Direct Investing vs. REITs
What’s the difference, anyway, between a marketplace’s individual common equity real estate investments and REITs?
Marketplace platforms like RealtyShares offer equity real estate investments through “direct participation” investment vehicles such as limited liability companies (LLCs). These entities allow for the “pass-through” of depreciation, interest expense, and other deductions that can reduce or defer investors’ taxable income. In addition, the payout structures within those entities are designed to align the interests of investors with those of the sponsoring real estate company.
Direct Investing vs. REITs
When RealtyShares organizes an LLC for an equity investment, that entity generally invests in (or alongside) a professional real estate developer or renovator —referred to as the project “sponsor”—who finds the opportunity and handles the related property management tasks.
Such sponsoring real estate companies typically need other investors to provide some (or most) of the capital required for any single opportunity. These investors then share in the project’s risks and rewards. There are several ways to invest in these projects; which one is right for you?
One way is through real estate investment trusts (REITs), which operate pools of many different properties and, if publicly traded, offer some degree of liquidity. If an investor is willing to let a REIT choose the investments in their portfolio and doesn’t need the potential tax benefits of real estate ownership passed through to the investor’s own tax returns, then REITs are not a bad option.
It’s interesting to note, however, that many institutional investors have historically placed between 80% to 95% of their real estate allocations into private real estate investments rather than publicly traded REITs. Some of this preference may be due to the fact that many publicly traded REIT securities get caught up in market sentiment and can experience severe price volatility, just like common stocks.
Some of the appeal, too, lies in the inability of REITs to fully take advantage of the various tax benefits available through direct pass-through structures. Importantly, REITs do not allow for net operating losses (NOLs) to be used by investors to offset their income from other “passive” activities.
How Do Direct Investments Work?
With direct participation investments, a primary investment decision involves how the potential financial benefits of the project are to be divided among passive investors and the sponsor.
Investors want to know that a sponsor has sufficient “skin in the game”—their own investment capital—and that any extra “carry” or “promote” compensation to the sponsor come only after investors have received some primary level of return – so that the sponsor’s interests are better aligned with those of investors.
The negotiations involved in particular transactions result in varying outcomes, of course, but over time some common patterns have emerged for many transactions:
- Finance most of the equity capital (typically 80-95%)
- Have a “preferred return” on their investment (often 5-10% per year)
- Collect the largest part of the remaining cash flow and profits (usually 50-80%)
- Get the bulk of any tax benefits (depreciation and interest deductions)
- Finances a smaller portion of the capital (typically 5-20%)
- Can get the same preferred return as other investors on its own invested capital
- Receives a “promote” (carry) share of the excess cash flow (profits)
- Can take fees for the property acquisition, management, and disposition
- Receives some share of any tax benefits
The “preferred return” to investors assures that investors putting cash into a project have the first priority on the project’s returns — before the sponsor gets any “carry”, or promote, payouts for having taken the lead on the opportunity. The preferred return is not a guaranteed dividend payment, but if it’s not timely paid then it continues to accrue, and investors have a first claim on such amounts when the property is sold.
Conversely, providing the sponsor with a “promote” interest on excess available cash flow tends to align its interest with that of investors, by incentivizing them to manage the property such that cash flows exceed their own investment position. Since investors also get a portion of that excess cash flow, everyone wins!
Taxes and Direct Investing
The commercial real estate industry clearly benefits from the Tax Cuts and Jobs Act recently passed by Congress and signed into law by President Trump.
Subject to certain limits, the 20% deduction in income received through pass-through entities like partnerships or limited liability companies utilized by marketplaces like RealtyShares was one of just several big wins for real estate investors.
“Real estate does great,” said Daniel N. Shaviro, a tax professor at NYU Law. In his capacity as a congressional staff member, Shaviro helped write the last tax overhaul, in 1986. “It’s hard to imagine what they might have asked for that they don’t have.”
So pass-through investment vehicles such as LLCs now avoid double taxation and allow investors to potentially obtain the full benefit of any available tax losses or incentives. With real estate, the magnitude of the depreciation and interest expense deductions make this advantage potentially significant.
The pass-through structures of LLCs allow partners/members to receive “flow-through” of these tax offsets, and to thus receive periodic distributions without incurring (much) tax. Investors may ultimately see some or all of this tax benefit “recaptured” by tax authorities upon a sale or other disposition—but in the meantime, they have tax-free use of the cash.
Taxes and REITs
REIT investors generally receive income free of an entity-level tax, but a sizeable difference remains: REIT distributions are still taxable as ordinary “portfolio” income, like dividends. That means they can’t be sheltered by losses from other “passive activities” of an investor, as they can with direct participation structures.
REITs can also be less efficient tax vehicles in other, more minor ways. For example, distributions not paid in the year earned can be subject to entity-level tax. The ability to receive tax-deferred cash flow, and in some instances to be able to utilize NOLs, are major factors favoring “direct participation” real estate investments utilizing pass-through entities.
Curated marketplaces like RealtyShares allow smaller investors to follow the lead of larger institutions in allocating their real estate investments into these private placements. The LLC structure can give investors direct access to many of the full benefits of real estate ownership. That includes taking advantage of the depreciation, interest, and other deductions that act to shelter or defer much of the income that is distributed from the investment property.
Risk Factors for Private Direct Participation Vehicles
It should be noted that the direct participation vehicles discussed above still carry significant risk. All of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC, and the disclosures are less detailed than would be expected from a registered public offering. Ongoing disclosure requirements are negligible.
The investments are also illiquid, with undetermined holding periods and no real preset liquidity terms. These offerings are also only available to accredited investors, so the illiquid nature of any investment is heightened – further emphasizing the differences of these securities compared to registered, publicly-traded securities.
Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.