Commercial real estate has always been identified as an investment sector that is open only to those who have a fortune of wealth. This statement would have been true a decade ago, but the recent introduction of REITs and Fractional Ownership indicates the opposite.
According to a study, approximately 145 million Americans or 44% of American households invest in REITs and fractional investments were valued at $255 million in 2021. These two investment instruments are emerging as the favored mode of commercial real estate investment.
In this blog, we will discuss REITs and fractional ownership investment methods to help you make a more informed choice.
What is a REIT?
A REIT, or Real Estate Investment Trust, is an organization that purchases, manages, and finances real estate properties such as offices, multifamily apartments, warehouses, commercial complexes, and others.
Although the existence of REITs dates back to the 60s, however, they have been growing in demand for the last couple of years. Investing in REITs is becoming the preferred choice of investment since the purchasing power of real estate has drastically fallen over the years.
Similar to mutual funds, REIT is a unified investment scheme. It allows a group of investors to invest in high-end properties which are generally inaccessible for solo investment due to the requirement of high capital.
REIT investors earn dividends based on their percentage investment without owning, managing, or financing properties.
There are three types of REITs based on their accessibility and trading methods
- Publicly Traded REIT
As the name implies, investing in publicly traded REITs involves buying and selling shares of REITs on a national securities exchange.
- Private REIT
They are the opposite of publicly traded REITs. These REITs are not registered with the SEC and are not traded on the securities exchange
- Publicly Non-Traded REIT
On the other hand, publicly non-traded REITs are registered with the SEC but are not available to trade on the securities exchange platform.
REITs can be further subcategorized based on the type of assets:
- Mortgage REIT
- Equity REIT
- Hybrid REIT
- Diversified REIT
- Industrial REIT
- Industrial REIT
- Retail REIT
- Office REIT
- Healthcare REIT
- Hotel REIT
Check out our blog to know more about the various type of REITs in detail.
How do REITs work?
A REIT allows anyone to invest in an entire portfolio of real estate assets through the purchase of company shares or the purchase of a mutual fund or exchange-traded fund (ETF).
Unlike some real estate sectors, a REIT does not involve in the development of properties but only deals in purchasing and selling them. A REIT provides investors with the opportunity to invest in Real estate assets and expand their portfolios.
REITs generate revenue by collecting rents from a leased investment property and distributing the profits amongst the shareholders. According to the US SEC, a company must meet the following requirements to qualify as a REIT.
- Must have a minimum of 75% investments in real estate.
- Must have a minimum of 100 shareholders.
- Less than 5 shareholders should not possess more than 50% of a REIT’s shares.
- A REIT must pay its shareholder 90% of the taxable income.
- Should be managed by a board of directors and trustees
- Must obtain at least 75 % gross income from rent and mortgage interest.
- Income from sources other than real estate, dividends, and interests should not be more than 5%.
- Must be taxable as a corporation
Benefits of REITs investing
1. High Returns
REITs provide investors with 90% of the returns, the highest return in any investment sector. Moreover, investors further benefit from the opportunity of passive real estate investing.
2. Diversified Investment
As mentioned, REITs facilitate a wide range of asset classes and types. Therefore, investors can easily diversify their portfolios and safeguard their investments using REITs
Public traded REITs are listed on major stock exchanges, thus giving investors a complete and detailed view of the REIT share prices.
4. Tax Advantages
The tax treatment of REIT’s dividends varies depending on the source of income.
Since most REIT dividends are non-qualified, their payouts are generally taxed at ordinary income rates rather than long-term capital gains rates. REIT dividends are usually better utilized in tax-advantaged retirement accounts like IRAs, 401(k)s, and 403(b).
Moreover, investors can avail of benefits like Pass-through deductions, Depreciation, and dodging double taxation.
What is Fractional Ownership?
Fractional Ownership, also known as Co-Ownership or Shared Ownership is an investment strategy that allows real estate investors to purchase a fraction of a property instead of a whole.
Similar to REIT, Fractional ownership is meant for creating investment opportunities for small investors to invest in high-value assets. Here, the total property is divided into tickets or tokens which are used to purchase a portion or multiple portions.
Generally, fractional investments target Class A commercial properties like commercial complexes, warehouses, office buildings, luxury hotels, etc.
Moreover, investing in fractional real estate means you own a fraction of a property but gain all the benefits of owning the whole property.
How does Fractional Real Estate Investing work?
Investors with limited capital can still invest in high-end commercial real estate properties by forming an SPV (Special Purpose Vehicle) via Fractional Ownership.
SPVs help in creating tickets that represent the percentage of ownership of that particular property. Combining the investment capital can be used to acquire big ticket-sized properties with market values in the millions.
