2023-08-10 07:00:00 ET
Summary
- Publicly-traded REITs offer liquidity and can be easily bought and sold on stock exchanges.
- Publicly-traded REITs provide transparency through reporting and disclosure requirements governed by the SEC and GAAP.
- Both public and private real estate offer diversification benefits, but private real estate also offers tax advantages such as 1031 exchanges and cost segregation.
As most of my regular readers know, I’ve been actively involved in commercial real estate for over 30 years.
In fact, I’m the third generation of real estate investors, as my grandfather was a successful motel landlord in the 1960s.
Ocean Pines Court in Myrtle Beach owned by W. Carl and Pauline Thomas (1960s)
Most of you know me from my REIT investing articles in which I have authored more than 3,500 on Seeking Alpha with a record of more than 111,000 followers. Since 2012 I’ve become a REIT maven, as I pointed out in a recent blog :
“Mavens are not persuaders. Rather, their motivation is to educate and help others.”
Education is a key part of my publishing empire, as I’ve authored (or co-authored) four books.
As much as I love REITs, I must admit that I’m also a big fan of private real estate investing. I forged a net worth of over $30 million before I was 40-years-old, thanks in large part to this less volatile asset category.
There are advantages and disadvantages to public and private real estate, and in this article, I wanted to provide readers with a clear and unbiased piece.
Given my vast experience on both sides of the coin, I thought that readers would appreciate my viewpoint in my latest “lessons learned” format.
I hope you enjoy, and I look forward to your comments below.
Liquidity
Publicly-traded REITs score well on the liquidity attribute.
As a private real estate developer and investor for over two decades, I can attest to the fact that publicly-traded REITs are excellent vehicles which make them the easiest and most efficient method to invest in real estate.
REIT shares are bought and sold on major U.S. stock exchanges every day, and there are more than 200 REITs with a combined equity market capitalization of more than $1 trillion traded on U.S. stock exchanges.
Liquidity events in private real estate transactions are much longer.
Much like selling a house, it takes time to market the property, find a buyer (usually using a broker), agree on a price, and close the transaction. On average, it could take 90 to 120 days to cash out on a private transaction.
Alternatively, it takes seconds to sell (or buy) a REIT.
This is one of the most important attributes for REIT investors and one that resonates with me.
Back when I owned a large private real estate portfolio, I had difficulties with my business partner (that’s putting it mildly) and this made it virtually impossible for me to liquidate my partnership interest.
I ended up losing substantial capital (millions of dollars) which is one of the reasons I ended up on Seeking Alpha (there’s always a silver lining).
One of my trophy assets was a shopping center known as Blackstock Center that was anchored by PetSmart, Party City, and Red Lobster. The managing partner had illegally borrowed money on the asset (without my consent) which led to four mortgages (on top of the senior secured debt).
When I found out about the mortgages, the loan already was in default and the only way that I could claw back my fair share of equity (I owned 50%) was to put the asset into bankruptcy…which I did.
My plan with the BK was to give me time so that I could attempt to negotiate with the creditors and reclaim my equity in the property.
Unfortunately, I was not successful with the negotiations and one of the lenders ultimately foreclosed on the property and my equity interest (over $4 million) was wiped out.
Conversely, had I owned shares in a shopping center REIT like Federal Realty (FRT) or Kimco (KIM), I could have sold my shares and preserved my hard-earned equity.
Transparency
Publicly-traded REITs score well on the transparency attribute.
The light shines brighter in the world of publicly-traded REITs than it does in the shadowy world of privately offered partnerships.
Publicly-listed REIT reporting and disclosure is governed by the U.S. Securities & Exchange Commission (‘SEC’), Generally Accepted Accounting Principles (‘GAAP’), and the various stock exchanges on which their shares trade.
REITs also report Funds from Operations ('FFO') as a supplemental earnings measure in their financial statements.
FFO is considered by many to be the most reliable metric to value property-owning real estate companies, and provides a good indication of the dividend-paying capacity of REIT.
Also, independent directors, analysts and auditors, as well as the business and financial media, monitor listed REITs’ performances and outlook. This oversight provides investors with a measure of protection and more than one barometer of a REIT's financial condition.
Using my above-referenced example, had my ownership in Blackstock Center been inside a publicly-traded REIT wrapper, I could have avoided the agony of losing it all.
