Ground-Up Development Over REIT
June 25, 2019

Real Estate Investment Trusts (REITs), a diversified pool of assets that give quarterly dividends as well as a long-term capital appreciation, make them appealing for an investment portfolio. But like most vehicles with high returns, they still carry additional risks that should be taken into consideration. From some standpoints, investing in ground-up real estate developments continues to be a less-stressful investment strategy; here is why.

MORE CONTROL OVER YOUR PROPERTY
When you invest in ground-up real estate development, you become an owner of the property and can choose to do as you please at your sole discretion. You are in control to buy whatever you want, wherever you want, whenever you want. However, with a REIT, you’re a passive investor. You have just a choice to invest in professionally managed companies that own many types of commercial real estate ranging from office and apartment buildings, to warehouses, hospitals, shopping centers, hotels, storage facilities, and even data centers. They buy the property, manage it, and do the accounting for you. Your sole role is to be ensured that small or big slices of your properties are managed properly.

When you invest in ground-up real estate development, you become an owner of the property and can choose to do as you please at your sole discretion. You are in control to buy whatever you want, wherever you want, whenever you want. However, with a REIT, you’re a passive investor. You have just a choice to invest in professionally managed companies that own many types of commercial real estate ranging from office and apartment buildings, to warehouses, hospitals, shopping centers, hotels, storage facilities, and even data centers. They buy the property, manage it, and do the accounting for you. Your sole role is to be ensured that small or big slices of your properties are managed properly.

STABLE RETURN AND LOWER VOLATILITY
Another benefit of ground-up real estate development is that you don’t need to worry about what’s happening with the price of your property on the stock market in the short-term. Instead, REITs are more susceptible to stock’s up and down. Despite the fact that REITs’ long-term returns are good, their short-term performance could be slow or even negative, especially during a crisis. For example, the Dow Jones Wilshire REIT Index WILREIT, +0.12%  lost half its value in just two years, falling 17.6% in 2007 and another 39.2% in 2008.

REITs could also produce negative absolute returns when interest rates are rising. When rates are low, investors typically move out of safer assets to seek income in other areas of the market. Conversely, when rates are high or during uncertain times, investors often gravitate back to fixed-income investments.

Another key point is that REITs are not ‘bonds substitutes’; they are equities and, like all equities, they carry a measure of risk significantly greater than, for example, government bonds. What’s more, the growth of a publicly-traded REIT is lower than the normal stock. The main reason is that REITs only have 10% of their annual profits to drive growth, given that 90% of their profits must be distributed in the form of dividends. Although it could look attractive for the investor, it doesn’t give a REIT much capital to fund itself and its future needs. Instead, REITs have to look for additional investment if they want to expand and diversify their portfolio.

As for diversification and mitigating of risks, REITs are susceptible to macroeconomic movements as well. Approximately 24% of REIT investments are in shopping malls and freestanding retail. At the same time, the latest trends demonstrate that a big part of malls might also close over the next two years. This means that diversity within just one sector might not be the best strategy for diversification.

TAX DEFERRAL
Regarding taxation for commercial or investment properties, savvy real estate investors and business people know about IRS Section 1031. For tax deferral in a “1031 exchange,” a taxpayer must exchange real property for other “like-kind” real property. This strategy could reduce the overall tax burden. For REITs, dividend distributions for tax purposes are allocated to ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. Although a REIT can do a 1031 exchange at the entity level, individual REIT shares are considered personal property and do not qualify for a 1031 exchange.

To sum up, although investments in a ground-up real estate deal give you more control and protect you from the movement of the public market, there are still risks like with any other asset class. As a solution, research, analyze metrics, check reports and find professionals with experience and a track record working on REITs or developing ground-up projects to ensure that risks are mitigated to best of your ability and your investment dollars are protected.

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