Another form of fractional ownership involves utilizing blockchain technology where the property is represented by tokens using asset tokenization.
Fractional Ownership Models
In the US, there are generally two types of fractional investment structures. However, with the introduction of blockchain technology, there has been a new addition to the fractional investment model.
Tenancy-in-Common (TIC) is one type of shared ownership where two or more investors share the ownership rights of a property.
Depending on the percentage of ownership, each independent tenant-in-common owns a separate interest in the property.
Furthermore, owners can transfer their interest shares to their beneficiaries and can buy or sell shares independently.
- Delaware Statutory Trust
Unlike other real estate ownership structures, Delaware Statutory Trusts (DST) are legal entities owned by multiple investors who hold undivided fractions of the trust.
However, unlike other fractional ownerships, DSTs generally focus on only one property type. Thus, to diversify portfolios, investors need to invest in multiple DSTs.
- Blockchain-based Fractional Ownership
With the advent of blockchain technology, investors are introduced to asset tokenization of real estate properties and fractional ownership of the same.
The Tokenization process turns an asset into blockchain-based digital tokens representing a fraction of the property. Investors can purchase shares/tokens with prices as low as $100, thus making them accessible to all investors.
Furthermore, this investment process eliminates intermediaries and makes real estate investing faster and more efficient.
Benefits of Fractional Ownership
1. Increased Liquidity
Investors can sell their assets to other investors and trade shares/tokens instantly. Furthermore, the assets can be traded peer-to-peer on a secondary market.
2. Accessible Investments
Fractional ownership reduces entry barriers to real estate investing by making it cost-effective and accessible to a wider range of investors. Moreover, blockchain-based fractional ownership allows global trading of real estate property.
3. Increased Transparency
In blockchain-based fractional ownership, information is stored in a digital ledger that is accessible by all. This increases transparency and improves authenticity in property ownership and real estate transactions.
4. Portfolio Diversification
Investors can choose from a wide range of asset classes for fractional investment and diversify their portfolio by fractional investing in multiple properties.
5. Quick and Easy Investments
While the traditional real estate investment processes take a lot of time, the Fractional Ownership investment process is much faster by allowing investors to seamlessly trade real estate assets and also utilizing blockchain technology to automate processes and eliminate intermediaries.
REIT vs Fractional Ownership: What factors should you consider before investing?
1. Property Selection
When it comes to choosing a property, the fund managers decide to select the property in REITs. Investors have no control at this stage.
Whereas, fractional ownership gives full control and power in choosing the property. Investors can choose how to invest in real estate without any external influences influencing their decisions.
2. Type of Property
According to REITs norms, at least 80% of REIT’s investment should be income-generating properties.
Whereas, in fractional ownership, there is no such restraint. Fractional investment properties can be both existing properties or under construction.
3. Income Potential
As per SEC norms, REITs are required to regularly distribute 90% of their income as dividends among investors. Thus, investors benefit from a stream of high-revenue passive income.
Fractional ownerships also distribute payouts to investors at regular intervals. However, the dividends in fractional ownership are not as high as in REITs and depend upon the performance and capital needs of investment properties.
4. Initial Investment Cost
A REIT has comparably lower entry costs and is easy to withdraw since it trades like a stock.
Whereas, the cost of purchasing a share or token of a fractional property ranges from as low as $100 to $10000 or even higher.
5. Investment Term
REITs are short-term investments suitable for speculative investors aiming to make a quick profit from real estate.
Whereas Fractional Ownership is a long-term investment that generates wealth from rents collected and property appreciation.
Since investors do not directly own properties, transferring shares in REITs is not possible. However, they can sell their shares at any instant.
Fractional ownership on the other hand offers no restrictions in transferring ownership stake and tokens.
Since REITs are traded on the stock market, the share price is subject to high market fluctuations. Thus, making REITs highly volatile during times of economic distress.
The value of a fractional ownership property is determined at longer intervals, usually monthly or quarterly. Hence, they tend to be less volatile.
8. Portfolio Diversification
In REITs, investors are not directly involved in controlling the diversification of their portfolios. REIT portfolios comprise a wide range of real estate assets that are determined and diversified by the market.
Whereas, in fractional ownership, investors can directly choose the type of property they want to invest in. Thus giving them total control to diversify their portfolios.
The Lilypads Bottomline: Where should you invest?
Even though both REIT or Fractional Ownership have their set of pros and cons, they both have the capability of generating returns if utilized properly.
REITs or Fractional ownership make investing in real estate accessible without the constant stress of tenants and all of the problems that come with it.
However, if you want a higher return and have the capability of risk tolerance then REIT might be the right investment option. On the other hand, if you are looking for long-term growth and appreciation, you might be better off with fractional ownership.