Why Would I Ever Invest In A Private REIT Instead Of A Public REIT?
Hooman Tabesh, Alliance REIT's CEO, answers your questions about getting started with private REITs so you can reach your financial goals.
November 15, 2019
· 8 min read
This is the latest article for our “Demystifying Real Estate Investments" series at Homebound, where we get inside stories from executives of Canadian investment companies to help you navigate the world of alternative real estate investments.
Let’s start with a little bit about who you are and what you do.
My name is Hooman Tabesh and I’m the CEO of Alliance REIT. I grew up in downtown Toronto in the West end, and Toronto is a place I’m very passionate about.
I studied both Business and Law, and worked on Bay Street for over 15 years. But while I was doing that, I was also investing in real estate in Toronto’s downtown core — I have been investing in and developing residential real estate for 20 years now.
My job is to help our fund source, purchase, and develop properties that are in gentrifying or pre-gentrified neighbourhoods. We develop the properties into multi-residential buildings, rent them out, and manage them. When we invest in a property, we look at where we believe that neighbourhood will be in 5 years time.
So let’s pretend I don’t know anything about private REITs. Can you explain to me what they are, who they’re good for, and why people should invest in them?
A REIT is a tax-efficient vehicle that gives people exposure to a diversified portfolio of income producing properties.
It can be a way for you to invest less capital, so that in 5, 10, or 15 years, when you’re ready to purchase — or manage properties on your own — your capital has appreciated by the same amount as the broader real estate market.
Private REITs are typically more exclusive and may not be accessible to everyone.
In many cases, such as with ours, a private REIT can not only provide investors with income distributions, but also with terrific growth. For example, in the last three years, our REIT has had 66% growth in value — that’s roughly 15% growth year-over-year.
REITs provide income throughout the year, which is also why, historically, they were an investment for retirees or anyone else who depended on a regular income.
But REITs are also really good for millennials and younger generations. Especially for people who want to buy into the real estate market, but can’t because the market keeps getting away from them. With a growth-oriented private REIT, you could potentially see your investment match — and even surpass — the pace of the broader residential real estate market.
So why would I put my money in a private REIT over a public REIT, which is more accessible through any stock exchange?
By far the largest benefit of private REITs is that the value of their units (similar to shares when referring to a corporation) is based on the intrinsic value of the properties they hold. Whereas with public REITs, that value is a little more volatile, going up and down based on market events, analyst expectations, and public perception.
That means, often, the unit price in a public REIT is not actually based on the intrinsic value of the real estate portfolio it holds.
But with a private REIT, it is.
For example, our properties are appraised every three months. So the value of each unit of the REIT is assessed frequently enough and is directly correlated to the value of the properties. This also means that every time an investor buys or sells units, they are getting a proportionate share of the fair value of the underlying assets.
There are also a lot of costs associated with maintaining a public investment. With a public REIT, or any public company, you’re paying for the stock exchange listing, banker fees, regulatory compliance, etc.
Which means another benefit of investing in a private REIT is actually the savings — you’re not paying for all of those additional administration fees.
Also, public REITs, by virtue of their size, cannot execute on every opportunity. They need opportunities that are larger in scale and size.
What sets a private REIT apart is that it can go after smaller opportunities — and a wider set of opportunities — and execute on them in a more timely fashion.
So as a result, a private REIT can target higher returns.
What are the immediate risks of investing in private REITs?
Liquidity can be the biggest risk associated with private REITs.
When you view real estate as an investment, generally the smartest mindset is to have a longer investment horizon. That’s why many private real estate funds are “closed funds”, which means you can’t sell or redeem any units until a specified period of time — ranging from 5 to 10 years. On the other hand, public REIT units can be bought and sold on any exchange and you can exit at any time.
For us, we’ve tried to mitigate the risk by operating as an open fund that maintains very low debt levels. Because we invest in smaller properties, we can always either refinance or sell properties to fund any larger redemptions needed by our investors.
Real estate values are another obvious risk and so are interest rates if they’re one day increased dramatically. Not just for private REITs, but for all.
Interesting. So as an investor, would I be betting that a smaller, more hands-on, management team’s expertise would be better than a larger corporation?
I’m not sure if this is a significant differentiator, but in a private REIT, you’re generally getting a smaller management team. That means important decisions can be made faster and teams can execute on opportunities more efficiently.
There’s also less opportunity to run into any agency problems, which is when the person running the management company is not necessarily an owner.
And typically with private REITs, the members of the management team are also owners in the fund. So there’s generally a strong relationship and alignment of interests with investors.
How about minimum investment amounts, management fees, and cash distributions — is there a difference between private and public REITs?
Generally, for private REITs you would expect to have better returns and distributions.
In the past, private REITs were only open to big family offices and high net worth investors who could afford a minimum investment that’s anywhere between $100,000, $200,000 or half a million dollars.
For us and many others, it’s about leveling the playing field. So we’re taking the same product that wasn’t previously available to the general public, and making it available with a lower minimum investment, say $20,000.
