Although private real estate funds and REITs seem like similar real estate investment vehicles, the two are very different. For sponsors setting up a real estate investment vehicle, it’s important to understand the characteristics of both. Below is a breakdown of each investment vehicle and important considerations.

Real Estate Investment Trusts (REITs)

A real estate investment trust, more commonly referred to as a REIT, is an entity (usually structured as a corporation) that owns, operates, and/or finances income-producing real estate by selling shares of stock to investors. REITs can be publicly traded, non-traded, or private, with most REITs being publicly traded. To qualify as a REIT, the entity must:

Invest at least 75% of its assets in real estate or related assets;
Derive at least 75% of income from rents, mortgage interest, or real estate sales; and
Distribute 90% of taxable income to shareholders each year.

Congress created REITs to give smaller investors greater access to real estate investment opportunities. Because of this, investors often find REITs appealing for their potential to generate consistent income through required distributions. However, REIT dividends are taxed as ordinary income, which can make their tax treatment less favorable compared to real estate funds. From the sponsor’s perspective, REITs often involve higher compliance and administrative costs and generally require a large capital raise to justify those expenses. Unless the sponsor has multiple cash flowing assets that will be operated long term with no short term plans to sell (such as within the next five years), then REITs are typically not the best structure.

Private Real Estate Funds

A private real estate fund is an investment vehicle that is usually structured as a limited liability company (“LLC”) or limited partnership (“LP”) where investors passively invest in real estate assets that are controlled and managed by the manager or general parter. Assets are acquired by pooling investor capital together in accordance with a defined strategy. Usually, the sponsor raises capital from accredited investors and potentially sophisticated investors under a Regulation D exemption. Because private real estate funds are structured as LLCs or LPs, they offer a more flexible structure where economics and voting can be structured in a way that aligns investor and sponsor incentives. Furthermore, in contrast to REITs, private funds are pass through entities where income, losses, and depreciation flow directly to investors.

From the Sponsor Perspective, Which is Better?

For most sponsors, particularly those raising under $100 million, private real estate funds usually make more sense for several reasons. First, private funds allow sponsors to determine when and how capital is deployed, reinvested, and distributed without the stringent income or asset tests that apply to REITs. Second, private funds are easier to administer since they do not require the same ongoing qualification testing, distribution tracking, and compliance obligations applicable to REITs. Third, private funds allow sponsors to structure economics more flexibly and in a way that better aligns investor and sponsor goals. In addition, because private funds offer pass through taxation unlike REITs, investors may offset taxable income through the depreciation and capital gains that flow to them.

While both REITs and private funds offer advantages and may be the better fit depending on a sponsor’s specific goals, most sponsors seeking flexibility in strategy, structure, and economics tend to prefer private real estate funds.