As we've mentioned before and will continue to explore, real estate has historically behaved differently from other assets. It therefore adds another dimension of diversity to stock, bond, cash, and even gold and art investments.
REITs are hardly the only way to take advantage of these factors though. Plenty of people choose direct ownership, for example, by being in the real estate business. In which case, they (hopefully) asked themselves questions like: Do I have the time to manage property? Do I know the best time to buy or sell? Do I have or can I obtain the insider information necessary to make it worth my while? Can I attract and retain the best tenants?
Depending on the market climate, buying real estate on the cheap to sell “on the expensive” is often more profitable than holding and managing it. That's why flipping houses holds such an appeal.
Then again, there's a reason why people can lose just as much as they can make on such ventures. Judging the markets appropriately, not to mention the costs and efforts involved, requires access to constantly evolving data. As for buying and holding to rent out to others, this necessitates effective and efficient property management. These cautions can't be overstated, especially since individuals often lack the time, money, and/or expertise to handle those tasks on their own.
It might seem intensely more profitable to keep all the profits from real estate instead of sharing it with fellow investors. But it's also riskier. Investment value is very often determined by the local economy. Therefore, at any given time, commercial properties may be doing well in one place and poorly in another. And most individuals simply don't have the financial resources to buy up a portfolio big enough to be safely diversified, either by property type or geography.
There's the problem of liquidity as well. Selling a single piece of real property can be very time‐consuming and even costly. It's not a simple matter of determining to sell and pressing a button. Far from it. And maintenance and security make for even more headaches. Most people don't want to be the one taking calls about break‐ins, clogged pipes, and stuck elevators. Yet using an outside management company can significantly reduce their profits.
Some investors claim they don't need to own either rental properties or REITs since they own their own homes. However, the dynamics of home values are often very different from those of commercial real estate – something we'll discuss again, albeit briefly, in Chapter 4. For starters, the same diversification and liquidity issues just described factor into owning just one home, as does emotional attachment. It's true that equity can be pulled out of one's home by refinancing, but that usually requires a tradeoff of substantially higher monthly mortgage payments.
So, simply stated, home ownership is no substitute for owning commercial real estate. That's why, for most individual investors, gaining access to real estate through professional rather than personal means is a far wiser course of action.
Private Partnerships
To solve those problems, some more entrepreneurial types trend toward private partnerships with 2, 10, or 20 partners: however many they see fit. They then delegate the tasks of property leasing and management, either to a general partner or an outside company. That comes at a price, of course. Plus, most private partnerships own only one or a few properties, once again rendering them something less than diversified.
Liquidity, meanwhile, may depend on the financial strength or solvency of the other investors involved. Although it's theoretically possible for one partner to sell his or her interest to another, that option comes with numerous potential problems. Conflicts of interest often abound between the general and limited partners with regard to such things as compensation, selling, and refinancing. And there's always the question of personal liability if the partnership experiences financial difficulties.
These private partnerships can be good investments at times under the right conditions with the right partners. But they still don't stand up to REITs more often than not.
Publicly Traded Limited Partnerships
Publicly traded real estate limited partnerships were once very popular, which was largely a shame. In the 1980s, these entities plucked billions of dollars from investors seeking the benefits of real estate ownership combined with tax breaks. The end result was their victims were lucky to recover 10 or 20 cents on the dollar.
There were several reasons for this failure, including the fees that were sometimes so high that they demolished all potential profits for the little guy. Often, there were conflicts of interest going on with the general partners. And in other cases, they bought into the real estate cycle too late. After grossly overpaying for properties, they hired mediocre managers, failing to recognize that real estate is a very management‐intensive business.
As a result, publicly traded limited partnerships aren't popular today. Nor should they be.
The Private REIT Phenomenon
Beginning in 2000, another real estate alternative to public REITs burst onto the scene – non‐publicly‐traded, or private, REITs. Exactly as their names suggest, these entities comply with U.S. REIT laws but don't trade in public markets. Sponsored by various real estate organizations, they're usually sold to small investors by financial planners and investment advisers.
Like their public counterparts, private REITs will own a collection of commercial properties and distribute the resulting income to their shareholders as dividends. But they operate more as accumulators and aggregators of assets than vertically integrated operating companies. Their yields can be fairly high, though that doesn't make them automatically superior.
These investments actually come with a number of drawbacks. Perhaps most important is their lack of liquidity. And that's true even when they make offers to repurchase certain amounts of shares at certain times under certain conditions, as some of them do. Shares still can't be quickly sold by calling one's broker or pressing a button.
Furthermore, nonpublic REIT shares are usually sold with large commissions – often over 10% – that go to the selling agent. That means fewer investment dollars are available for real estate investment. Or for real estate investors. Too often, the corporate sponsor also earns significant additional revenue via property acquisitions and management fees. So there can easily be conflicts of interest and attempts to grow the REIT for exclusive gains instead of mutually shared benefits.
Investors should therefore carefully analyze these entities’ organizational structures, balance sheets, acquisition criteria, operating costs and fee payments, prospective cash flows, and dividend coverage from recurring free cash flows.
Privately held REITs, privately held property, bonds, preferreds, utilities, MLPs, and the like can and do provide alternatives to REIT investing. But that doesn't make them replacements.
Publicly traded REITs focus entirely on commercial real estate, and their stocks have both liquidity and reasonable prospects for capital appreciation over time. Because of their structure, their management teams tend to hold closely aligned interest with shareholders. And their financial conditions and operating results are quite transparent via Securities and Exchange Commission (SEC) disclosure requirements and industry practices.
The key point is this: Publicly traded REIT shares are unique and distinguishable from other higher‐yielding investments, including other forms of commercial real estate ownership. As such, it doesn't need to be an either/or choice. A wise investment strategy is to own both REITs and other higher‐yielding
