By Dr. James M. Dahle, WCI Founder
Once upon a time, I wrote an article about private real estate investment trusts (REITs). These are some of the favorite tools of salesmen masquerading as financial advisors (there's a reason they're called “brokers”). They would sell these investments with a promise of high income. 8% yields were not uncommon. The value of these REITs were not marked to market. For years. So although you knew you were getting that juicy 8% yield, you had no idea what the actual value of the investment was, and thus no idea of what your total return was. They were the perfect product for a salesman to sell to a financially unsophisticated client. They set up shop in retirement communities and sold their wares over steak dinners. These “investments” (scams would probably be a better description) had heavy front-loads (as high as 15%) and heavy ongoing fees. Primarily due to those fees as well as similar abuses by management, the long-term returns were often terrible. Sometimes investors found out that shares that were illustrated as “never dropping below $10 a share and likely worth twice that at some vague future liquidity period” were found to be worth $6 a share. Or $3 a share. Or even less. It turned out a great deal of that juicy yield was really just returning principle to investors.
The Publicly Traded REITs
In contrast, are the publicly traded REITS which are marked to market thousands of times per day on days the market is open. Not only do these “real estate flavored stocks” provide ready liquidity and transparency, but you can buy them without paying a load. You can also readily diversify at a very low cost by using a mutual fund such as the Vanguard REIT Index Fund.
That fund has a moderately high correlation (0.61 last I checked but it varies over time) with the overall stock market. Sometimes it zigs when the market zags, but sometimes it zags when the market zags. In fact, sometimes it zags really dramatically, like in the Global Financial Crisis when it lost 78% of its value from peak to trough. Since the purpose of diversifying into real estate is to get solid returns and low correlation with the other assets in the portfolio like stocks and bonds, that moderately high correlation turned off a lot of potential real estate investors.
In addition, REITs by their very structure are not particularly tax-efficient. By law, they are required to pay out 90% of their return every year to investors. And those distributions are generally fully taxable at your ordinary income tax rates. The investors don't get to benefit from depreciation and 1031 exchanges and the other benefits that direct real estate investors enjoy. High returns plus low tax efficiency meant that these assets really belonged only in the limited tax-protected investment space available to investors.
Why Some Investors Hate REIT Index Funds
Lack of retirement account “space”, lack of control of the asset, tax inefficiency, and that moderately high correlation, prompted a lot of investors to give up the liquidity, diversification, and convenience of a low-cost index fund of publicly-traded REITs in favor of owning the real estate investments directly.
Many investors have retired primarily on portfolios composed of a handful of rental properties. However, buying anything but single-family homes, a few duplexes, and maybe a small apartment building was beyond the reach of most real estate investors. So they got together with other interested investors and began “syndicating” properties, so that, like a mutual fund, they pooled the resources of multiple investors in order to buy more and larger real estate properties, such as large apartment complexes. They hired professional managers and then sat back and collected the checks for 5-10 years before selling off the property. Or perhaps they used a private real estate fund, again with a manager, so they didn't have to pick each investment individually.
Rise of the Crowdfunders
Technology has provided a way for many more investors to get involved in syndicated real estate through “crowdfunded” websites such as Equity Multiple, Fundrise, Realty Mogul, Crowd Street, AcreTrader (all affiliate links) and over a hundred others. They all have a different focus. Some invest on the equity side, and others on the debt side, and still others do both.
However, most of these sites, like most of the syndicated deals available before the existence of these sites, required investors to be accredited. That is, rich enough (and theoretically then also sophisticated enough) that the Securities and Exchange Commission (SEC) didn't have to babysit their investing activities. In general, this meant liquid investments of more than a million or an income of over $200,000 ($300,000 married).
The real estate crowdfunding space became very crowded, very quickly and so firms tried all kinds of ways to distinguish themselves from their competitors. One of the obvious ways to do that is to go after the non-accredited investors. Since an income of $200,000 gets you into the top 2 or 3%, and an investable net worth of over $1 Million gets you into the top 10% or so, it was obvious that the group of non-accredited investors was far larger than the accredited investors. Even if their average investment was smaller, the total amount of money to manage was still substantial. So as they dissected the regulations, they realized one way they could bring crowdfunded investments to the masses was to form the investments into what are really privately traded REITs, but which are different from your grandma's broker's REIT.
FundRise and Realty Mogul
There are currently two main companies out there offering this product, both of whom have advertised on this site. In the remainder of this post, I'll discuss their particular products and compare them to both publicly traded, and the old broker-focused privately traded REITs.
