This is the third installment in a series on alternative asset classes and your portfolio. The first covered strategies that use liquid underlying assets like stocks and bonds, which are freely tradable. Yesterday, we talked about how illiquid asset classes can also fit into a portfolio, with some examples, but didn’t really delve into details. Today, I want to discuss real estate as an example of an asset class that can be used in both liquid and illiquid forms.
The liquid form is known as a real estate investment trust, or REIT for short. REITs are publicly traded and are essentially stocks in every way except for the underlying asset, which is a portfolio of commercial real estate buildings, mortgages, or both. Investopedia offers a pretty good definition of REITs.
One of the key characteristics of a REIT is that the income from the underlying assets has to be passed through to investors to preserve a favorable tax status. Therefore, REITs have typically been seen as income generating investments, but not a direct investment in buildings.
A REIT share can be sold more readily when compared to a building or mortgage. However, REITs are only pass-through entities that offer investors an equity interest in a pool of real estate assets, including land, buildings, shopping centers, hotels and office properties, and, in some cases, mortgages secured by real estate. Thus, investor’s participation in a real estate program is an investment in the program and not a direct investment in real estate or any other assets owned by the program. The distribution rates of REITs are not guaranteed but can offer some investors a source of income when available.
Now let’s look at a building, as compared with those REIT shares. Shares are homogeneous and liquid; they can be sold easily, quickly, and cheaply. Buildings are all different; they are expensive, slow, and difficult to sell. Buyers of buildings tend to hold on for years, share owners for much less time.
Because of this, investors in buildings require higher returns to justify their costs and their risks. Prices of buildings move much more slowly, and in response to different factors, than prices of stocks, which potentially makes direct property ownership a better diversifier.
Pricing and yield on real estate is typically expressed as a “cap rate,” which is the net operating income—a term of art here—divided by the price paid. This is the cash yield on an unlevered property, and, as noted above, it is higher in the private markets than in the public markets. A building will be worth less if sold on its own than its contributory value as part of a REIT. In my opinion, this is what has driven the expansion of the REIT industry: the ability of REITs to pay more, thanks to their lower cost of funds, than private investors can. Because of this, I believe returns have been driven down, and consequently, prices have gone up, for high-quality commercial properties.
For us as investors, there are still options to invest in illiquid forms of real estate and attempt to harvest those higher returns. Buying individual properties, such as a small apartment building, remains an option for many people, but this has additional costs and requirements. Investing in a private partnership that invests directly in real estate is another option. Finally, there are vehicles—nontraded REITs—that attempt to have it both ways.
These are public in structure, like a traded REIT, but are not traded. Instead, the share price remains fixed initially and then is regularly adjusted, based on the value of the underlying assets, until the manager disposes of the portfolio—either selling the properties individually or as a whole, or by taking the portfolio to the public markets. The goal is to capture the value created by moving from the private market to the public, as well as the interim cash flows, with the hoped-for higher returns justifying the limited liquidity of the investment. In this, nontraded REITs are similar to a private partnership, but with a clearer and more regulated structure.
Real estate is an asset class available in different forms with different levels of risk and liquidity, and, as such, provides a good illustration of how different forms of an asset class can affect your portfolio as a whole. With this discussion, you can get an idea of how the different types of illiquidity may benefit your portfolio—and at what cost.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.
A nontraded real estate investment trust (REIT) is a REIT that is not traded on any public stock exchange. A nontraded REIT lacks the marketable liquidity of a publicly traded REIT and may be difficult to redeem at any price. You should consult with your financial advisor and carefully consider your short-term and long-term liquidity needs. Real estate investments are subject to a high degree of risk because of general economic or local market conditions; changes in supply or demand; competing properties in an area; changes in interest rates; and changes in tax, real estate, environmental, or zoning laws and regulations. Real estate units/shares fluctuate in value and may be redeemed for more or less than the original amount invested.