I would have known that my business partner had obtained four mortgages above the senior secured loan and that the second mortgage lender that ultimately foreclosed on the property was in violation of the mortgage because it was invalid.
I also would have known that the rents were used to pay the senior secured loan and make partnership distributions instead of misappropriating funds.
Keep in mind, there are always bad actors, as we found out with American Realty Capital (formerly ARCP) that fudged the books by overstating FFO. But even then, I was able to exit ASAP, to preserve some of my capital.
Since the investor ultimately obtains exposure to the real estate that underlies either the publicly traded or the privately held securities, investors must identify compelling reasons to forego the greater transparency and superior liquidity of public securities.
Diversification
Public and private real estate offer diversification advantages
Diversification and equity orientation represent important objective principles for long-term investors.
It provides the free lunch of improved return and risk characteristics, while equity orientation promises the possibility of greater wealth accumulation.
As mentioned earlier, I have more than three decades of real estate investing experience, so I’m comfortable with over-weighting real estate (via REITs and private real estate) given my unusual expertise that offers the potential for generating superior returns.
Investors who diversify their portfolios have historically had a better chance of ending up with higher returns because diversification reduces portfolio volatility and mitigates losses from any one security or asset class.
Personally, I’m extremely comfortable managing REITs and private real estate, and in fact, I would argue that I have a competitive advantage in that arena because of the vast experience of my research team.
There are certain property sectors like data centers and life science properties that I could never own myself (or in a partnership) so the REIT vehicle makes a lot of sense.
In fact, Digital Realty (DLR) has become a core holding for me and I’ve been adding exposure during Q2-23.
I’ve also been scooping up shares in Alexandria Real Estate (ARE) hand over first.
Another property sector that I could have never owned without a REIT structure is gaming, and I’ve also been scooping up shares in VICI Properties (VICI).
I have recently purchased properties leased to billboards – Lamar Advertising (LAMR) and cell towers. In addition, I buy a few net lease properties for my retirement account.
I will discuss below some of the benefits enjoyed from my direct real estate exposure.
There also are REIT ETFs that appeal to certain investor groups because they make it easier to own a basket of REITs across property sectors. I recently launched my first REIT ETF Index that provides exposure to high quality US listed common and preferred equity securities of REITs while ensuring sector diversification.
Also, for certain investors, it makes sense to own publicly-traded and private real estate, or in simple terms, you should adopt an asset-allocation strategy that dovetails with your personal risk tolerance level.
Tax Advantages
Public and private real estate offer tax advantages
A REIT, unlike a typical corporate entity, pays no income taxes as long as it distributes at least 90% of its taxable income and generates at least 75% of that income from rents, mortgages, and sales of property.
REITs serve as a pass-through structure in which income passes through the security without being taxed to the security holders who take responsibility for the tax liability, if any; REITs exist in both publicly traded and privately held forms.
I often hear the argument that REITs are just “loopholes” that exist so that these real estate landlords don’t have to pay taxes.
That’s not true.
The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37% (returning to 39.6% in 2026), plus a separate 3.8% surtax on investment income.
Taxpayers also may generally deduct 20% of the combined qualified business income amount which includes Qualified REIT Dividends through Dec. 31, 2025.
Taking into account the 20% deduction, the highest effective tax rate on qualified REIT dividends is typically 29.6%. A historical record of the allocation of REIT distributions between ordinary income, return of capital and capital gains can be found below:
Many investors own REITs in retirement accounts, so you get this really unique double tax benefit.
In other words, not only do you not pay tax on the corporate level because of the special treatment that REITs get but if you have them in your retirement accounts, you don't have to pay that individual income tax as well. It's essentially tax-free profits that aren't taxable at all until you have a traditional IRA or 401(k) that is only taxable when you withdraw the money.
However, for certain investors, especially developers (like me), high net worth investors, or family offices, private real estate has some really attractive attributes:
1031 Exchanges (or DST)
One of the most popular tax deferral strategies for investment property owners is the 1031 tax deferred exchange.
Section 1031 of the U.S. Internal Revenue Code allows investors to avoid paying capital gains and other applicable taxes when selling an investment property.
