Why not a REIT?
Touted as cure-all's, certain flavors have key limitations that may make them unsuitable as core investments for investors.
June 15, 2015 BY IAN IPPOLITO
As we discussed in a previous article ("Why invest in direct real estate?"), investing in direct real estate has many advantages. They include 9.2%+ historical returns, low volatility, income, portfolio diversification and protection from inflation.
But why go through the trouble of creating a portfolio of direct real estate, when you can just invest in a REIT (Real Estate Investment Trust), and be done with it? In fact, REITs are often touted as real estate cure-alls by brokers and financial advisors who aren't experienced with other alternatives. But this doesn't hold up to scrutiny. Let's take a look at why.
What is a REIT?
If you haven't heard of REITs, they are companies that manage portfolios of direct real estate for you. For that convenience, they charge a fee. Instead of having to learn about real estate (like you're doing right now), a professional manager does it for you.
In addition, one type of REIT (publicly listed REIT) trades on public exchanges. This means you can move your money in and out at any time. In the previous article we discussed one of the main disadvantages of direct real estate is its lack of liquidity. Publicly listed REITs don't have this limitation, which is a strong advantage if you have an emergency and need the funds quickly.
So on the surface, it seems like a REIT is the perfect way to invest in real estate. However, if you look deeper, you'll see many limitations, that make REITs unsuitable as a core real estate investment vehicle, for most investors.
What can go wrong with a REIT?
There are three different types of REITs, and each has its own unique limitations when compared to direct real estate investment.
Investing in certain institutional private REITs is like dating your dream celebrity of choice. On paper, it's everything you could possibly want. In reality, they're unlikely to let you do it.
Old-school nonlisted REITs have exorbitant fees, a track record of extremely poor performance, and FINRA warnings about Ponzi schemes resulting in "zombie REITs". (Note: many of these issues have been addressed with the newer batch that has come in since about 2017).
Publicly listed REITs may have a place in your real estate portfolio. But due to key limitations, they are rarely an ideal core investment.
Here's the details…
Instituational Private REITs: The celebrity you'll never date.
Private REITs are nonpublic, and are not traded on the stock exchange.
Many novice investors and inexperienced advisors confuse them with nonlisted REITs (which are completely different, and we'll talk about next).
The top private REITs have billions/trillions of dollars in assets. Due to their massive economies of scale, their management fees are amazingly low (for an investment requiring such active management): often around 1%. They have no load fees nor broker fees. And the top private REITs don't just try to match their benchmark index (NPI or NFI-ODCE). They make up the index.
With their perfect trifecta of low fees, economies of scale and world-class managers, investing in a private REIT is the real estate equivalent of dating your favorite celebrity.
Unfortunately, just like your favorite celebrity, your odds of being accepted by them are extremely slim. Most won't accept money from individuals, and deal exclusively with billion-dollar institutions and pension funds. The few that will, require minimum investments of $5 million.
This makes them a non-option for most accredited investors.
Update: 1/1/2018: The private investor club is creating a vehicle to invest in core private REITs, with just a $50,000 minimum. Click here for more information.
Old-school Nonlisted REITs: Broker's dream/investor's nightmare
Old-school Nonlisted REITs (also called nontraded REITs) are also nonpublic, and also not traded on the stock exchange. Unlike private REITs, they are known for exorbitant fees (annual fees, load fees, broker fees), and poor returns. (Note: those created around 2017 and later began using a very different structure that doesn't have these problems).
Front end fees can be as painfully high as 15%. Brokers take an additional pound of flesh as high as 10%. And yearly management fees are often exorbitant as well.
Since they pay such high commissions, brokers recommended over $20 billion of these to unsuspecting clients, between 2009 and 2013 alone. Many nonlisted REITs lured in investors with rates higher than they could afford to pay. Ultimately, many investors lost money. And worse, as the Wall Street Journal described in 2015 in their article "Property Investors’ Latest Horror: Zombie REITs": a significant number still haven't gotten their money back, and don't know if and when they ever will.
So many nonlisted REITs have gone zombie, that FINRA (the Financial Industry Regulatory Authority) issued a warning about them:
"Furthermore, the periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal"
This is exactly how Bernie Madoff operated his Ponzi scheme.
Old-school nonlisted REITs are excellent moneymakers for your broker and the fund itself. In my opinion, they are a completely unsuitable investment for any investor that has any other options.
Update 1/1/2018: in the last year, a new generation of nonlisted REITs has been created, where the front and commissions and fees have been significantly reduced. They still aren't as low I'd like to see, nor as low as accredited-only investor options. However, they are quite a bit less, and this makes them much less liable to go the zombie route than the previous generation. These have been reviewed in the nonaccredited investor section of the site.
Publicly listed REITs
Publicly listed REITs trade on the stock exchange. As a result, you can cash in and cash out of your investment at any time. This is a significant advantage over the other types of REITs, and direct real estate investment. All of these require you to lock up your money for some period of time.
But this liquidity comes at a cost: volatility, loss of diversification protection and liquidity premium. As a result, public REITs can be useful, but usually not as a core investment.
Since these require more explanation, we'll talk about them in part two of this article: "Why not a REIT? Part 2: Publicly Listed REITs"
About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.