By Dr. James M. Dahle, WCI Founder
I often get asked why I bother investing in private real estate syndications, funds, or REITs (or allow companies offering these investments to advertise at The White Coat Investor) instead of just investing in the Vanguard REIT Index Fund. Today, I'll explain.
However, before we get to the question being asked, we need to address a few other issues. First, let's make the case for investing in real estate at all.
Why Invest in Real Estate?
Why do I invest in real estate at all? Three very simple reasons:
- High returns
- Low correlation with the other major components of my portfolio (stocks and bonds)
- Relatively resistant to inflation (like every component of my portfolio)
That's it. That's why I do it. I don't do it for the cash flow (I still practice medicine and get paid by WCI). I don't do it so I have a “hard asset” that I can drive by and check on. It's purely a financial decision. I believe having real estate in my portfolio improves the risk-adjusted returns of the portfolio.
Why Overweight Real Estate?
An indexing purist would point out that the publicly traded stock market already includes lots of real estate. Every company owns buildings and land. A total stock market index fund contains more than 150 real estate investment trusts. Real estate is one of the 11 sectors in the stock market—it's worth well over a trillion dollars and equal to about 3% of the stock market. Isn't that enough? Why would you want MORE than that?
I overweight real estate in my portfolio (my portfolio is 60% stocks, 20% bonds, and 20% real estate) because the vast majority of real estate is NOT publicly traded. There is something like $70 trillion in real estate in the United States, about half of that in residential real estate. So 98% or so of real estate is private real estate. That's a massive part of our economy, so “overweighting” real estate is just making up for the fact that most real estate is privately held.
The same thing happens with other sectors of the economy but not nearly to the same extent. There are only a few thousand publicly traded companies in the US and 27 million private ones, but 21 million of those private ones don't even have an employee. Still, 86% of firms with 500 or more employees are privately held. However, when you look at profits, more than 80% of company profits come from publicly traded companies. That's just very different from real estate. So it makes sense to overweight real estate despite the fact that there is real estate in your index funds.
The Case for Direct Ownership of Real Estate
When I look at how people structure real estate investments, I see it as a continuum.
On the left side, you have direct ownership. On the right side, you have a publicly traded REIT mutual fund. There are benefits to both sides of this spectrum and to everything in between. The main benefit to operating on the left side of the spectrum is control. The main downsides? Hassle and risk.
The case for direct ownership is as follows:
- Maximal ability to add value to the investment through your own efforts
- Maximal control over taxation
- You get to keep all the profit; you don't have to pay any to a manager
- You could potentially use depreciation to offset ordinary income if you (or your spouse) can qualify as a real estate professional
However, most of the people asking me why I bother with private real estate are not talking about direct ownership, even through a turnkey company. They're talking about private syndications, funds, and REITs. These are the passive ways to invest in real estate, just like investments in publicly traded REITs are passive investments. These people have no interest in finding properties, choosing tenants, dealing with Airbnb/Vrbo, or upgrading a home before flipping it. They have already decided against direct ownership due to hassle and risk issues. They want more diversification and just want to invest their money—not their time.
The Case for Private Real Estate
Private investments are illiquid. They have shorter track records, and they involve a lot of operator/sponsor/manager risk. Fee structures can be complex, and they will seem very high compared to the expense ratios of an index fund. Why would anyone choose to put money into them instead of the solid blue-chip REITs found in the public markets? Here's why I put some (and, in fact, the majority) of my real estate money into private real estate.
#1 Illiquidity Premium
One of the biggest downsides of private real estate investments is their illiquidity. You can trade a publicly traded REIT, ETF, or mutual fund every day the markets are open. Some real estate investments provide no liquidity at all until the property is sold after seven or even 10 years. Even the most liquid investments usually require a one-year commitment and, even after that, only provide liquidity once a quarter (and they may take several weeks to send your money once you do sell). There's only one reason to deal with the hassle of being illiquid, and that's because you are being paid more to do so. That's the illiquidity premium. While everybody needs some liquidity in their lives, very few investors need all of their investments to be liquid. If you could earn an extra 2% or 3% a year for being illiquid, how much of your portfolio would you allow to be illiquid? Probably quite a bit.
