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.
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.
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.
Among the significant advantages of the REIT and Private Equity models have over the DIY model are:
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.
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.
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.
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.
Do It Yourself vs. REIT vs. Private Equity (the Kenwood model)
| Do It Yourself Model | REIT Model | Private Equity Model (Kenwood Model) | |
|---|---|---|---|
| Active Versus Passive Investment | Active – You are responsible for everything. | Passive – The REIT handles all real estate matters. | Passive – The Sponsor (i.e. Kenwood) would handle all real estate matters. |
| Property Management Responsibilities | Active - All responsibilities are yours. You collect the rents, respond to tenant calls, and pay all bills. | Internal or external 3rd party management team. External management may not have the same goals as the internal management team. | Kenwood provides this service exclusively for its investment properties. |
| Capital Required to Invest | Generally large - You need to provide 100% of the equity plus closing costs and working capital. | Relatively small – based on share price. | As little as $25,000. |
| Liquidity | Not liquid. You would need to sell the property to create liquidity. | Very liquid. Easy to sell shares. | Considered illiquid; however, Kenwood’s sponsor will generally buy out an investor’s interest. |
| Deciding What Property to Invest in – Know What You Own | You have complete control. | No control over properties purchased. REIT may specify property type, but not location. | Investors are purchasing a specific property. The investor has complete control if they want to invest. |
| Market knowledge | It depends on you. Continuing to keep up to date with market developments is important. | Generally good understanding of markets that they invest in. Wall Street analysts may encourage REITs to invest in certain markets. | Kenwood only operates in the Washington DC and Baltimore submarkets. By limiting the number of markets Kenwood operates in, our market knowledge is extensive |
| Experience of Sponsor and Operating history | It depends on your experience. | Varies with each REIT. | Kenwood has been a real estate owner and operator since December 1996 |
| Alignment of Interests | Yes – it is all your money. | Uncertain – generally senior executives own shares in the REIT. Wall Street analysts may also encourage REITs to make certain decisions in an attempt to increase share price. | Yes - Kenwood’s sponsors always invest in each property. Kenwood generally invests between 10 – 20% of the needed equity with the balance coming from outside investors. |
| Tax Advantages Available Through 1031 Tax Deferred Exchanges | Yes – these benefits are available. | Not available to REIT investors. | Yes – these benefits are available. |
| Benefits of Refinance Proceeds | Yes – When the property is refinanced, the proceeds are tax-deferred. | Not available. | Yes – When the property is refinanced, the proceeds are tax-deferred. Want to dig deeper? Get your comprehensive guide to analyzing these investment models. |
Want to dig deeper? Get your comprehensive guide to analyzing these investment models.