For investors interested in a steady stream of passive income, real estate and bonds are two common choices. While both of these options offer the potential for passive income, there are critical differences that investors should be aware of.
By reading this article, investors will learn what REITs and bonds are, how to invest in them, and how they compare with the types of private equity commercial real estate investments that we offer. Let’s start with a simple definition.
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What is a REIT?
A Real Estate Investment Trust (REIT) is a company that buys, sells, operates, or finances real estate. REITs can be privately traded – which means that investors must meet certain income and net worth requirements before buying or selling them. Or, they can be publicly traded, which means that their shares can be bought and sold by anyone with a brokerage account on major stock exchanges. Broadly, there are two types of REITs, equity and mortgage. In this article, our focus is on the former.
Equity REITs own/operate commercial real estate assets and they are very popular with individual investors. Most specialize in a specific property type like office buildings, multifamily apartments, or retail shopping centers. For example, Prologis is a large publicly traded REIT that owns and operates industrial/warehouse properties.
Pros and Cons of a REIT Investment
From an individual investor’s standpoint, allocating capital to a publicly traded equity REIT comes with several benefits:
- Ownership: For investors who want to own real estate or those just interested in real estate investing, a REIT has low barriers to entry and can provide shareholders with the benefits of real estate ownership without the hassle of actually managing it.
- Income: REITs have a tax advantaged structure that does not require them to pay income tax at the corporate level as long as they distribute at least 90% of their taxable income to shareholders. This means a steady stream of dividend income, which creates a strong dividend yield.
- Diversification: REIT capital is spread over many different real estate properties and locations. So, in a single share of a REIT, investors get a broadly diversified portfolio of real estate assets.
- Capital Appreciation: The share price of a REIT is driven by the underlying value of its properties. If the REIT manager chooses well and the properties increase in value, investors can also benefit from capital gains on the change in the share price. These gains, combined with dividend income, can create strong total returns.
- Liquidity: Finally, because REIT shares are bought and sold in the stock market, they are far more liquid than other types of real estate investments.
But, a publicly traded equity REIT also comes with risks. They tend to be highly sensitive to changes in interest rates, have the potential for significant short-term stock price volatility, and investors have no control over how capital is deployed.
What is a Bond?
The easiest way to think of a bond is as a small loan. When a corporation or government needs to raise capital, they frequently sell bonds, which is an instrument of indebtedness that comes with a promise to repay the original principal amount, plus interest, over a certain period of time. As such, the amount of interest that a bond issuer is required to pay is directly related to their financial strength and history of repayment.
For example, a treasury bond issued by the United States government comes with a relatively low interest rate (yield) because financial markets and investors have a high degree of confidence that they will repay their loans. At the other end of the spectrum, a corporation with a high debt load or a history of bankruptcy would likely have to pay a very high yield to attract investors. Fortunately, there are third party rating agencies who independently assess the risk of a bond offering.
Pros and Cons of a Bond Investment
The pros and cons of a bond investment are very similar to those of a REIT. They can provide steady income and certain types of bonds, known as municipal bonds, offer some tax advantages.
On the downside, bonds are also highly sensitive to interest rate changes and have some default risk should the issuer go out of business or can no longer afford to make the required payments.
Given the similarities between REITs and Bonds, it is logical for investors to ask, what are the differences?
4 Key Differences Between Bonds and REITs
When these two asset classes are considered as potential investments, there are four major differences that investors should be aware of:
1. Capital Stack Position
Bonds fall into the “debt” component of the capital stack, which means that bondholders have a priority repayment position. A REIT investment falls into the “equity” component of the capital stack, which means that investors are further down the line in the order of repayment. If the investment performs well, this is a relative non-issue. But, this can be the difference between an investor getting all or some of their money back versus losing their entire investment in the event of a bankruptcy or default.
2. Returns
Because bondholders are first in line for repayment, their potential return is lower than that of a REIT. Bond returns consist primarily of income with little chance for major capital appreciation. REIT returns consist of some income and the chance for capital appreciation. As such, they are slightly more risky and typically carry higher returns to compensate.
3. Value Drivers
The value of a bond is driven by market interest rates, the issuer’s cash flow, and the market’s belief in their ability to repay the debt. The valuation of a REIT investment is driven by the cash flow produced by the underlying properties in the REIT’s investment portfolio.
4. Maturity
Bonds have a fixed maturity date, at which point the issuer must return investor capital. A REIT investment is open ended and could potentially continue indefinitely or until the shareholder decides to sell the stock.
For those who want exposure to the real estate market, but aren’t comfortable with a REIT investment, there are other investment vehicles through which they can allocate capital. For example they could invest in a real estate focused mutual fund, or a real estate focused exchange traded fund (ETF). While these may be suitable alternatives for some investors, we want to highlight the opportunities that can be pursued with a private equity commercial real estate investment.
How Do REITS and Bonds Compare to Private Equity Commercial Real Estate Investments?
A private equity commercial real estate investment is similar to a REIT in the sense that they both raise capital to be deployed into real estate assets. And, they are similar to a bond in the sense that they pay regular dividends. However, they are unique in the following ways:
Leverage
Private equity firms like ours spend years developing relationships with national brokers, tenants, and developers. These types of relationships provide them with access to deals that are typically not available to individual investors. But, by working with a private equity firm, investors can leverage their network, access, and expertise to gain access to deals they would otherwise not be able to invest in.
Accessibility
Anyone with a brokerage account (Fidelity, Vanguard, etc.) can buy a publicly traded REIT or a bond. Private equity commercial real estate investments are only available to “accredited investors” who can demonstrate a certain level of income and/or net worth.
Liquidity
REITs and bonds are fairly liquid investments. Private Equity CRE investments typically require a commitment of 5-10 years during which time an investor is not able to access their capital. But, this type of commitment provides the manager with the time and space to fully implement a business plan for a property, which can take several years.
Knowledge
In the single deal private equity investments that we offer, potential investors have an opportunity to learn about the property before committing capital to it. For example, they will have a chance to know where the property is, who the tenants are, what the income statement and balance sheet look like, and what the business plan is to maximize returns. These data points allow investors to closely pair the investment opportunity to their own individual preferences and objectives.
For individuals who believe that a private equity commercial real estate investment is commensurate with their risk tolerance, time horizon, and return objectives, they may find an attractive alternative to a REIT or bond.
Final Thoughts on REITs vs. Bonds
A REIT is a company that owns, operates, or finances real estate assets. They can be publicly or privately traded and they tend to specialize in certain property types. Investors like REITs for their liquidity, diversification, and potential for capital appreciation.
A bond is a debt instrument that investors can purchase. In doing so, they receive a promise from the bond issuer to receive their money back, plus interest, over a defined period of time. Investors like bonds for their relative safety and steady income.
Although they both offer a return with income and some potential for capital appreciation (less so for bonds), there are significant differences between REITs and bonds. To start, a bond is a debt investment and a REIT is an equity investment. A bond’s value is driven by the financial strength of the issuer and a REIT’s value is driven by the performance of the properties in their investment portfolio. Finally, a bond has a fixed maturity date where a REIT has an open ended maturity.
While REITs and bonds are both viable investments, some investors may find that a Private Equity Commercial Real Estate deal is a more suitable alternative.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or [email protected] for more information.