To receive full tax deferral treatment, the IRS requires that proceeds from the sale are reinvested within certain time limits in a property or properties of like kind and equal or greater value.
1031 exchanges represent approximately $300 billion in annual real estate transaction volume and are regularly used by REITs, real estate funds, and smaller investors who want to profit from the sale of their real estate holdings without recognizing tax liability.
To quote Warren Buffett… “compounding is the eighth wonder of the world.”
By not paying taxes, 1031 exchange investors are able to compound wealth creation for additional income and optimized estate planning through enhanced wealth transfer.
Smaller investors can particularly benefit from 1031 exchange rules, as this is a great strategy for growing and keeping wealth.
According to estimates from the Urban Land Institute, more than $6 trillion in investment real estate is currently held by individual investors. In most cases, these investors are older, and their properties have been depreciated over many years resulting in a substantial capital appreciation.
Further, they have actively owned and managed their properties through many market cycles and are ready to transition from active property management to passive lifestyle income.
One alternative to the traditional single-owner 1031 exchange is the growing popularity of a passive-ownership strategy referred to as the Delaware Statutory Trust or “DST” for short.
DSTs are pooled investment structures that invest in higher-quality, professionally managed properties that can be combined into individual 1031 replacement property interests.
Using the pre-structured DST property strategy, 1031 exchange investors can sell one property and exchange it for multiple (passive-income) properties featuring multi-asset and multi-sector diversification.
In many cases, DST programs are arranged and managed by nationally recognized REIT companies representing billions under management and access to all major asset classes and diverse strategies.
In addition to compounding wealth through 1031 tax deferral, individual property owners can experience freedom from the burden of active day-to-day property management in favor of passive lifestyle income.
As my readers know I'm fond of the term SWAN Income — which stands for Sleep Well At Night. A carefully diversified portfolio of DSTs can reduce the risk of property ownership and transform Return on Investment to Return On Life!
Cost Seg and Bonus Depreciation
For income tax purposes, real estate investors generally depreciate residential rental property over 27.5 years and commercial property over 39 years.
Because depreciation occurs when a purchased building ages, it loses value over time.
Actually, your building is not only one piece of property, but comprised of subcomponents (such as lighting fixtures, heating and air conditioning systems, and other components that deteriorate over time).
But unlike the whole of a building, which is seen as having either 27.5- or 39-year lifespan, subcomponents are granted a five- or 15-year lifespan, making the depreciation deduction larger, especially in the first several years.
Consequently, whether your property is residential or commercial, you can write off that cost either in a 27.5- or 39-year timeframe.
A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows you to benefit from an accelerated depreciation timeline for some of those building components.
While cost segregation studies bear up-front cost, the tax savings from accelerating depreciation deductions can result in significantly increased cash flow over several years. The benefits of a cost segregation study are as follows:
- Reduced tax liability
- Increased cash flow
- Increased efficiency
Engineered Tax Services
Net Operating Loss (NOL)
A net operating loss ('NOL') is a situation in which the annual tax deductions of a business are worth more than the owner's adjusted gross income - AGI. The owner may be able to use this loss to offset other income on their personal tax return, reducing the owner's total tax bill.
Instead of taking all of the NOL deduction on the year of the loss, a business may carry some of those deductions forward to years when it has a profit, effectively decreasing its tax bill in those years.
As I mentioned earlier, I was a real estate developer for over two decades and during that period I accumulated a sizeable NOL (over $2 million) that has been a huge advantage now that my income has increased over the years.
Here's a more detailed look at NOLs HERE .
In Summary…
As you can see, there are many reasons to own REITs and private real estate, and that’s why most of my net worth is concentrated heavily in “both” categories.
As a publicly-traded REIT, there are some great reasons to own shares including:
- Liquidity
- Transparency
- Diversification
- Professional Management
And in private real estate, there are also terrific benefits including:
- 1031 Exchanges (DSTs)
- Cost Segregation (Bonus Depreciation)
- Net Operating Loss (‘NOL’)
As far as I’m concerned, owning public vs. private real estate doesn’t have to be an “either/or” decision. There are great benefits to both and besides, and as you now, I always like to have my cake and eat it too.
As always, thank you for reading and commenting.
Happy SWAN Investing!
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
Lessons Learned: Why I Own REITs And Private Real Estate