A Beginner’s Guide to Private REITs

– Vatsal Rai

June 14, 2024

Introduction

Real estate can be an attractive investment for many, offering both consistent income and the potential for long-term growth. However, managing properties directly can be intricate and time-consuming. Real Estate Investment Trusts (REITs) provide a way to invest in real estate without the complexities of property management. While many investors are acquainted with publicly traded REITs, there is also a lesser-known category: private REITs. This article will explore private REITs, discussing their various types, benefits, drawbacks, and how you can invest in them.

What are Private REITs?

Private Real Estate Investment Trusts (REITs) are not listed on national stock exchanges and do not register with the Securities and Exchange Commission (SEC). Consequently, they are not bound by the same disclosure requirements as publicly traded or public non-listed REITs.

These private REITs distribute shares under various exemptions to securities laws established by the SEC, bypassing the need for SEC registration. One common exemption is Regulation D, which allows the sale of securities to “accredited investors.” Another is Rule 144A, which permits the issuance of securities to qualified institutional buyers (QIBs).^[1]

Private REITs, often referred to as private placement REITs, are offerings that do not require SEC registration under Regulation D of the Securities Act of 1933. These shares are deliberately kept off national stock exchanges. Typically, private REITs are available only to institutional investors, such as substantial pension funds, or to “Accredited Investors.” An accredited investor is defined as an individual with a net worth of at least $1 million (excluding the value of their primary residence) or an annual income exceeding $200,000 in the past two years ($300,000 if combined with a spouse’s income).^[1]

History of REITs

Real Estate Investment Trusts (REITs) originated in 1960 under President Dwight E. Eisenhower’s administration through Public Law 86-779, also known as the Cigar Excise Tax Extension of 1960. This legislation enabled REITs to invest in and finance real estate. Subsequently, the Tax Reform Act of 1986 expanded REITs’ capabilities to include property management and operation. Over time, these regulations evolved to include innovative offerings such as UPREITs. Currently, REITs collectively own approximately $4.5 trillion worth of U.S. commercial real estate, which accounts for around 31 percent of the total market.^[10]

A REIT functions as a corporation that directly invests in real estate through property ownership or mortgages, offering shares as securities to investors. Typically, REITs raise between $1 to $2 billion in capital^[10], acquiring property portfolios over several years with the goal of generating rental income and property value appreciation. They often have low investment thresholds, sometimes as accessible as $2,500, which makes them attractive for a diverse range of investors, including those with lower accreditation standards.^[10]

Initially, REITs are usually offered privately to accredited investors during their initial fundraising phase, which tends to be illiquid. Due to the risks associated with illiquidity and their smaller size compared to publicly traded REITs, private REITs generally offer higher capitalization rates. This can potentially result in substantial appreciation when the REIT goes public and becomes tradable.

Advantages of Private REITs

While private REITs may not be suitable for every investor, there are several compelling reasons why they might be appealing:

Attractive Dividend Yields: One notable advantage of private REITs is their typically higher dividend yields compared to public REITs. On average, public REITs offer dividend yields around 5% to 6%. In contrast, private REITs often provide yields in the 7% to 8% range, as reported by the National Real Estate Investor.^[2] This higher yield can be enticing for investors seeking greater income from their investments. According to data analyzed by NYU’s Stern School of Business, as of January 2020, the average dividend yield from REITs was 3.93%.^[9] However, certain REIT sectors might provide even higher dividends. In comparison, S&P 500 funds had dividend yields of approximately 1.71% as of August 2020.^[9] Additionally, one of the key features of REITs is their obligation by law to distribute at least 90% of their taxable income to shareholders in the form of dividends, and to have no more than 50% of its shares held by 5 or fewer individuals during the last half of the taxable year.^[6] This requirement ensures that investors receive a steady and reliable stream of income, which is a significant draw for those seeking consistent returns.

Reduced Sensitivity to Market Volatility: Another appealing feature of private REITs is their reduced exposure to daily market fluctuations. Over the last two decades, REITs have shown a moderate performance correlation with the broader equity market, standing at 0.56 correlation, and minimal correlation with investment-grade bonds, at 0.16 correlation.^[8] These correlations are noteworthy as they highlight REITs’ tendency to move somewhat independently from both stocks and bonds, which are often considered essential components of a well-diversified investment portfolio. Unlike public REITs, which have share prices that change daily, private REITs usually update their share prices quarterly. This means investors are not subjected to the daily ups and downs of the stock market. For those who tend to worry about the constant movement of stock prices, this infrequent pricing can offer a more stable and less stressful investment experience.

Lower Compliance Costs: Private REITs also benefit from significantly lower compliance costs. Public REITs must adhere to strict financial reporting and corporate governance regulations, which can be expensive. Private REITs, on the other hand, face fewer regulatory requirements, which allows them to save on these costs. Theoretically, this cost-saving can translate into better risk-adjusted returns for investors when compared to their publicly traded counterparts.

