Investing in Commercial Real Estate: REITs vs. Limited Partnerships
Real estate can be a rewarding investment. This holds true for its performance potential as well as its tangible appeal. Unlike a bond or share of stock, an investment in real estate is "real" -- land or buildings which can be seen and visited -- providing a more gratifying investing experience for many. Exactly how gratifying an experience this may be, however, will depend on a number of factors, not least of which is the ownership structure.
Other than direct purchase of a property, there are two main institutional structures for investing in commercial real estate: real estate investment trusts (REITs) and limited partnerships (LPs). The two vehicles differ in terms of their liquidity, flexibility, and control. They also differ in their tax treatment. Because of these differences, one structure may be more appropriate than the other, depending on what you're investing in and your own specific investment objectives.
Real Estate Investment Trusts
REITs are companies that invest in groups of professionally managed properties, such as office buildings, apartments, warehouses, or health care facilities. They come in three varieties: equity, mortgage, or a hybrid of the two. REITs enjoy certain tax advantages but must meet certain requirements: To qualify as a REIT, a company must invest at least 75% of its total assets in real estate assets; it must derive at least 75% of gross income from rents or interest on mortgages; and, most important, it must pay dividends of at least 90% of its taxable income in the form of shareholder dividends. By meeting these requirements (and others), REITs can pass through income to shareholders without being taxed, thus avoiding the double taxation of regular corporate dividends. Keep in mind, however, that shareholders still pay taxes on the dividends received as well as any capital gains.
The biggest advantage of REITs over limited partnerships is their liquidity. Since most are traded on a major exchange, they can be easily bought and sold at per-share prices comparable to stocks. You can also buy mutual funds that invest in REITs. Like all real estate investments, REITs are sensitive to changes in interest rates and subject to the cyclical variations in real estate markets.
REITs can provide a steady income component to a portfolio and also allow for capital appreciation. As a growth investment, REIT performance has often compared favorably to stocks. For example, for the 20 years ended December 29, 2017, the NAREIT Index of publicly traded equity REITs generated an annualized return of 9.12% compared with the S&P 500's annualized return of 7.20% over the same period.1 But because a high portion of REIT returns is derived from income rather than capital appreciation, they tend to behave more like fixed-income securities. As a result, they have a relatively low correlation with equities.
For investors who survived the market turmoil of the late 1980s, the words "limited partnership" may conjure up images of empty buildings, corrupt syndicators, and bankrupt investors. But today's limited partnerships are a different animal; the tax changes that effectively negated their loophole status are now entrenched, and LPs are a viable and widely used structure for investing in commercial real estate.
Perhaps the major characteristic distinguishing LPs from REITs is their status as private equity; most offerings are restricted, and shares (units) are generally not publicly traded. Private partnerships face far fewer restrictions on what they can invest in and what must be distributed to investors; they can own one property or many and can own equipment or virtually any other type of income-producing asset. Accordingly, investment parameters and performance vary significantly from partnership to partnership.
A major concern when considering LPs is liquidity -- or lack thereof. No formal public market for units exists, secondary markets are sporadic, and prices can be deeply discounted. As private equity vehicles, most LPs also have high investment minimums (generally, $2,000 or above and often substantially more). Moreover, many LPs require investors to be accredited (i.e., they must meet certain minimum income and net worth requirements). Typically, investors are required to have an investable net worth of over $1 million and annual income of over $200,000. In other words, LPs have barriers to entry, and once you're in, it may be difficult to get out. So LP investors should be prepared to invest for the long haul.
On the positive side, LPs can offer greater tax benefits than REITs. LPs can pass through tax losses, which may then be used by investors to offset taxable gains. In a typical net-lease partnership, for instance, properties will generate paper losses in the early years because of high depreciation expense. These losses can be used by the limited partners to offset gains from other investments.2 Such limited partnerships can be particularly appealing for individuals in top tax brackets.
Partnerships, however, differ significantly from REITs in the way they pass through income to investors; partnership income and losses are allocated proportionately to the partners regardless of whether there is a corresponding cash distribution. Accordingly, investors may be taxed on "phantom" income for which they receive no cash dividend.2
In summary, LPs can offer better tax benefits and higher growth potential than REITs, but at a cost. They usually carry much higher risk, have high investment minimums, and are illiquid investments.
Whether you invest in a REIT or a limited partnership, keep in mind that real estate investment performance, regardless of the structure, is largely a function of the property being invested in -- its type, location, leasing status, condition, management, and market. How an individual partnership or a REIT performs will ultimately depend on these factors more than on its structure. So remember to look closely at the property portfolio, and talk to your investment advisor before investing.
1Sources: Standard & Poor's; NAREIT. The NAREIT Equity REIT Index is an unmanaged index of real estate investment trusts considered representative of the publicly traded U.S. REIT market. Data for the 20 years ended December 29, 2017. Assumes reinvestment of all dividends. Past performance is no guarantee of future results. The performance shown is for illustrative purposes only and is not indicative of the performance of any specific investment.
2Pass-through loss limitations apply. Passive activity rules governing limited partnership taxation are complex. Investors should consult a tax advisor before investing.
Pursuing Portfolio Returns With a Sector Rotation Strategy - Interactive Chart
Private Equity -- Beyond the Traditional - Article