FundRise used to be similar to most of the other crowdfunded sites, offering individual properties to groups of accredited investors. However, they have transitioned to primarily offering their “eREIT” products, available to everyone. They've addressed many of the issues that were seen with the broker-focused REITs. For example:
- Low minimum ($1,000)
- No load
- Lower ongoing fees (0.85%)
- Quarterly liquidity
Fundrise actually offers five of these eREITS— focused on Growth, Income, West Coast, Heartland, and East Coast. Fundrise also offers “eFunds” (currently one in Washington, DC and one in Los Angeles). These are similar to private real estate investment funds available only to accredited investors, but with a much lower minimum (again $1,000). Instead of getting a 1099-DIV form each year like with the eREIT, you get a K-1. There is no guaranteed quarterly distribution and you should expect to leave your money there for five years.
The primary competition in this space is with Realty Mogul and their “MogulREIT” product. MogulREIT I and II (presumably there will be more down the line) offer the following:
- $1,000 minimum in a taxable account or $5,000 minimum in a retirement account
- No load
- 1% management fee
- Quarterly liquidity (after the first year)
Realty Mogul, unlike Fundrise, continues to offer “regular” (single property) investments to its pool of accredited investors, but the MogulREIT managers get first pick of the larger deals. There are slight differences between the two MogulREITs. For instance, MogulREIT II has a $5,000 minimum and invests just in apartment buildings (MogulREIT I had a broader mission).
Other Real Estate Investment Trust Companies
Although Fundrise and Realty Mogul seem to be the biggest players here, there are a few more of these out there (and probably more coming). Ian Ippolito does a nice job reviewing them.
Should You Invest in a REIT?
Now for the big question—should you invest in these new, more investor-friendly REITs? Well, it depends.
While these properties are more diversified than just buying a few crowdfunded, syndicated properties directly from crowdfunded sites, they are dramatically less diversified than buying the Vanguard REIT Index Fund. The Vanguard fund holds 155 companies. The largest of those 155 companies, Simon Properties, owns 325 properties. With one purchase, you will own a piece of tens of thousands of properties. You also give up significant liquidity with these online private REITs. You can sell that Vanguard REIT Index Fund in seconds any day the market is open. It would take you a full year to liquidate your MogulREIT holding and that's after the mandatory one-year holding period and possibly two more years where a 1-2% fee is assessed to early liquidators, which adds up to four years. The management fees of the Vanguard fund are also 1/10th as large as those in these private REITs. Given those downsides, why would anyone buy into these online private REITs?
The main reason is because these online private REITS aren't buying the same properties that the larger, publicly traded REITS are buying. You're not going to find a big mall. More like some strip malls, a restaurant, and some single-family homes. The investments come from the same place as their other crowdfunded offerings, which are far more Main Street than Wall Street. So it is a diversification play into a different aspect of the real estate market with smaller properties.
Accredited investors may turn up their nose at these online private REITs, but they are also eligible to invest directly with syndicators or through funds due to their ability to cough up the minimum investments of $50-200K. Non-accredited investors not only can't come up with those sums, but are specifically excluded from those investments. It makes you wonder if Robert Kiyosaki was right when he said the wealthy get to invest in different investments than everyone else.
Critics say that only inexperienced or desperate real estate developers would go to a crowdfunded syndicator for funding, and thus their investments, whether in a REIT form or not, are inferior to those available to a more established syndicator. I suspect there is some truth to that, although both companies screen out the vast majority of projects they are brought.
All of these options can be attractive to busy high-income professionals (like me) who are not interested in purchasing, owning, managing, and selling properties themselves. For the non-accredited investors, the online private REITs are your only option to invest in these smaller properties that don't make it into the REITs traded on the stock market and found in the Vanguard REIT Index Fund. For accredited investors, there are some who will be willing to pay the 0.85-1% management fee for the increased convenience, increased diversification, and decreased tax hassle compared to buying individual syndicated properties either directly or through the crowdfunded sites. Other accredited investors who either want to avoid the additional layer of fees, prefer to select their properties themselves, or simply prefer the benefits of a private fund structure will want to avoid the online private REITs. Either way, they've come a long way from the private REITs that were used to swindle your grandma.
In my recent post about my real estate investments, I talked about what I'm doing with the 20% of my portfolio that I dedicate to real estate, but for now, you should know that I don't have any money invested in online private REITs. However, I have invested directly into properties both with Fundrise and RealtyMogul and enjoyed positive returns.
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What do you think? Do you invest in REITS? How? Would you consider the Fundrise eREIT or one of the MogulREITs? Why or why not? Do you expect to see more online, private REITs come onto the market? Comment below!