Alternative real estate investments for the retail investor

• There are alternatives to direct investment in real estate that are just as lucrative while minimizing risk
• RELPs enable individuals to invest in a diversified portfolio of real estate assets
• The benefit of a RE mutual fund is that it offers flexibility to the individual or retail investor

Conventionally speaking the traditional avenue of investing in real estate is to pay cash for it if you have the resources or to save money for the down payment and then raise the difference in purchase price through a mortgage from a bank or financial institution.

This is because of the high unit value of holding property in your portfolio.

One of the features that make the property unique as an investment is that it has a high unit value in comparison to other investments.

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A nominal amount like ZWL$1,000.00 can buy an individual investor shares of a publicly listed company on the ZSE and the same amount in US dollars can purchase a decent number of shares through an offshore brokerage account.

This is not usually the case with real estate. There is very little an individual investor can do with ZWL$1,000.00 in terms of direct property investment, at least in the conventional sense. Even with access to mortgage finance, an investor will also tend to be limited by their credit standing in terms of the funds that they can deploy into property investments.

This high unit value in the property market is a deterrent to many retail investors as the financing requirements tend to crowd them out.

Are there other ways for retail/individual investors to participate in the real estate market?

Yes, there are!

The conventional method of investing and financing real estate is not by any means the only way individuals can invest in the property market. There are alternatives to direct investment in real estate that are just as lucrative while minimizing risk.

They include among others Real Estate Limited Partnerships (RELPs), Real Estate Investment Trusts (REITs), Real Estate Mutual Funds, Real Estate Private Equity, Real Estate Syndications and Real Estate Operating Companies among others.

As will be seen later the individual has room to be creative by literally coming up with their own avenues of investment in this market. The individual investor is truthfully limited by their own imagination when it comes to investing in real estate.

Real estate limited partnerships

The classical definition of this type of business is when two or more people operate a business with a view to making a profit. It is not very different in terms of real estate. It involves a group of individuals and investors who pool their resources to invest in purchasing a property, developing property and or leasing properties.

A typical RELP will have a “general partner” who assumes full liability as well as one or more limited partners who are liable only up to the amount that they would have contributed to the partnership. The general partner can be a corporation (as will be seen when the more sophisticated real estate syndicate is discussed later), an experienced property manager or a real estate development firm.

The limited partners are usually outside investors who provide financing in exchange for an investment return.

Investments in real estate of this nature are especially appealing in that they give the individual access to an asset class that they would otherwise not if their means were considered in isolation. Investing as a collective in this manner reduces the amount of risk an individual is exposed to. Partnering with a general partner who is seasoned mitigates the critical risks of making mistakes in this business that a novice would make.

Limited Partnerships are a creative way of investing for people with common interests where they can come together to pool their resources and acquire property. Members of the Jewish community know and appreciate the power of this kind of collective investment very well. A good number of the high-rise buildings in Harare and Bulawayo were acquired by them in this manner and remained under their ownership for generations.

Ownership of real estate through a limited partnership has tax advantages and benefits. In the United States for instance the tax code does not provide for taxation of partnerships. They are categorized as pass-through entities generally where the business entity in this case the Limited Partnership does not pay taxes on its earnings from operations but rather all distributions made to the partners are taxed at the individual level. Zimbabwe’s case is not very different.

RELPs enable individuals to invest in a diversified portfolio of real estate assets due to the scope of resources available from investing as a collective. They, RELPs are also unique and versatile in that they can be structured in such a way that limited partners may not have to be involved in the management of the business on a day to day basis.

This aspect, more than any other indicates how important this avenue of investment is in terms of the creation of residual income for the participants/members of the business.

The partnership agreement which creates and formalizes the business will give details of the full provisions of the business entity, roles and responsibilities of partners, minimum investments, fees, distributions, partnership voting all of which can be agreed upon by the people coming together to form the partnership.

