How Real Estate Funds and REITs Compare

By: Andrew Lucas, Director of Capital Markets

There are millions of investors out there who want exposure to the booming property markets but lack the know-how and high capital requirements to get involved in multifamily and other commercial real estate opportunities. For those investors, REITs and real estate funds offer a way to access these markets, and benefit from their growth, without sacrificing portfolio diversity, and without having to put in the considerable sweat equity that comes with active property investing.

Trion’s approach for our funds is to seek out opportunistic real estate investments, which we then rehabilitate and manage on behalf of our investors. From our founding in 2005, we have closed over $300 million in transactions in this space, and our approach combines substantial renovations with an aggressive lease-up policy to maximize returns for our investor partners. Let’s get into the nitty-gritty of what you should know before investing in a REIT or real estate fund.

What is a Real Estate Fund?

A real estate fund is a guided, managed fund that makes investments in real estate and/or companies within the real estate sector. They operate similarly to mutual funds, but instead of investing in equities/stocks, they invest in real property and associated services. Real estate funds utilize direct investments in assets, like multifamily apartment buildings, shopping centers, raw land, and others, as well as with indirect investments in REITs, or real estate investment trusts.

Legal Requirements for Real Estate Funds

When a real estate fund is formed, the sponsor – the person responsible for managing the fund – must set the terms of the investments to be made by the fund. To be properly structured, a real estate fund must offer documents that contain terms that outline the risks and rewards relating to the fund to investors. These terms are dictated by the strategy of the fund, market trends within the fund’s asset class, and any specific needs or objectives of the fund. Any legal counsel that works with a fund to set up shop must have an in-depth knowledge of current market trends, as well as how those trends may affect the fund’s overall strategy.

Closed-end real estate private equity funds are usually structured in a similar manner to standard private equity funds, though there are some differences. Real estate fund managers may have different conflicts of interest when compared to traditional funds – primarily because RE fund managers may seek to retain their affiliates to work for the fund for remuneration.

In addition, the economic structure of a fund can be relatively uncommon, especially when the real estate fund receives income from operations. Furthermore, real estate funds fall under a tax regulatory framework that is materially different from standard private funds.

Investor Qualifications for Real Estate Funds

Most real estate funds focus on generating returns via appreciation, rather than from continuous, short-term income, as is the case with a REIT. Some real estate funds are open to all investors, though some come with minimum investment amounts that start around $10,000 and up. There are also many funds that have much higher capital requirements and that require investors to be accredited investors. Before investing in any fund be sure to research their criteria for accepting new investors.

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Types of Real Estate Assets in Funds

Real estate funds are differentiated by the assets in which they invest. Some of the more common types of real estate funds include:

Residential Funds

These focus on investments in multifamily and single-family homes, typically shooting for appreciation-based returns, but some also engage in active management of rental properties for income.

Commercial Funds

Commercially focused real estate funds invest in commercial real estate assets like retail and shopping centers, office parks, industrial facilities, and multifamily properties. There is overlap between residential and commercial funds as anything over a 4-unit apartment building, though technically residential, is classified as being commercial.

Industrial Funds

These funds focus on heavy, medium, and light industrial properties like manufacturing facilities, distribution hubs, foundries, and other properties used for industrial purposes.

Raw/Undeveloped Land Funds

As real estate funds tend to focus on appreciation rather than regular cash flow, many invest in raw and undeveloped land intending to hold it until it appreciates to a desired level, or to land bank assets ahead during entitlement periods prior to development.

Mixed Funds

Many real estate funds do not stick to one property type or asset, instead mixing their investments in a variety of real estate sectors. RE funds often choose to diversify their investments to reduce risk.

What Makes a Good Real Estate Fund?

Experience

Investors should look for sponsors with a long and successful track record in real estate investing. The right team is also vital – a leader is only as good as those around them – a good real estate fund must possess high-level real estate and finance professionals at all levels to ensure stability and long-term growth.

Portfolio Diversity

The first rule of investing is to diversify- this holds true for asset classes, as well as subcategories of those asset classes. For instance, if you invest in the stock market, it isn’t enough to simply own equity shares- you want to own shares in a wide variety of fields to defend against a downturn in any particular industry, or from the failure of a single company.

You don’t want to be stuck holding the bag like retirement savers who bet big on Enron or WorldCom. The same logic applies to real estate fund investments- you want to choose a fund with exposure to multiple markets or property types to protect your retirement portfolio.

A Clearly Defined and Detailed Strategy

If you don’t know where you’re going – any road will take you there. When selecting a real estate fund, look for those with a clearly defined strategy. Almost every fund out there will have an overarching strategy, a value proposition they sell to potential investors. For instance, a plan to generate returns through a focus on multifamily properties in high cap areas, or erecting mixed-use commercial/residential projects in dense urban cores.

But an eye on the big picture is not even close to what you need to succeed. Your job as an investor is to find a company that can clearly define not only the big picture, but the nitty-gritty details in their plan to generate returns on your investment.

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What is a REIT?

