Many investors looking to the real estate sector have at some point heard of a Real Estate Investment Trust or “REIT” for short but may not know much about the asset class. What is a REIT? How do you make money in one? How does investing in a REIT compare with 12M’s investment model of direct, fractional ownership in commercial multifamily properties?
Well, I’m glad you asked…
What is a Real Estate investment Trust (REIT)?
A REIT is and investment vehicle that allows investors to acquire ownership in real estate ventures. REIT’s must have at least 100 shareholders, no five of whom can hold more than 50% of shares between them. At least 75% of a REIT’s assets must be invested in real estate, cash or a US Treasury and 75% of the gross income must be derived from real estate directly.
How do you make money in a REIT?
There are essentially two ways you make money in a REIT. The first, like any stock, is with appreciation in the stock price beyond your purchase price. This gain is realized at the time of sale and is taxed at capital gains rates. The second way you make money is through cash dividends paid out by the REIT. A unique feature of a REIT is that it is required to distribute at least 90% of its disposable income to its shareholders. While this can be a great perk to the investor compared to the average stock, these dividends are taxed at ordinary income rates and as such, net returns are greatly diluted.
What are the components of a 12M commercial multifamily investment?
As explained in our “Commercial Multifamily Returns-101” post, 12M uses a direct, fractional ownership model with our investors. Each property we acquire is set up in its own sole purpose entity and our investors are classified as limited partners on the project. Our investors make returns from three core areas and are able to preserve these gains with the unique tax and estate planning benefits that the commercial multifamily asset class offers. These areas include:
Cash Distributions- Quarterly cash returns to investors based on the net income of the property
Appreciation- An increase in the value of a property created through increased revenues and/or decreasing operating expenses per apartment unit. Since properties in the commercial multifamily space are valued based on a multiple of their net income, (see “So What Is a Cap Rate, Anyway?” post) it follows that as income increases so does investor equity.
Principal Pay Down- The principal on the property loan decreases over time as monthly debt service payments are made. As the principal on the loan balance decreases, investor equity increases.
Tax Savings- By deducting annual depreciation and interest expense on the mortgage before calculating the property’s taxable income, the investor’s annual Schedule K-1 will generally show a loss for many years into the project, even though they are receiving cash distributions throughout the hold.
How does a REIT compare to a 12M commercial multifamily investment?
Most of the information you will find on the Internet that provides a comparison between a REIT and real estate, seems to focus solely on the single-family rental home market. The major take away the authors of these articles want you to have is that a REIT is superior because it is void of the headaches that being a landlord can bring, provide a higher level of diversification across real estate asset classes and are also much more liquid investments. When using single-family rental homes as the comparable asset class, there may be truth to some of these claims but when compared to investing in a direct, fractional ownership model like 12M’s where we acquire 100+ unit commercial multifamily properties, a REIT’s supposed advantages don’t stand up well.
As a passive investor in 12M commercial multifamily projects, there are no landlord “headaches” to deal with. Our properties are managed by professional property management companies who employ a host of professionals ranging from back office administrators to full time maintenance technicians. In addition, while diversifying across a large range of real estate classes sounds comforting, the result of this is really nothing more than diluted returns. A passive investor can typically achieve better returns with an investment firm that specializes in one thing and does that one thing very well than with an organization that invests in multiple real estate classes (i.e., office + retail + industrial + multifamily) across a large geographic area and who’s portfolio of properties vary greatly in size. I don’t know many businesses that do “everything well”. Lastly, the liquidity argument does have merit, but at 12M we are looking to help people build long term wealth through investment opportunities that carry a historically lower risk profile with stable and predictable returns. High liquidity is not generally a requirement for accredited level investors when their investment performs consistently year after year.
All of this being said, the truly “big” win for the investor in a direct fractional ownership model like 12M’s vs. a REIT, resides in the potential to not only see much more attractive annual returns but also the ability to realize these proceeds without getting hit with the high taxes you incur with a REIT. While a REIT can get you exposure to the real estate sector, you have to own the real thing to get the benefits commercial multifamily can provide.