The other benefits of RELPs include but are not limited to:

1. Combined talents: partnerships form the best way to synergize talent. The whole is larger than the sum of its parts essentially. What individual investors can accomplish as a collective will be greater than they would as individuals separately. Partners can have specific roles assigned to them. This will vary according to each specific RELP. Ideally, partnerships will include a financial partner(s) who is responsible for arranging the funding package needed to finance investments and a technical partner(s) who is responsible for the management of the properties in the portfolio.
2. Expanded networks: following on the aspect of synergy just mentioned above, a wider network is provided by a group of investors is invaluable in terms of the long-term success of the business partnership.
3. Financing options: these are increased because of the partners involved as opposed to the funding they would have access to individually. Partnerships give rise to synergies in terms of financing. The quantum of money to be deployed in property investments can be increased through the participation of a larger number of partners or by finding fewer partners with deep pockets so to speak.

These advantages, of course, are not to say that there are no challenges with operating this kind of business and investment. It must be approached with careful due diligence to avoid financial pitfalls in the future.

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Real estate investment trusts (REITs)

These are companies that own or finance income-producing real estate in a range of property sectors. REITS pool resources like RELPs, of numerous investors and make it possible for individual investors to earn dividends from real estate investments without having to buy, manage or finance properties themselves. They can be listed on the stock exchange or they can be privately held.

These companies must meet several requirements to qualify as REITs. According to the Johannesburg Stock Exchange (JSE), for a company to be classified as a REIT it must return no less than 75% of its earnings to its shareholders. This classification is stricter in the United States. To be classified as a REIT in that country requires a company invested in real estate to return no less than 90% of its earnings to shareholders.

According to the National Association of Real Estate Investment Trusts (NAREIT), REITs have historically delivered competitive total returns based on a high steady income and long-term appreciation. Their comparatively low correlation with other assets makes them an excellent portfolio diversifier that can help reduce overall portfolio risk and increase returns.

REIT based real estate investment offers 5 advantages that make it appealing:

1. Liquidity: real estate by nature is an illiquid asset class (recall article: Why You Should Be Invested in Real Estate). It is next to impossible to sell a property in a rapid manner without affecting the price of the same property. REITs offer a way around and to circumvent this deterrent feature of property investment. They offer the ability to buy and sell like other stocks, mutual funds, and ETFs. REITs through this feature make it easier for retail investor to rebalance their portfolio.
2. Diversification: REITs are a kind of hybrid investment vehicle that is linked to tangible assets. They also offer low correlation with other stocks and bonds and higher risk-adjusted returns.
3. Transparency: because most REITs are listed companies, it implies that they strive for corporate governance that is aligned with shareholders’ interests and they produce audited financial statements/reports to keep their investors clued up on the state of the properties in their REIT.
4. Dividends: REITs provide regular income from the rents that the properties generate which are then paid out as dividends and enable investors to accumulate wealth. This regular flow of income reduces portfolio volatility.
5. Performance: particularly in the United States, total returns from REITs have outperformed the S&P 500 over the last 25 years! They also provide higher returns than most corporate bonds.

REITs can be further classified into 3 categories namely:

1. Equity REITs: that own and operate income-producing real estate. Most classical REITs are structured this way. They raise funds from shareholders and deploy them directly into a portfolio of properties in various sectors commercial, residential, offices, hospitality, cell towers, healthcare, and medical facilities.
2. Mortgage REITs (mREITs): these provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from interest on these investments.
3. Public Non-Listed REITs: these can be registered with the SEC but do not have to trade on national stock exchanges.
4. Private REITs: these are offerings that are exempt from the SEC registration and whose shares do trade on national stock exchanges.

Ultimately REITs allow any person to invest in a portfolio of real estate assets in the same way that they would invest in other industries through the purchase of individual company stock or through a mutual fund or exchange-traded fund. Just as in the case of Real Estate Limited Partnerships the shareholders of a REIT earn a share of the income produced without having to go out and buy, manage, or finance the property.

This avenue of property investment is huge globally. Statistically, it is said that over 145 million people in the US have invested directly in REITs or through their pension funds. This again is according to NAREIT.

Real estate mutual funds

These invest in REITs and real estate operating companies. They are like REITs in the sense that they also provide the ability to gain diversified exposure to real estate with a relatively small amount of capital which a retail investor has access to. The difference is that they provide investors with a much broader asset selection than can be achieved through buying individual REITs. Real Estate Mutual Funds do not in their nature provide the pass-through tax advantage that REITs and RELPs do.