A REIT, or real estate investment trust, is a company that owns, and sometimes operates, income-generating real estate assets. REITs, which are formed as regular C corporations, are subject to more regulation than real estate funds, which are typically set up as partnerships or limited liability companies. For example, REITs are required to make regular disclosures to the U.S. Securities and Exchange Commission (SEC).

Most REITs focus on a single sector of the real estate space, like multifamily, office, or retail shopping centers, but there are also firms that invest across property types. Examples of commonly held REIT properties include multifamily apartment buildings, office complexes, warehouses and manufacturing facilities, raw land, agricultural land, and pretty much any type of income-generating or appreciating real property.

REITs allow investors to own shares in a portfolio of properties from which they collect dividend-based income, rather than having to purchase a real estate asset outright, which may not be advantageous due to the capital-intensive nature of commercial real estate. REITs also provide the ability to diversify one’s holdings outside of traditional equities and bonds without having to deploy a substantial amount of investment capital within a single asset.

Legal Requirements for a REIT

To become and stay qualified as a REIT, a company must meet certain requirements, including investing 75% or more of total assets in real estate, US Treasuries, or cash. In addition, they must receive at least 75% of their gross income from real property rents, sales of real estate, or interest on mortgages that underlie the financing of real property.

Investor Qualifications for a REIT

Anyone with a brokerage account and the desire to get involved in the property markets has access to publicly-traded REITs. Private REITs are exempt from registering with the SEC, and their shares are not traded on public or national stock exchanges, in most cases, Private REITs are generally only sold to institutional investors.

Types of REITs

REITs are divided into three categories, equity, mortgage, and hybrid real estate investment trusts.

Equity REITs focus on operating and managing income-producing properties. Equity REITs tend to generate most of their income from tenant rents.

Mortgage REITs generate returns similarly to banks or mortgage lenders, through extending credit to property owners and earning money from the interest. They also seek out profit through investments in mortgage-backed securities.

Hybrid REITs are a combination of mortgage and equity REITs. They invest in both income-producing properties as well as chase mortgage-related returns.

What Makes a Good REIT Exchange Traded Fund (ETF)?

There are several characteristics investors can use to identify a “good” REIT ETF. Good is in parenthesis because every investor profile, and appetite for risk and reward, is different- but these are some general signs to look out for when evaluating REIT ETFs.

The top-tier ETFs usually have a significant amount of assets under management, due to the lower costs that the scale of larger funds can offer. Larger ETFs typically have lower expense ratios, and the associated costs of share trading are substantially lower with a higher-volume, easily tradable ETF, compared to an ETF with less financial clout and less liquidity.

Find out more about real estate funds, REITs, and real estate strategies at the Trion Properties Education Page.

Similarities between Real Estate Funds and REITs

REITs mimic equities and ETFs, while real estate funds more closely mirror mutual funds. They both fill a comparable role in the market, most notably as a way for retirement savers to diversify their portfolios out of traditional equities and bonds. RE Funds and REITs are alike in a few important ways:

Generate Returns Through Real Estate

Both REITs and real estate funds generate returns for investors through direct or indirect investments in real estate-related assets like apartment buildings, real estate service companies, or through regular cash flow from mortgage interest or rent payments from tenants.

Lower Investment Barriers

Financing, acquiring, and managing real estate assets at a high level is out of reach for many investors who do not have the time, capital, or expertise to manage multimillion-dollar property deals. REITs and real estate funds allow those investors to enjoy the appreciation, cash flow, and diversification benefits offered by real estate without having to buy or manage real property themselves. However, you should keep in mind that the barriers for entry are much lower for REITs compared to real estate funds.

Both are Managed

They both offer finance professionals who work for investors to identify and execute on opportunities, while also defending from risk.

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Differences Between Real Estate Funds and REITs

Of course, these two real estate investment options are not identical. There are several key differences between the two.

Advantages of Real Estate Funds

  • Real estate funds operate on a longer timescale than REITs. Each year, REITs are legally required to distribute 90% or more of their taxable income to shareholders through dividend payments. Real estate funds offer capital appreciation and dividend income for medium and long-term investors in a manner that REITs cannot match, which normally yield a higher total return.
  • Fund investors will receive an annual K1 which allows the investor to take advantage of passive losses against other investment income.
  • Real estate funds have a bit more freedom and variance. They are not required to disclose all operating results, although they typically provide reports to stakeholders. Real estate funds are usually structured as partnerships or limited liability companies. For example, investing in Trion’s Fund II technically means purchasing shares of the Trion Multifamily Opportunity Fund II, LLC. Further, the price of our fund is static at $1,000 a share.

