Equity Real Estate Investments
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, together with similar vehicles at the property title-holding level, 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.
When RealtyShares organizes an LLC for an equity investment, that entity generally invests in (or alongside) a professional real estate developer or renovator — a “sponsor,” or “operator” — that 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 — and these investors can then share in some of the project’s potential benefits (and risks). How best to do that?
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 its 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 institutional investors in the past sometimes 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” – its 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 it to manage the property to a performance level where excess cash flow is rewarding it in a way that exceeds its own investment position. Since investors also get a portion of that excess cash flow, everyone wins!
Potential Tax Advantages vs. REITS
In addition to typically being property-specific (as opposed to operations involving only “pools” of properties), pass-through investment vehicles such as LLCs not only avoid double taxation but also 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) current taxes. Investors may ultimately have some or all of this tax benefit be “recaptured” by tax authorities upon a sale or other disposition — but in the meantime, they can have tax-free use of the distributed cash.
REIT investors generally receive income free of an entity-level tax, but a sizable difference remains – REIT distributions are still taxable as ordinary “portfolio” income (like dividends), which means that they cannot be sheltered by losses from other “passive activities” of an investor, as they can be 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. Crowdfunding sites like RealtyShares allow smaller investors to follow the lead of larger institutional investors in allocating their real estate investments into these private placements. The LLC structures can give investors direct access to many of the full benefits of real estate ownership – including 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
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.