by Robert Kantor

Due to the rules that Real Estate Investment Trusts (REITs) must follow, REITs do not retain earnings and generally offer higher average dividend yields than pooled equity investments (currently 4.21% versus S&P 500 at 2.10%).  While publicly-traded REITs typically offer investors a diversified pool of real estate assets with attractive current yields, direct commercial real estate (CRE) investment can offer the same conservative investments with a higher cash flow profile and certain inflation hedging capabilities.

1. Market volatility. Publicly-traded REITs are subject to the same macro (and often irrational) forces that effect the stock market, which can lead to fluctuations in capital. This volatility, reflected in the changing market price of REITs, results from fundamental factors, such as interest rates and economic conditions, as well as technical influences like market liquidity and capital flows. Real estate investment is typically sought as a secure long-term investment with stable cash flow. Every real estate investor must ask: How important is liquidity versus long-term stability?

While there are market-indexed REIT funds and sector-specific funds, identify a CRE investment company with a proven track record of acquiring and managing real estate. An ideal CRE investment source would have the ability to identify intrinsic stability and cash flow prospects based on solid location demographics, low leverage (usually 50% LTV), and an ability to recognize investment opportunities that shield against volatility, and offer greater reliability of cash flow. Private equity CRE investments are better structured to weather economic recession.

2. Fewer tax advantages: REIT dividends are taxed at ordinary income rates that are not partially sheltered by depreciation expense, as is the case with CRE distributions. Investors tend to receive more cash annually in distributions than they are allocated taxable income with CRE investing, which effectively raises the investor’s after-tax return.

3. Equity-like profile. Like corporate equity investments, publicly-traded REITs require an expensive layer of management and governance that reduces available cash flow. Publicly traded REITS are subject to the operating risk associated with public equities, without a comparable opportunity for capital appreciation. Furthermore, the active M&A environment among REITS adds to volatility as ambitious managers seek to increase portfolio size while proportionally reducing operating expenses. Publicly-traded REITs are not simple pass-through investment vehicles; they are complex corporate investments that offer risks and rewards often unrelated to the underlying collateral. Again, every real estate investor must ask, Does the assumption of corporate risk detract from the true purpose of real estate investment?

4. Investment selection: REITs shares are generally not selected by CRE expert nor subject to rigorous selection criteria employed on each individual deal by a CRE company. A CRE company specializing individual deal structure, as well as boots on the ground selection and asset management throughout the lifecycle of every single asset for maximum returns is most desirable versus buying into a basket of real estate with spread risk across numerous investments.

5. Opportunism. With an unprecedented volume of investment capital and an amplified global demand for U.S.-based assets, domestic real estate assets are being acquired at record-low cap rates. The weight of this demand has caused a convergence of cap rates across the quality spectrum. This convergence is particularly acute in the coastal metropolises such as Boston, New York or San Francisco.

Large public REITS have neither the cost structure nor the market aptitude to target secondary locations in the continental interior. Due to the attractive economic profile of many of these secondary markets, local commercial real estate assets often provide a superior risk-return profile. Whether acquired as single asset investments or as components of smaller private portfolios, these assets avoid the high cost structure of publicly-traded REITS. Finally, the real estate investor must ask, Is the high cost of publicly-traded REITs justified when targeted investments in secondary markets offer significantly higher yields?

It is often said that the three most important criteria for real estate investment are location, location and location. In reality, for most investors, the answer is location, management and structure. In the current real estate climate, location means targeted secondary markets, manager refers to professional investors capable of deep due diligence and possessing specific market knowledge, and structure considers the costs and benefits of governance and liquidity. Today, well managed private CRE investments offer the ideal combination of risk and reward for investors seeking long-term, stable cash flow.