where should your money go? We will cover key details to know about real estate funds and REITs.
What are REITs?
REITs are real estate investment trusts that use their funds to buy real estate. These funds trade on stock exchanges and typically offer high dividends. Instead of investing in a single property, REITs give you small ownership of many properties. You won’t have much say about what happens to these properties, but you will get a percentage of the cash flow and appreciation based on how many shares you own.
REITs give you exposure to several real estate assets. For example, you can buy REITs that focus on residential assets such as single-family homes and apartment complexes or REITs that focus on commercial or industrial properties. This range lets you profit from properties that are very difficult to acquire on your own.
REITs must distribute at least 90% of their taxable income to shareholders. This structure helps shareholders receive a higher percentage of the cash flow as if they owned the real estate. These companies generate at least 95% of their income passively and have real estate as at least 75% of their holdings.
What are Real Estate Funds?
Real estate funds are similar to REITs and mutual funds. These funds also have parameters they use to find optimal investments. Some real estate funds invest in existing properties, while others buy land and build assets from the ground up.
A sponsor will assemble investors and combine their capital to acquire a property. The sponsor typically has many years of experience, making it easier for them to detect compelling investments. Vertically integrated real estate sponsors handle every step of real estate investing. You won’t have to worry about accounting, property management, marketing, or other details. Real estate funds simplify your path to investing in cash flows reducing assets.
REIT vs. Real Estate Fund: Key Differences
REITs and real estate funds have the same concept: make it easier for investors to access real estate investment opportunities. However, these two investment vehicles have different structures that impact return potential and other factors.
Investor Requirements and Qualifications
REITs are accessible to any investor with a brokerage account. You can buy REITs as if you would buy stocks. As a result, these assets are better for investors on a budget who only have limited funds.
Real estate funds have more requirements. Only accredited investors can invest in these funds. You will need at least one of these characteristics to qualify as an accredited investor:
- $1 million net worth (excludes primary residence and regardless of filing status)
- Annual income over $200,000/yr (or over $300,000/yr for married couples)
- Your company has over $5 million AUM
- You are an investment advisor or registered broker
Liquidity
REITs are far more liquid than real estate funds. If you desire, you can day trade REITs throughout the day. Some investors look at price fluctuations and swing trade these assets. You can also buy and hold them for the long-term and reinvest cash flow, just like traditional real estate.
Real estate funds do not offer the same liquidity. Your capital can be inaccessible for several years after committing to an investment. Real estate funds will provide cash flow along the way, but these funds are closer to traditional real estate. You can’t quickly enter and exit traditional real estate, and the same truth holds for real estate funds.
Investment Minimums
You don’t need much money to buy REITs. With fractional shares accessible to any investor, you can start a REIT position with $1. You can invest as little or as much as you desire to start and grow your REIT positions.
A real estate fund has a higher investment minimum, sometimes over $100,000. These minimum investments can scare off smaller investors, explaining why real estate funds only cater to accredited investors. You can invest higher than the minimum amount to obtain a higher percentage of the property’s cash flow and appreciation.
Control
Investors value control. They want to feel as if they have input on an asset’s performance. Owning real estate can give investors more control and work than they would like to have. Unfortunately, REITs offer zero control since you are with thousands of other investors. Of course, you can exit a REIT position at will, but that’s the only degree of control REIT investors get.
Real estate funds give you more control over the property. These funds have fewer investors, which puts you closer to the decision-makers. The fund managers will reach out to the investors and ask about changes to the business plan. You can approve or disapprove of the changes along with other investors. This structure gives you significant control over the direction of the investment while allowing you to retain your status as a passive investor.
Capital Gains Tax
Capital gains get taxed based on the holding period and your total income. Your total income will stay the same regardless of whether you invest in REITs or real estate funds. However, you can end up with higher capital gains taxes if you invest in REITs. Selling REITs before a year of ownership results in an unfavorable short-term capital gains tax rate. You can mitigate this high rate by holding onto the REIT for over 365 days. Real estate funds are long-term investments in nature. It can take several years to receive the full payoff from your investment. This delay results in a more favorable long-term capital gains tax rate.
Leverage
Real estate funds can use more leverage for their investments due to shorter lifecycles. Many real estate funds buy a property and exit after a few years. REITs strive to achieve long-term sustainability. They take on less leverage, knowing that too much of it can leave them unprepared for a recession. Real estate funds don’t have to worry about this issue as much since these funds dissolve in a few years and repay investors during that process.
Profit Distribution
REITs are required to distribute 90% of their taxable income to investors. This requirement results in more upfront profits, but these distributions get taxed as ordinary income rather than qualified dividend income. Some real estate funds also provide profit distributions, but others use investors’ capital to acquire assets with high appreciation potential. Some real estate fund investors trade cash flow for long-term growth and embrace a buy-and-hold strategy. This approach can lower your taxes since you will have higher capital gains instead of a higher ordinary income.
Diversification and Risks
Real estate funds require you to put more capital into a single asset. While a minimum contribution over $10,000 can rattle many investors, real estate funds are primarily for accredited investors. Most of these investors already have millions of dollars’ worth of assets. Therefore, their real estate fund investment will not take up a large percentage of their net worth.
REITs offer more diversification, lowering risk in the process. Owning more assets offers more protection in case one of those assets underperforms. In addition, you can quickly exit a REIT position and respond to company, market, and economic developments.
Similar Investments
REITs and real estate funds each let you access real estate. These assets turn you into a passive investor who doesn’t have to worry about property management, marketing, and other responsibilities. If you want to buy real estate without doing the work, REITs and real estate funds can help your portfolio.
REIT vs. Real Estate Fund: Which is Better?
REITs and real estate funds appeal to different types of investors. REITs are better for investors with less capital to spare and a desire for quick diversification. Some real estate investment trusts give you exposure to hundreds of properties.
Real estate funds offer less diversification and liquidity, but they give you more control, leverage, and appreciation potential. Real estate funds are primarily for accredited investors. An accredited investor usually has a multimillion-dollar investment portfolio, making a real estate fund less risky for their portfolios.
Invest in Real Estate
Real estate investing lets you benefit from a proven asset. These assets generate cash flow and have high appreciation potential. People will always need a place to live, work, and store inventory. Investing in the real estate market gives you exposure to those assets, but doing it alone can become a significant commitment. Some investors prefer to reap the benefits of real estate as passive investors.
