Private Equity Real Estate vs Equity REITs: Which Is Right for Your Portfolio?

Self-directed IRAs allow investors to maximize investment potential using a variety of alternative assets to build exponential wealth, outpace inflation, and increase their return potential. Private equity value-add real estate is one alternative asset that has the ability to appreciate aggressively and offer great returns.

However, value-add real estate can be a riskier investment compared to other types of real estate assets, which is unattractive to some investors. Novice or risk-averse investors may be interested in real estate investment trusts (REITs). REITs offer a simplified way for individuals to invest in real estate through their regular IRAs and 401(k)s. REITs also allow experienced investors to easily diversify their real estate holdings.

In today’s article, we compare and contrast private equity value-add real estate with REITs to see the advantages and disadvantages of each.

What Is Private Equity Value-Add Real Estate?

Value-add properties, as opposed to standard or “core” properties, require significant improvements to increase the property’s value up to its full potential before it can be rented out or resold. A value-add property may need extensive renovations, strategic marketing efforts, or management restructuring before an investor can expect to see a return on the property.

Private equity companies concentrated in value-add real estate look for properties that are underdeveloped or underperforming in terms of maintenance, occupancy, or facilities. Properties like this may suffer from poor management, outdated features, or disrepair, but they have a high potential for cash flow if they can be refurbished or managed to their full potential. 

Though companies engaged in value-add real estate try to minimize risk, no investment is without risk. And the risks associated with value-add real estate are worth considering. For example, a project might overrun its budget as prices for materials increase due to supply chain issues and inflation. Or the timeline for renovations may be pushed back by inclement weather or unreliable contractors.

However, the potential for value-add real estate investments to appreciate and subsequently produce positive cash flow is what makes them so attractive. Value-add real estate investments typically use more leverage than core real estate investments. In other words, investors tend to utilize more debt in order to fund this kind of project. And once improvements on a value-add property are complete, the risk profile is lower and the real estate loan can be refinanced. 

Value-add real estate may be a worthwhile investment for the investor who won’t be intimidated by taking a calculated risk. If the investor is willing to invest more capital or sweat equity into improvements and the improvements go smoothly, the property has a high potential to appreciate and produce high returns.

What Are REITs?

Real estate investment trusts (REITs) make real estate investing more available to investors who want to capitalize on real estate appreciation but may not have the capital or capability to renovate and manage physical properties themselves. Instead of buying a property outright, investors who purchase REITs are combining their money with other investors (similar to ETFs and mutual funds) to invest in a property or multiple properties.

A REIT firm may lease its buildings to tenants and collect the rent, which it then distributes to its investors in the form of dividends. These are called equity REITs; income is derived from rental income on properties owned by the firm. Mortgage REITs, on the other hand, invest in property debt rather than the property itself. Earnings on a mortgage REIT are derived from interest payments on mortgages or mortgage-backed securities the firm has extended to borrowers. 

One interesting aspect of REITs is that they are legally mandated to distribute a minimum of 90% of their annual taxable income as dividends to shareholders. Although these dividends are attractive, this does mean that REITs are hampered in their ability to use their annual income to acquire more property. 

Liquidity is perhaps the biggest advantage of REIT investments. Shares can be bought and sold similarly to stock purchases and dividends can provide a nice stream of income. The biggest disadvantage may be the low capital appreciation due to the fact that 90% of the fund’s annual income must be paid out as dividends. 

With all these advantages, you may decide that REIT shares are an attractive asset class to diversify your portfolio or enter into the world of real estate investing. But how do REITs compare to private equity value-add real estate?

REITs vs Private Equity with Value-Add Real Estate

REITs offer an opportunity for more liquid real estate investing. Private equity real estate does not, as capital can be tied up for a long period of time. REITs may provide steady income in the form of dividends, yet capital appreciation may be slow. Private equity value-add real estate may not provide income right away, but does pose an opportunity for massive appreciation and subsequent positive cash flow should renovations yield desired results.

What about the differences in risk? As mentioned above, value-add property renovations and changes may fail due to a number of reasons, making this type of investment inherently risky. For this reason, it may be advisable to evaluate potential private equity real estate firms from a bottom-up perspective. It’s worth looking at a company to see if it has demonstrated an ability to successfully add value to other properties before you invest in the company’s projects. 

REITs, on the other hand, are traded much like stocks and other traditional assets. And like stocks, the price of a share will rise or fall depending on innumerable factors including the fundamentals of an individual REIT firm, the healthiness of its portfolio of properties, and the performance of the market as a whole. Neither REITs nor private equity value-add real estate investments are without risk, but their respective risks are different in nature. 

So which is better for you? 

Ultimately, the best investment for your portfolio depends on your desired goals, outcomes, and abilities. Do you want a liquid asset that is easily traded? Are you seeking to get involved in real estate, yet wish to remain free from the responsibility of managing a property or putting sweat equity into a property yourself? If so, consider adding REIT shares to your portfolio. 

On the other hand, real estate private equity firms deal with value-add property for a reason: they provide the opportunity for greater returns than simpler kinds of real estate investments. And there is something to be said for the sense of empowerment that the deliberate transformation of a property may afford an investor. If you are someone who likes the feeling of being in control of what you own, then private equity real estate may be the investment for you. 

How Chicago Trust Administration Services Can Help

The good news is, you don’t necessarily have to decide between one or the other. Whether you invest in REITs, private equity value-add real estate, or both, let Chicago Trust Administration Services help you put your plan into action. Non-traditional assets such as private equity with value-add real estate can be more than worthwhile, but the transactions are complex and highly regulated when using retirement savings from an IRA or other retirement account. 

At Chicago Trust Administration Services, we handle your transactions in a timely, IRS-compliant manner so you can focus on what you do best: planning your investments. To see how we can help, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.

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*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.