In a contest, nobody wants to compete behind the eight ball or with one hand tied behind the back. Nobody wants to start already from behind. Starting from behind means you’re at a handicap and limited in some way that would prevent you from competing at your peak.
“One Hand Tied Behind Your Back”
“Start from Behind”
Nobody wants to be in this position, especially investors.
Investors are drawn to commercial real estate for its many financial benefits. Including cash flow, appreciation, non-correlation to Wall Street – but very few investors can invest directly and buy an apartment building, office complex, or warehouse on their own.
That’s why investors seek out passive investment opportunities to benefit from commercial real estate investments without being hands-on and without high capital requirements.
For passive investing, private REITs and private real estate funds are two popular options, but only one of these options should ever be considered.
Private REIT
When investing in a private REIT (aka non-traded REIT), an investor is often “behind the eight ball” from day one. That’s because non-traded REITs have proven historically only to benefit their managers.
Why is that? Because unlike public REITs that can be bought and sold on public markets for as little as $5-$20 per transaction, shares in private REITs can be subject to brokerage fees and upfront costs of up to 15%.
Instead of 100% of their capital being used to invest in income-producing assets, only 85% is available after commissions. Trying to generate returns for a $100 investment with only $85 dilutes the potential returns to the investor.
There are two problems with the high brokerage fees charged by private REITs:
- The first problem. If the sponsors of the REIT are also acting as the brokers – as is often the case – and pocketing the broker commissions. This is a direct conflict of interest between the sponsors’ motivation to make money from commissions and their responsibility to the investors to provide a return on their investment.
- The second problem is related to the first. Any incoming capital paid towards commissions is dead money. It’s capital that’s diverted from the principal purpose of the REIT, and that’s to invest in income-generating assets. The less money that is invested, the less money that will be available to generate income to distribute to investors. The higher the commission, the more money that ends up in the sponsors’ pockets and less in the investors.
There’s another major drawback to private REITs. According to IRS regulations, REITs are required to distribute at least 90 percent of their taxable income as dividends to their investors every year.
Although this can be a major draw for investors, it can also be a significant source of abuse by private REIT managers. That’s because the pressure to pay dividends can drive managers to pay dividends even when cash flow is not available.
Private REIT managers have pressure to pay dividends because a failure to pay dividends or even missing a scheduled dividend is a death sentence to a private REIT and will prevent it from raising additional capital.
To pay investors their promised income payments, managers may borrow money against the REIT’s investment assets or, worse, pay from incoming investor capital. If that sounds like a Ponzi scheme, it’s because it is. And because private REITs are loosely regulated, investors may never find out until it’s too late.
Take the case of Behringer Harvard Opportunity REIT I, which became one of the largest non-traded REITs in the country after launching in 2005. It raised a total of $559 million, stopped paying dividends in 2011, and liquidated in January 2017. Investors were only able to recover $0.19 on the dollar for their shares at liquidation.
Investors sued Behringer executives for breach of fiduciary duty for paying current investors with incoming investor money, while at the same time draining the company of millions of dollars from broker and management fees.
Behringer Harvard Opportunity REIT demonstrated exactly everything wrong with private REITs. Behringer executives compensated themselves from the get-go by diverting almost 10% of investor capital in commissions to an affiliated company.
With one hand behind their backs, Behringer executives were never able to steer the REIT to profitability. Desperate to keep the charade going, they raided incoming investor capital to pay current investors. Unfortunately, the Behringer case was not the first case and will not be the last case of a private REIT acting in this manner.
Private Real Estate Funds
For passive commercial real estate investing, a private real estate investment fund is superior to a private REIT. Without the high upfront commissions or costs, investors in a private real estate fund can have the confidence of knowing that nearly all of their funds will be invested in income-producing assets.
The absence of commissions also eliminates conflict of interest as the fund’s managers focus on providing a return to their investors and not making a ton of cash upfront.
With most private real estate funds, a manager’s compensation is tied to the fund’s performance, which aligns management’s investment objectives more closely with those of the investors.
Besides, with less dead money taken upfront in commissions and costs and less pressure to pay out dividends, managers of a private real estate fund have more capital to work with and more motivation to put that capital to its best use to generate a profit for their investors.
Click here for more information on private real estate funds.