Tax Benefits: Private Real Estate Investment Trusts (REITs) present a range of tax advantages that can be particularly beneficial. One notable benefit is the ability to claim depreciation deductions, which can help reduce the amount of taxable income. Additionally, private REITs can facilitate the deferral of capital gains taxes through mechanisms such as 1031 exchanges.^[3] These exchanges allow investors to defer paying capital gains taxes when they reinvest the proceeds from a sale into a similar property. By utilizing depreciation and amortization, investors can significantly lower their taxable income derived from private REITs. This is significant because as compared to public REITS, dividends from public REITs are generally taxed as regular income, which can be substantial for certain investors. The tax rate can be as high as 37% based on the investor’s income level, along with an extra 3.8% Medicare surcharge on investment earnings.^[5]This makes private REITs especially attractive to high-net-worth individuals who can take full advantage of these tax-efficient strategies. Consequently, private REITs not only provide potential returns from real estate investments but also offer a strategic approach to minimizing tax liabilities

Focus on specialized segments: Private REITs have the flexibility to focus on specific or specialized segments of the real estate market that are often ignored or underrepresented by public REITs. These investments can encompass unique property types, niche geographic areas, or opportunistic real estate deals. By concentrating on these less conventional sectors, private REITs can tap into markets with potentially higher returns and lower competition, allowing them to capitalize on unique opportunities that may not be available in the broader public market. This approach enables private REITs to diversify their portfolios and potentially achieve better performance through strategic investments in undervalued or emerging real estate assets.

Making the Right Investment Decision

These investment options are more appropriate for long-term investors who are willing and able to commit their capital for several years. Due to the illiquid nature of private REITs, investors need to be comfortable with having their funds tied up for extended periods, typically ranging from five to ten years or even longer.

Private REITs generally carry higher risks because they are subject to less regulatory oversight and offer lower transparency. These REITs often invest in high-yield properties, which can be more vulnerable to market volatility and economic downturns. Consequently, investors need to conduct thorough due diligence and be prepared for the associated risks.

One of the key advantages of private REITs is their potential to offer higher dividend yields, often in the range of 7-8%.^[7] This is made possible by their ability to invest in high-yield properties and benefit from lower regulatory costs. These higher yields can be particularly appealing to investors seeking substantial income and who are willing to accept the increased risk that comes with these investments.

Additionally, private REITs allow for more specialized investments in niche markets or specific types of properties that are not typically accessible through public REITs. This can include distressed assets, properties in high-growth markets, or unique property types, providing investors with opportunities for significant growth and higher returns. By investing in these specialized areas, investors may benefit from the unique opportunities and potential for higher profitability that these markets can offer.

SREIT: The Sortis Advantage

Sortis REIT is distinguished by several notable features. Designed for Accredited Investors, it requires a minimum investment of $25,000 and offers quarterly distributions for consistent income. Investors can redeem after six months, with limits of 2% quarterly and 5% annually, subject to fund availability and advisor approval. The REIT has an impressive maximum offering of $1 billion, reflecting its scale and potential. Management fees are transparent at 1.25% of Net Asset Value (NAV), with a profit-sharing mechanism adding to the transparency.^[4]

Sortis REIT focuses on acquiring stabilized or easily stabilized real estate assets, prioritizing off-market deals. Transaction sizes range from $2 million to $20 million, keeping it competitive.^[4] Backed by Sortis Holdings, Inc., they enhance acquisitions through tailored retail experiences. Their asset classes include multifamily, hotel, retail, office, light industrial, and life science properties.

Led by a team with proven investment management expertise, the REIT targets opportunities for strong risk-adjusted returns. Concentrated on the Western States, they leverage local knowledge. As a boutique-sized fund, Sortis REIT retains market flexibility and avoids forced investments. Their diverse relationships provide unique access to deals, and staff members’ personal investments align their interests with those of investors.

Conclusion

Private REITs offer an alternative way for accredited investors to gain exposure to the real estate market without the liquidity constraints and volatility associated with publicly traded REITs. While they come with higher risk due to reduced regulation and transparency, private REITs can potentially provide compelling benefits such as higher dividend yields, tax advantages, and the ability to invest in specialized niche markets.

For investors seeking substantial income streams, the typical 7-8% dividend yields^[2] from private REITs can be quite attractive, especially when compared to the lower yields from public REITs and the broader stock market. The tax deferral strategies available, like 1031 exchanges and depreciation deductions, further amplify the appeal for high-net-worth individuals looking to minimize tax liabilities.

However, it’s crucial for investors to thoroughly evaluate their risk tolerance and investment horizon before allocating capital to these illiquid investments. The long lock-up periods require a buy-and-hold mentality. Thorough due diligence on the private REIT’s management team, investment strategy, and track record is essential to assess potential risks and returns.

For accredited investors comfortable with the inherent risks, allocating a modest portion of their portfolio to a reputable private REIT can provide diversification benefits and exposure to unique real estate opportunities. Offerings like the Sortis REIT, with its focus on strategic Western acquisitions and alignment of investor interests, exemplify the potential advantages this asset class can offer to sophisticated investors. Ultimately, investing in private REITs demands prudence, but can be a rewarding avenue for those prepared to embrace the associated illiquidity and risks.