RE mutual funds are professionally managed like REITs which makes them attractive to smaller investors who prefer a diversified professionally managed passive income as well as a high level of liquidity. They differ from REITs as well in terms of classification to be considered a REIT.

RE mutual funds do not have to pay out 90% of their earnings in the way that REITs are required to.

An investment fund in this case a RE mutual fund is a pool of capital that has been aggregated on behalf of multiple investors. It is generally spearheaded by a sponsor who has experience in the real estate industry. The fund manager will carefully analyze all individual opportunities and then execute on them using capital from the fund.

The structure of the mutual fund can take many forms. Some funds can be open to the public and have no limit to the number of people who can participate in it. In such a case they are considered open-ended or they can be close-ended where participation in terms of membership is limited to accredited investors. The mutual fund can focus on specific geographies, asset classes, asset types and more.

The benefit of a RE mutual fund is that it offers flexibility to the individual or retail investor. When an individual invests in a single asset, that person would have placed all his or her eggs in one basket, however, investing in the mutual fund provides more control and flexibility in terms of entering and exiting the investment. For example, an investor with US$1 million can choose to invest that in tranches of US$250,000.00 across 4 different funds. This allows them to customize their portfolios without having to buy individual assets directly.

In terms of profitability, real estate investment and mutual funds can be structured in such a way that profits are returned to investors before any profit is earned by the fund’s sponsor. This gives the sponsor a strong incentive to ensure that the mutual fund is operated in an optimal manner by ensuring that dealings of the mutual fund achieve intended profit thresholds. Funds structured in this way tend to align interests between the fund’s sponsors and investors. The other benefits are generic and encompass things like the ease of diversification and tax efficiency.

Real estate private equity

This refers to firms that raise capital to acquire, develop, operate, improve, and sell buildings to generate returns for their investors. It is done predominantly by companies that raise capital from private investors and they deploy that capital to make investments in real estate. This method of investing is typically only available to institutional investors or accredited, high net worth individuals and not the average retail investor. In many instances to participate in a real estate private equity fund an investor must make a minimum contribution of at least US$250,000.00. This is an arbitrary sum; however, it is not surprising to find real estate private equity funds calling for sums of money in this region.

Other funds will require that individual investors demonstrate they have a minimum of US$5 million. RE private equity may be like REITs, however, they differ in terms of liquidity. REITs are highly liquid by virtue of them being publicly listed companies whereas private equity funds will often require contributions to be held for several years. Furthermore, REITs tend to be highly regulated but private equity funds do not face the same level of oversight and or strict requirements.

It is important to note that private equity real estate often takes the form of partnerships in terms of structure albeit a more formalized structure. The greatest advantage of this form of investment is the substantial returns that an investor stands to make. This potential comes not only from the vast sums of money that PE funds raise but the instruments used to generate those returns like leverage. The other advantages are again generic like the other forms of investment discussed earlier like diversification and professional management of the fund.

The main disadvantages are that this form of investment requires large sums from participants which can be a deterrent and barrier of entry to the retail investor. Funds like these often attract management fees that may be high depending on the fund. Management fees have the effect of reducing the profits that the fund makes which translates to lower investment returns. What is most unpleasant about these funds is that they are “needs-based” investments, which means that the funds can require participants to contribute capital on an as needed basis.

If an individual is not able to meet a capital call, the fund may force the individual to dilute their share of the fund and in the worst cases forfeit their shares entirely!

So, investors in this type of fund need to be able to assess the fund’s future cash flow to anticipate any future shortfalls and capital requirements should they occur and when they occur they have the wherewithal to meet capital calls. This avenue of investment is not for the regular and average Joe!

Real estate syndication

This is a way for investors to pool their financial and intellectual resources to invest in properties and projects much bigger than they could afford or manage on their own. Syndications are transactions between a sponsor and a group of investors in the same way as RELPs.

If an investor’s portfolio consists of only single-family homes that investor might consider investing in apartment buildings or commercial property. Because properties are expensive and require a very high level of management expertise it makes it necessary to consider real estate syndication.