#2 Lower Correlation with Stocks
Publicly traded REITs are traded publicly on the stock market. Sometimes the stock market goes down for a reason that has little or nothing to do with real estate performance, and this can also affect the REITS traded on the market. Certainly it affects them more than it affects private real estate. It can be a bit hard to sort out how much lower the correlation is since private real estate is not valued on a minute-to-minute or even a day-to-day basis like the stock market. But it is hard to argue the correlation is not lower at all with a private property.
REITs also benefit from depreciation like any other property and pass that on to their owners. However, it is not passed on in the same way. Whether owned privately or publicly, a REIT uses depreciation to make more of their distribution a “return of capital” rather than an “ordinary dividend.” That depreciation cannot be used to offset the income from other real estate investments, much less any of your earned income. However, if you are invested in syndications or funds, that depreciation is passed on to you on a K-1 to use however you may qualify to use it.
REITs aren't all bad tax-wise. There's something to be said for getting a 1099 in January rather than a delayed K-1 in June that forces you to file an extension and potentially file multiple state tax returns. REIT dividends also qualify for the 199A deduction. But the inability to benefit from getting the depreciation directly is a downside of public (and private) REIT investing.
#4 Less-Efficient Market
All real estate is local, and it takes a great deal more time and effort to get information about individual privately owned properties than it does to learn about publicly owned companies. The real estate market is simply less efficient than the stock market. That creates both opportunity and risk. A good manager can take advantage of those inefficiencies to create alpha, especially when their competitors in the space are often less sophisticated “mom and pop” investors.
#5 Different (Usually Smaller) Properties
Large publicly traded REITs have a lot of money they need to deploy. So they tend to buy very large properties. Large malls. Large office buildings. Large apartment complexes. That leaves opportunities in smaller properties for private investors. Small properties perform differently than large properties, so private real estate investments allow for diversification into different areas of real estate.
I still invest in publicly traded real estate via the Vanguard REIT Index Fund. It makes up 5% of my total portfolio and 25% of my real estate allocation. But I think there are enough benefits with private real estate to also include it—despite its risks, illiquidity, and hassle.
The Case for Debt Real Estate
My real estate portfolio also includes an allocation to real estate debt (5% of portfolio, 25% of real estate). My preferred vehicle here are private funds that lend money to real estate developers for periods of 6-18 months with loans of less than 75% of value in first lien position. Typical returns in this space are 6%-11% and are quite tax-inefficient since the entire return is paid out every year and is taxable at ordinary income tax rates. That doesn't matter inside retirement accounts but certainly does outside of them. These funds tend to be more liquid than equity funds but do require accredited investor status to invest.
The main risk is that they become equity funds in a downturn when developers decide they would rather give up the property than keep making payments on the loan, but by keeping the Loan-to-Value (LTV) low and having a mechanism in place to manage the properties, this risk can be kept relatively low.
There are also publicly traded REITs that do this, although they are not included in the Vanguard REIT Index Fund (the fund only invests in equity REITs). However, I prefer the privately traded funds/REITs due to their higher yields. They simply earn more. For example, I used to own the Broadmark fund. It went public and immediately went up in value 25% or so, as its yield equilibrated with those of similar companies already being publicly traded. That increase in value, of course, lowers future yields/returns. The risk here is obviously higher than with a treasury bond, but I think I am being paid enough to make up for that additional risk.
What If I'm Wrong?
Every time an investor makes an investment decision, they should consider the probability that they are wrong and the potential consequences. Perhaps I'm wrong about private real estate. Perhaps there is no illiquidity premium or what premium exists is eaten up by fees. Perhaps the correlation with stocks and bonds is not lower than publicly traded real estate—it is just disguised because the properties aren't regularly marked to market. Perhaps the risk of debt real estate is far higher than I believe, reducing the risk-adjusted returns. If this is the case, I will have wasted a lot of time, effort, and hassle. However, based on my experience over the last decade, it seems unlikely that the returns are significantly lower than what I would get in publicly traded real estate.
I hope this post helps you understand why I invest some of my real estate allocation into private real estate and why WCI sells advertising space to private real estate investing companies. If you are interested in learning more about investment opportunities available through real estate companies we work with (most of which I have personally invested with), sign up for our free real estate newsletter. There's no commitment and you can unsubscribe at any time.
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What do you think? Do you invest in real estate? Public, private, or both? How did you decide between the options? Comment below!