Advantages of REITs

  • Liquidity and freedom are among the chief benefits offered by REITs. Let’s say you invest in a multifamily apartment building. Unless you want to take a significant loss from transaction fees, startup costs, and lost time, in most situations, you’re going to have to sit on that asset for some time. Even if you are able to find a buyer, paperwork, inspections, meetings, and financing all take time. REITs give investors the ability to jump in and out of positions with the same speed and liquidity as traditional stocks.
  • They also tend to have lower barriers to entry than private funds, with the price of a share sometimes as low as $500.
  • Income investors are drawn to the tax advantages offered by REITs. REITs pay out dividends to investors via taxable income generated by either rent or mortgage loans, depending on the type of REIT. Their status as a REIT allows them to avoid corporate-level income taxes- the only applicable income taxes are those that get paid by shareholders after they receive income distributions from the trust. This helps investors to avoid being taxed twice, an advantage that is not shared by the vast majority of corporate business entities.
  • Private fund sponsors can be more discerning and pursue assets within as wide or narrow a scope as they prefer, or that take longer to acquire or require significant value-add renovations, as they are not obligated to pay out investors within a certain timeframe. While this can introduce more risk, funds present the potential to deliver exponentially higher returns than a REIT.

Real Estate Funds vs. REITs: Which is Better?

Major differentiating factors between those who invest in real estate funds and those who invest in REITs are their risk tolerance and the level of control they prefer over their investments. Knowing how each factor comes into play with the two fund types, as well as the risks and the benefits of each type of fund, is essential to making the right real estate investment choice.

Real estate funds are preferable for those investors who have a mid to long term horizon, and who do not need immediate liquidity in their investment. Taking the long view has the potential to foster exponentially higher returns, and real estate funds offer greater control, substantial tax benefits, and a much lower correlation to other financial assets making them good options for portfolio diversification. Private fund sponsors also can go after assets within their own defined scope, rather than having to work in the knowledge that they will need to pay out investors within a short timeframe.

For those investors with less appetite for risk, a shorter investment window, or less capital- REITs may be the answer. They allow for greater liquidity and access to investment capital when needed. You can also scoop up a REIT for significantly less than an investment within a real estate fund, with some REITs starting in the low tens of dollars.

Trion’s approach to our funds is a focus on growing wealth over a mid to long term. Our goal is to maximize investor returns by increasing net operating income throughout the holding period. We accomplish this through a hands-on management style of substantial property renovations, and an aggressive approach to the lease-up process. This is a major contributing factor to Trion’s success in the property markets with an over 30% internal rate of return since 2005. Determining which of these two options is the right choice for you is highly dependent on your individual retirement portfolio and personal investment needs.

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How to Invest in a Real Estate Property

Assuming you do not want to become a property owner or manager as an individual investor, there are a couple of different options available for investing in real estate property.

Investing With REITs

To invest in a REIT, you will need a brokerage account with a company like Charles Schwab, Morningstar, or Robinhood. These accounts are available to all levels of investors, from those with a few hundred dollars to start, all the way up to people with significant accumulated wealth. It is a relatively simple process to sign up and should take about 15 minutes. Investing in a REIT is as simple as firing up your broker’s site, app, or calling them and choosing your designated REIT. While there is no set minimum across the board with REITs setting their own minimum investments.

Investing With Real Estate Funds

Investors can purchase shares in a real estate fund by contacting a developer or looking at any of the numerous real estate crowdfunding platforms. Minimum investments can vary but are usually within $10,000 to $50,000 and in most cases, you have to be an accredited investor to qualify to participate in the fund.

Sponsors who operate fund will typically have a detailed outline available for you to review that will describe the funds primary focus in terms of the kinds of projects it looks to invest in, what its geographical areas are, and the economic hurdles it is looking to clear. Real estate funds typically focus on mid to long term growth, which maximizes returns, while leaving the fund manager the flexibility to hold on to properties in order to ride our recessionary periods if need be.

Investing in Multifamily: Real Estate Funds or REITs?

Investors seek out multifamily projects for their stable cash flow, potential appreciation benefits, and the tax-advantaged status of real estate assets. Multifamily projects are by no means “passive income,” and they take a great deal of time and effort to succeed, but a properly managed multi-family property has the potential to create incredible returns for investors.

A REIT lacks the control and planning that is necessary to generate truly spectacular returns, but it also avoids the pitfalls that may come with capital intensive renovations, leasing issues, and local market downturns, which can turn a multifamily project into a boondoggle. In relation to REITs and real estate funds, choosing which is better is again highly dependent on your tolerance for risk, investment horizon, and your individual portfolio makeup.

Conclusion

Both REITs and real estate mutual funds can be fantastic additions to your investment portfolio. They allow retirement savers to diversify their holdings outside of traditional stocks and bonds, without having to put a large chunk of their capital directly into real estate assets, which is what tripped up so many Americans during the housing crash in 2008.

If you take away one thing from this article, let it be that REITs are excellent for short timeframes, and offer investors regular payments in the form of monthly, quarterly, or annual dividends, and that real estate funds are a better option for those with a longer timescale and the ability to handle more risk in exchange for potentially higher returns.

Take a look at Trion Properties’ portfolio of multifamily properties.

Posted By Andrew Lucas, Director of Capital Markets

Andrew sources new investors and manages relationships with current Trion investors. Trion is a private equity investment company which acquires opportunistic real estate investments that need moderate to heavy rehabilitation on a mid to long term investment horizon.

The company maximizes investor returns by increasing net operating income throughout the holding period through a hands-on management style of heavy renovation and aggressive lease-up.

Since its inception in 2005, Trion has acquired hundreds of millions of dollars in real estate and has generated internal rates of return in excess of 30%.