Investor Resources

Recently, a business owner I was talking to asked me about the benefits of investing in real estate as a way to diversify her portfolio. After explaining some of the fundamental advantages of real estate over stocks and bonds, I wanted to expand the conversation.

We discussed the pros and cons of different methods to invest, the potential responsibilities involved and the knowledge needed, whether she was considering a long-term or short-term investment, and different tax-deferred strategies. After that meeting, I thought I would share that information with other potential investors.

Five Criteria to Evaluate the Three Investment Models:

• Market Knowledge
• Experience and Operating History
• Alignment of Interests
• Tax Advantages Available Through 1031 Tax Deferred Exchanges
• Benefits of Refinance Proceeds

Real Estate Investment Modeling

In real estate, there are three primary investment models: buying a property directly (a DIY approach), buying shares in a publicly traded real estate investment trust (the REIT model), and investing with a private real estate sponsor (the private equity model).

Previously, we examined real estate investment modeling with criteria including property management responsibilities, liquidity, and capital required to invest. Today, we’re going to dive into more ways real estate investment modeling is right for you.

Market Knowledge

Understanding the real estate markets is a critical element of an effective investment strategy. Since real estate market values are highly influenced by their local markets, knowing certain key issues is important. These include understanding the market drivers (the key factors that lead a particular tenant to be in a specific submarket), the advantages and disadvantages of every competitive property, the potential for new supply (future construction), the amenities that are important to tenants, and the local government and its desire to support or hinder construction and development in their community. The Private Equity and REIT models utilize full-time professionals who focus on these items daily. With the DIY model, these responsibilities would largely become the owner’s/investor’s.

Experience and Operating History

Among the significant advantages of the REIT and Private Equity models have over the DIY model are:

1. Their operating experience
2. Their ability to achieve savings from various contractors or service providers due to their size
3. The volume of business these real estate owners potentially represent to a contractor or service provider

Being a larger property owner also increases the likelihood of repeat business to the contractor or supplier, which can produce faster response and better performance. These represent material advantages over a single DIY owner/operator.

Alignment of Interests

When choosing to invest with someone else, it is important to determine if their interests are aligned with yours. When everyone has “skin in the game” then interests become aligned. In the Private Equity model, generally, the Sponsors are investing alongside the outside investors. In Kenwood’s case, the Sponsors generally invest between 10 to 20% of the total equity raised. In the REIT model, an investor should research how many shares are owned by key executives. It is valuable to make sure that they are incentivized to produce results that would grow the share value.

Tax Advantages Available Through 1031 Tax Deferred Exchanges

The current tax code allows real estate investors to defer taxes by utilizing a 1031 tax-deferred exchange when a property is sold. As a result, the entire capital gain can be tax-deferred when the property is sold, if it is subsequently re-invested in a like-kind property. This is a significant reason why many investors choose real estate over stocks or bonds. When purchasing a property as a DIYer or through a Private Equity model, we can generally benefit from a tax-deferred exchange. However, under the REIT model, when selling your shares, ordinary income or capital gains taxes would be due.

Benefits of Refinance Proceeds

Another advantage in investing as a DIYer or through Private Equity comes from refinancing proceeds. Refinance proceeds represent the cash available to an investor from a new loan after the original loan is paid off and any related expenses are paid. Most mortgages that are backed by an investment property are not fully amortizing, meaning they need to be refinanced every 5 or 10 years. This shorter loan term permits investors to capture some of the appreciation gained from the property through refinance proceeds. For example, if a property was purchased 10 years ago for $1,000,000. Assuming the loan was $700,000 and $300,000 represents the equity provided.

After 10 years of appreciation, the property is now worth $1,450,000, at 3.8% compounded growth per year. If a lender provides proceeds based on a similar 70% loan-to-value ratio (the ratio of the loan amount to the property’s value), the total proceeds will be $1,150,000. The initial $700,000 loan will then be paid off and there will be more than $300,000 in refinance proceeds that the investor receives. The real benefit is that these excess refinance proceeds are not taxed at this time. This represents a significant benefit for the DIY and Private Equity models that are not available to the REIT investor.

Below is a chart that summarizes the differences between the DIY, REIT, and Private Equity models.

Real Estate Investment Model Comparison

Do It Yourself vs. REIT vs. Private Equity (the Kenwood model)

Want to dig deeper? Get your comprehensive guide to analyzing these investment models.