For real estate investors just starting out, one of the biggest misconceptions is that the only way to invest or make money is through flipping or being a landlord of single-family properties.
That misconception likely draws from the countless infomercials, banner ads and social media feeds by real estate gurus inviting potential real estate investors to buy a course or attend a seminar on real estate investing — which typically involve flipping or renting single-family homes.
Flipping and renting are not the only investment options.
Real estate investing comprises a large universe with diverse investment vehicles offering opportunities through a vast array of asset classes and strategies. Many of these vehicles don't require the capital and time associated with flipping or being a landlord. For the purposes of this article, I want to focus on the ways you can invest in real estate passively.
First of all, passive investments open up the pool of asset classes to include commercial real estate (CRE) and within the CRE class a variety of asset types. These include multifamily, office, industrial, retail, hospitality and development. Investors also have the option to invest in location and condition — as well as strategies.
When it comes to grading properties, a letter grade is the most common system.
Factors brokers consider when grading a property include location, age of the property, tenant profile, amenities, rental income and appreciation prospects. With these in mind, properties are typically assigned a letter grade from A-D. Properties exhibiting high marks among these factors receive the highest Class A classification with the lowest scoring properties receiving D grades — not unlike the grading system in schools.
These strategies can be categorized as core, core-plus, value-add and opportunistic. Core and core-plus require little to no renovations and have the highest graded tenants with the lowest vacancies. They are low-risk properties but offer limited potential upside because of fewer opportunities for making value-adds.
Value-add and opportunistic opportunities on the other end of the spectrum will require work to improve occupancy and net operating income (NOI). They are higher risk strategies but also offer the potential for more NOI and overall capitalization rate (RO) than core and core-plus properties.
With the investable universe of CRE out of the way, what are the different types of investment vehicles available to prospective investors? Here's a noncomprehensive list divided by public and private options along with their pros and cons.
REITs: Real estate investment trusts are companies that invest directly in real estate and are statutorily required to distribute at least 90% of its taxable income to shareholders annually in the form of dividends.
Pros: Traded on the stock market, public REITs are highly liquid with low barriers to entry. Investors can buy as little as one share of a REIT stock.
Cons: The liquidity of REITs is also its weakness since they can be subject to the same market volatility all stocks are subject to. Also, the 90% rule is based on taxable income and not gross income, so that means unscrupulous management can deplete taxable income through high salaries and excessive asset management fees, leaving little in the way of dividends to distribute to investors.
Real Estate Operating Companies (REOCs): Public REOCs are companies that invest in and operate CRE. Like companies underlying most common stock, REOCs are not statutorily required to distribute dividends like REITs, and gains to investors are in the form of appreciation.
Pros: Traded on the stock market, public REOCs are highly liquid with low barriers to entry. Investors can buy as little as one share of a REOC stock.
Cons: There are no guaranteed distributions, gains are solely dependent on appreciation and stock prices are susceptible to stock market volatility and arbitrary valuation.
Private Equity Real Estate (PERE): A private equity real estate fund — not to be confused with a private equity fund specializing in leveraged buyouts — is an open-ended fund that invests directly in CRE or other private companies that invest in CRE. PERE funds compensate investors in the form of cash flow from operations and profits from appreciation upon distribution.
Pros: In the hands of seasoned and expert management, PERE funds have the potential to deliver above-market returns through cash flow and appreciation with low correlation to Wall Street volatility.
Cons: PERE funds are illiquid with minimum lockup periods of typically five years. In the hands of wrong management, they can be high risk.
Real Estate Syndication: A real estate syndication is a private company — typically structured as a partnership — that invests in one or more specific CRE properties. Profits are distributed through a waterfall structure with investors — the limited partners or nonvoting members of an LLC — receiving a preferred return. They also receive first rights to profits based on a percentage of each individual's outstanding capital account balances until a specified target return has been achieved.
After the limited partners (LPs) receive their preferred returns, profit from operations is shared between the LPs and general partners (GPs) based on predetermined profit splits.
Upon disposition, profits from the disposition go first toward paying any unpaid preferred returns, then toward reducing the investors' capital accounts to zero, then split among the LPs and GPs.
Pros: With specific properties targeted, investors are better at evaluating the prospects of success of a particular fund strategy. In the hands of seasoned and expert management, syndications have the potential to deliver above-market returns through cash flow and appreciation with low correlation to Wall Street volatility.
Cons: Syndications are illiquid with minimum lockup periods of typically five years. In the hands of wrong management, they can be high risk.
There are various ways to invest in real estate without flipping or being a landlord. Passive investment opportunities in the CRE asset class abound in both public and private markets — each with their pros and cons.