Remember, public REITs are more constrained. They can only execute on much larger projects and buildings. Private REITs operate on a lower cost structure, can focus on smaller opportunities, and execute faster and more efficiently — therefore, they’re often able to have more control in driving higher risk-adjusted returns for every dollar invested.
Meanwhile, what’s been happening with public REITs is that annual distributions have been decreasing. Because they tend to have higher overhead costs, public REITs have suffered in the past, and so has their growth.
In terms of management fees, the only thing our private REIT pays for is a 1.5% fee based on equity and that’s it. It essentially pays for all of our administration and all of our management costs.
Depending on whether the public REIT has an internal or external management structure, you may not have to pay a management fee, but you’ll still be paying for the REIT's overhead costs. This could range from a 1-2.5% fee, based on both the equity and debt of the assets.
Going back to something you hinted at earlier – are there any tax implications or benefits that can be applied to directly private REITs?
Yes. From a tax perspective, they offer benefits that are similar to those of public REITs. The income is only taxed at the investors’ hands, not at the company level. Public and private REITs function very similarly in this way.
And I’m not sure how relevant this is, but there are some other interesting ways you can realize tax benefits with a REIT.
So for example, if folks have a property they want to sell, but it wasn’t their primary residence, they would be subject to capital gains tax. But with a private REIT — and to an extent with public REITs — you can roll your property into the portfolio of the REIT instead, and you’ll receive special units of the REIT in exchange. As long as they don’t sell those units, they don’t realize any taxes.
When they’re ready, they can then sell those units little by little in a tax-efficient manner and minimize the taxes they have to pay. Of course, this is more relevant for property owners, not necessarily for investors.
But overall, from a tax perspective, public and private REITs are both very tax-efficient.
I have to ask, given the long bull run the real estate market has experienced over the past 10 years. What do you expect would happen to a private REIT vs. a low-fee ETF during a major downtrend?
It’s a very different structure. An ETF can be hedged and may use derivatives.
The benefit of a private REIT is that it’s non-correlated to the stock market. People always need a place to live.
The only thing that would really affect our business is a major exodus of people from the city. As long as there is demand, we can be successful. If interest rates go through the roof, or there’s a shift of skilled employees, then that’s absolutely going to affect our business. But as long as we provide well designed, clean units in the right location, our business will be successful.
I can see a major reservation for potential investors being the long hold periods of cash illiquidity. Can people with say, $50K already invested across index funds or ETFs, still qualify or benefit from this?
Absolutely. Remember, real estate is a long-term investment. There’s a steady increase in the value of real estate across Toronto, particularly in the core. A private REIT that has the expertise in a local city will have a higher probability of success because it’s able to pick the better properties at more desirable locations.
Every firm makes bets on the right locations. It’s a way for you to diversify out of a broader market area. So a well managed private REIT would give you the expertise and opportunities to replicate the same returns, which you might have seen on your house, in your investment portfolio.
Let’s pretend you were in my shoes as a millennial, dealing with today’s real estate investment market in Toronto. Using the experience you have today, how do you think millennials should diversify their portfolios?
Well, I can give you personal experience. I don’t want to preach, but I’ll tell you my own experience. Back when I was 27 years old and I was articling at a law firm in Toronto, I never invested a dollar in the public market — in the stock market. The stock market, I think, from the average investor’s perspective, there’s too many underlying factors that affect that investment that’s out of control from the investor.
So ever since I could invest my own money, it was always in properties.
I think it’s important for millennials to aspire to hold property, to be able to have a piece of land or own a condo. That will become your biggest investment.
I know it is much harder to access the market because of the prices in Toronto. But I encourage you to not lose hope.
Buying into a REIT is the easiest thing you can do to get your foot in the door and own an income-producing property that you don’t have to manage yourself.
We live in a great city — a great country — it’s inevitable that in the long-term it will only become more dense and more expensive. So being able to secure a property that is going to appreciate as demographics expand is important. Owning a private REIT is just one way to do it.
How would I know if a private REIT is legit? What are some important details that I’m supposed to look for?
That’s a great question. That can be an issue.
For us, we are regulated by the Ontario Securities Commission (OSC). We’re also regulated by the Canada Revenue Agency (CRA). And on top of that, we’re also audited by BDO, which is a large reputable accounting firm. So I think you should look for a firm that has a track record and is regulated by a regulatory body, like a securities commission. It’d also be good to review if there are audited financials from reputable accounting firms. Look at their principles, look at their Board of Trustees. Is it is just one person running around with some money or is it a reputable Board of Trustees?
To get this information, you have to make sure there’s an offering memorandum. You should always read the declaration of trust, which is essentially the governing document of the REIT — it outlines your investor rights. It’s basically the constitution of that REIT. So it’s very important for investors to ask for these documents and review them. And, obviously, consult with your advisors or lawyers.
But you’re absolutely right. There are a lot of private REITs that don’t have the same oversight as others and the reason we do is because we wanted to become RRSP eligible. To become RRSP eligible, companies have to follow CRA regulations, have audited financials, and abide by several other regulations. These are the things that you should look out for.
As told to Sean Ho Lung exclusively for Homebound; transcript edited and condensed for clarity. Illustration by Felicity Tse.
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