A growing number of investors are discovering the advantages of diversifying portfolios through allocations to real estate assets. In fact, real estate is solidifying a reputation as the “fourth asset class” behind stocks, bonds and cash. As we drill down into this burgeoning asset class, it is important for investors to understand the important differences that exist between direct and indirect real estate investing, which has significant impacts on risk, returns and diversification.
What is direct real estate investing?
Direct real estate investing involves buying a stake in a specific property. For equity investments, this means acquiring an ownership interest in an entity that directly owns an asset such as an apartment community, shopping center or office building. Debt investing refers to capitalizing a loan that is collateralized by real estate, such as land or an existing property.
What is indirect real estate investing?
Indirect real estate investing typically involves buying shares in a fund or a publicly or privately held company. One of the common first steps for investors is to buy shares of non-traded or publicly-traded real estate investment trust (REIT) stocks. REITs are in the business of owning and managing portfolios of real estate properties. Therefore, for traditional REITs you are, in essence, investing in the operating profitability of the landlord and not directly in the underlying assets themselves.
Controlling your destiny
One of the advantages of direct investing is greater control in decision making, particularly when it comes to application of the investment strategy. For example, in a direct investing format, an investor can select properties with criteria based on location, product type (e.g. office vs. industrial) or structure (e.g. equity, preferred equity or debt) with full transparency into an array of information on the asset including tenants, physical asset condition, and operating performance as well as information on the key players involved, including the operating company and property manager. Direct investing empowers individuals with the opportunity to invest in what they know and are passionate about, which can range from criteria as broad as a metro to as granular as a specific street corner and applied to properties that may be located in their own backyard or out of state.
For example, CrowdStreet’s 2015 posting of Urban Green Investments’ equity offering for a memory care redevelopment in downtown Santa Monica, CA is an excellent example of a focused real estate investment opportunity. In this case, the sponsor is redeveloping a dormant, prime in-fill property based upon market research that validates strong local demographics, a dearth of competitive supply and high barriers to entry. Upon delivery and stabilization, the asset targets high annual cash yields. For investors who may a) know the asset, having driven past it over the years b) have belief in the business plan (i.e. operating a memory care facility in Santa Monica, CA or c) have become aware of the asset by having a relative that is a prospective future resident – a direct investment opportunity enables the individual investor to make a targeted investment decision based upon specific or unique knowledge or opinions.
In contrast, buying shares in a fund or REIT often equates to investing in an entity’s broader investment strategy. This may still be a viable, even attractive, strategy – it is just that it is a different type of investment. For example, under this format, an individual has no control and, in most cases even previous knowledge, of the individual assets that are bought and sold. In addition, certain REITs have vast real estate portfolios that include properties both in the U.S. and other countries, such as China and Brazil. This can create the unintended consequence of adding risk exposure to geopolitical, exchange rate and economic shifts of foreign markets.
Avoiding higher fees
Direct real estate offerings often have specified fee and compensation structures that can vary on a case-by-case basis. Specific to the real estate online marketplace, various platforms operate with different business models related to fees. So, it is important for investors to compare and contrast choices carefully. Investors on the CrowdStreet Marketplace do not pay any fees or “load” to register on the platform or invest in specific real estate offerings.
Investors can expect to pay fees for indirect real estate investments in REITs and funds. Non-traded REITs, in particular, have been widely criticized for their egregious front end loads. According to the Financial Industry Regulatory Authority (FINRA), front-end fees for non-traded REITs can be as much as 15% of the per-share price. Those fees include broker commission and expenses, as well as additional offering and organizational costs. Exchange-traded REITs may have front-end underwriting fees in the form of a discount that could be 7% or more of the offering proceeds, according to FINRA.
Capitalizing on incentives
One of the advantages of direct investment is that offerings are often structured to incentivize sponsors to deliver better than expected performance via what is commonly referred to as a “promote”. Promotes typically contain preferred returns to investors up until a first hurdle is met (usually measured on an internal rate of return basis) at which point sponsors begin to disproportionately share in excess profits. Because sponsors want to attract investors, they are motivated to create compensation structures that are aligned with them. Rather than collecting guaranteed fees and delivering a fixed return, sponsors often skinny down fixed fees in exchange for a promote that provides the opportunity for a bigger reward or percentage of excess profits if they outperform. It’s a win-win scenario. If sponsors perform well, they are compensated for those results and investors have the opportunity to share in that profit with a higher overall return. Conversely, if sponsors underperform then investors earn their entire pro-rata share of returns and sponsors are shut out of any back end compensation. REITs and funds are generally more fee-based, meaning that managers collect their fees regardless of performance.
Being patient with your money
Another aspect of direct vs. indirect real estate investing is understanding liquidity. Indirect investing in publicly-traded REIT stocks or mutual funds allows investors to easily buy and sell shares. Direct real estate investing has traditionally involved buying and holding assets over a period of years. The longer-term nature of direct real estate investing can produce some added benefits, such as delivering steady cash flow over the term of the investment but it comes at the cost of daily liquidity (in the case of publicly-traded REITs). Some debt financing offerings might include fixed terms of 12 to 18 months, while equity offerings might post targeted terms of three to seven years.
The CrowdStreet Marketplace makes direct commercial real estate easily accessible. The platform gives investors the opportunity to diversify their portfolio by providing transparent information on a variety of commercial real estate investment opportunities across the country, as well as providing tools to help investors track performance and manage their growing real estate investment portfolios.
