The Question About Liquidity
There are several ways that people get involved in real estate investing. The first is by being the accidental landlord. A person moves from one house to another and decides to keep the first house to rent it out. Or, a budding investor may purchase a house as an investment property.
The other common approach is to buy a publicly traded Real Estate Investment Trust (REIT). This type of REIT is sold on the stock exchange and can be purchased and sold very easily, thus offering liquidity. There are also non-publicly traded REITs, which we won’t cover here. Then, of course, we have syndications, which are private passive investments in real estate.
For the passive investor, investing in a REIT versus a syndication is a common choice to make. So which type of investment suits your goals the best?
Features of a REIT
A publicly traded Real Estate Investment Trust is a security registered with the SEC. It is sold on an exchange like stocks and other securities. These trusts are typically very large, to the tune of many billions of dollars. The REIT can be an equity REIT, which invests in commercial real estate, or mortgage REIT which invests in debt on properties. For the sake of this article, we’ll discuss the equity REIT as it is most similar to a syndication.
An equity REIT operates much like a large landlord. They purchase large commercial properties, for example, apartments or office buildings. They operate the properties with the goal of returning a profit to their investors. They must pay 90% of their profits to their investors on an annual basis, which can lead to significant tax implications for the investor. Some REIT distributions are taxed at the marginal tax rate, which for some can be as high as 37%. REITs also tend to have large fees to fund their operation, this includes large sales commission fees and ongoing servicing and management fees. The upfront fees can be as high as 9-10% and the ongoing management fees 1-3% per year.
Even with these large fees, the returns can be pretty good. Historically, REITs have been returning over 10% annually.
Real Estate Syndication
A real estate syndication is a non publicly traded investment in private real estate. A group of investors come together to purchase a piece of real estate with the expectation of generating a profit. The deals can vary from a few hundred thousand to hundreds of millions of dollars. But, the idea is the same. Investors, also known as Limited Partners, invest with a group of General Partners. The general partners then purchase the property and operate it according to the business plan.
Since a syndication is typically invested in just one property, the investment is not liquid. In a few cases, the investor may be able to sell the investment to a different investor, but in most cases, the investor is invested in the deal for the duration of the hold time, which can be 3-10 years or longer.
The fees in a syndication are typically lower than with a REIT. There is an up-front acquisition fee of 1-4% of the property’s purchase price, and then on-going asset management fees of 1-2%.
But, where the syndication really outperforms the REITs is on the tax treatment and equity growth. In a syndication, expenses and depreciation are passed through to the investor. Therefore, even if an investor earns monthly or quarterly cash flow, there may be a paper loss at the end of the year when taxes are prepared. So the investor can enjoy cash flow for years with little or no tax to be paid.
Syndications can also realize large appreciation benefits. If the operators have run the property well, there will be a significant amount of equity growth that is distributed among the investors and general partners when the property sells or is refinanced.
Of course, some of the delayed taxes may have to be repaid when the property is sold. But the investor has had the opportunity to defer those taxes for years and thus potentially grow their wealth even faster.
If an investor is looking for easy diversification, and wants liquidity, then a REIT may be a good choice as long as the fees and tax implications are considered.
For the investor with a long-term view who is interested in favorable tax treatment and equity growth, investing in a syndication should be considered.