Investors in this type of arrangement combine capital resources to purchase property and they also work together to manage the property especially if it is the case of a rental property.

Real estate syndication is a more sophisticated kind of partnership. There are usually 2 roles in this arrangement:

The sponsor: also known as the general partner who finds and acquires and manages the property and the investor(s): who provide capital to purchase the property. These arrangements can be structured as private limited or limited liability companies or in other countries as limited partnerships.

Furthermore, the private limited shareholders’ agreement or limited partnership deed are critical documents because they set forth the rights and obligations of the sponsor and investors which include rights to distributions, voting rights and the sponsor’s rights to fees for managing the investment.

These legal entities and documents are also there to protect the sponsor and the limited partners should the deal go south and in the event of litigation. Syndications are especially lucrative through appreciation and rental income for both the sponsor and the investors. The sponsor makes money from fees as mentioned earlier. Rental income from the syndicated property is often distributed to investors from the sponsor and this can be monthly or quarterly according to the present agreement.

A property’s value appreciates over time ideally so investors can net higher rents and earn larger profits when the property is eventually disposed of.

Real estate operating company

This is a company that owns and operates real estate properties, and it can either be privately held or publicly listed. Unlike REITs, REOCs can reinvest the bulk of their earnings into new and existing projects. REITs as established earlier are required to return most of their earnings to shareholders. REOCs operate as for-profit companies that are subject to standard corporate taxes like other companies.

These companies own and operate different types of property projects. They also fund real estate projects which they proceed to sell. REOCs face more lenient regulatory constraints which give them more flexibility with respect to how they invest their revenues and the projects they undertake. This lenient regulatory framework also means that they do not benefit from lower corporate tax rates enjoyed by REITs.

Like all the other alternative investment options in real estate REOCs are an alternative to owning real property. They can shield investors from some of the risks associated with holding real estate. Even in this case, it must be borne in mind that REOCs are subject to market risks including interest rate, the housing market, liquidity, and credit risks.

There is no fundamental reason why all real estate investors should not benefit from company level investing. This kind of investing, however, requires a broad-based approach including expertise in evaluating real estate management teams and company business plans, corporate structures, experience serving boards and providing corporate governance.

Some of the benefits of investing in real estate through an operating company include:

1. Alignment: of interest because operators tend to have a substantial portion of their own net worth alongside that of investors. This causes the interests of investors and operators to converge.
2. Governance: all companies have a fiduciary board of directors who provide oversight to ensure responsiveness, flexibility, efficiency, and that investors are prioritized.
3. Transparency: in terms of full visibility into the management team, personnel, structure, compensation etc.
4. Balance sheet: the company structure grants immediate access to capital for deployment, providing speed, the certainty of close and investment flexibility. Access to multiple forms for capital includes preferred equity.
5. Exit optionality: it is easy to exit in whole or in part through several ways like disposing through sales of assets in the portfolio or recapitalizing through refinancing or joint ventures or at the company level through an IPO.

The most important gains for individual investors and real estate operators is the alignment of interests and in governance and transparency more broadly. An integrated company is overseen by a fiduciary board of directors and comes with audited financial reports. Ultimately this places the investor and real estate operator under the same roof as other shareholders.

This contrasts with the special purpose vehicle structure where there is no obligation for the real estate operator to invest significant capital alongside other capital providers not any obligation to give providers oversight or report any financials beyond the level of the individual real estate deals. As such there can be strong incentives for real estate operators to collect fees while ignoring downside risk or neglecting to enhance upside potential. Particularly of one or more assets are affected by difficult market conditions.

The conclusion: Which avenue is best?

Real estate investment entails more than just ownership of brick-and-mortar structures. Investment in this asset class is no longer the preserve of the super-rich and institutional investors.

It is possible for retail investors to gain exposure to brick-and-mortar assets in their portfolio.

What used to be the biggest barriers to entry and participation in this market have gradually been reduced and in other instances removed altogether through either or a combination of the investment options described. The choice of investment depends on the prospective investor’s personal circumstances, their tolerance for risk and their goals.

Go forth and prosper!

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