There are many ways to invest in real estate. For example, a property may have a single owner or multiple owners. If there are multiple owners, they might each hold title directly to a fraction of the real estate, or they might own fractional interests in an entity that holds the title. Different structures can provide investors with different pros and cons depending on the situation. This article introduces five of the most popular real estate ownership structures:
- Sole Ownership
- REIT Investments
- Tenant-in-Common Investments
- Delaware Statutory Trusts
- Equity Funds
These are merely ways of structuring real estate ownership, and have nothing to do with the asset class of the underlying property. It is possible to invest in very similar assets by way of any of these structures.
Eligible for 1031 exchange
If an investor is the sole owner of a property, they have the freedom and responsibility to make all the decisions about the acquisition, financing, tenants, lease terms, management, disposition, and so on. There is a risk-reward tension in sole-ownership. As the exclusive owner, the investor has all the authority and reaps all the benefits of ownership, however they also shoulder all of the liabilities of the property. Should one wish to obtain financing, one must generally be “on the hook” for the loan, regardless of the success of the investment (“recourse” financing). Due to the increased responsibilities of the owner, the sole-ownership structure is typically recommended for investors who have experience in real estate and prefer direct control over their assets. It is generally thought that sole-owners should have significant net worth and the liquidity to purchase and actively manage and assets. For investors with a net worth north of $25,000,000+ the sole-ownership structure is viable and diversification can still be achieved simply by investing in multiple properties. For individuals with less than $25,000,000 in net worth, the ability to diversify is greatly limited, and therefore this structure is not recommended.
Not eligible for 1031 exchange
A Real Estate Investment Trust, or REIT, is a company that acquires, manages, and sells investment real estate for the benefit of the investors who purchase shares in the company. A REIT will generally purchase a variety of assets in order to diversify, however some are focused on a particular type of real estate or asset class. Some large REITs raise upwards of $2–3 Billion, and build a portfolio over a period of about 5 years that can include hundreds of properties. Shareholders have the ability to vote on certain items, however a REIT is a passive investment and shareholders have no management or day-to-day decision-making power.
REITs target purchases of debt, equity or a combination of both. This allows investors to find a particular REIT that fits their investment preferences. Due to the size of most REITs, there are a large number of investors that are able to purchase interests. This allows REITs to target a minimum investment of $1,000-$5,000 and allows for a large pool of potential investors. This makes the REIT the most common type of real estate investment as the barriers to entry for investors is small.
One major feature of a REIT is that only 90% of the taxable income must be distributed to the investors. This leaves 10% that may be retained by the managers who may or may not have invested any equity into the REIT. Most REITs will share in the profits after they have distributed the original capital back to investors in addition to a preferred return that is normally between 5-10% per year.
A REIT is best suited for investors who are new to real estate or those who are looking for stable cash flows coming from properties that are highly diversified. REITs are not 1031 exchange compliant. Most are non-traded which means that they do not have to publicly list their shares on an exchange. This makes them fairly illiquid and owners will generally need to wait for the REIT to liquidate which is normally after a period of 5 years. If an investor needs liquidity a REIT is not a viable investment as there are generally no ways to liquidate the shares until the underlying real estate is liquidated.
Eligible for 1031 exchange
This is a popular ownership structure that allows each investor in the group to own a portion of all the real estate held by the group. Tenant-in-Common (TIC) interests come with a percentage of control and voting rights. TICs provides real estate investors the ability to enter a multi-owner investment without the use of a partnership. A popular selling point of a TIC is its ability to use tax-deferred exchanges. In order to be eligible for 1031 exchange, a TIC investment offering must meet certain IRS guidelines. In the early 2000’s it became common for TIC investments to be pre-packaged with research and analysis on each of their assets (“due diligence”) for potential investors to review prior to acquiring interests. Each investor can have their own escrow, which makes it much easier to accommodate asynchronous 1031 exchange property identification and acquisition deadlines.
The TIC structure allows for a minimum of 2 investors and a maximum of 35 investors to each own an undivided interest in the property in proportion to the equity invested by each individual. Each owner revives distributions from property cash flow that is in proportion with their ownership percentage as well as the tax benefits and profits from sale. It is common for a TIC investment to be managed by a third party that is responsible for day-to-day management as agreed upon by the TIC’s who are able to use a majority vote to make choices regarding the property.
TIC investments allow for lower net worth investors to access quality institutional properties with a smaller minimum investment. Each investor can contribute equity and receive their ownership in proportion to the allocation of their equity. A primary drawback of this structure is the lack of control for the owners. Each TIC owner has the right to vote on major decisions and their votes are weighed in accordance with their equity allocation percentage. This does not allow owners the ability to directly control the operations at the property. TIC real estate is generally illiquid. There is no secondary market to buy and sell TIC interests and therefore the success of the investment is paramount to the success of the investor. A TIC is recommended for investors who do not require complete control of the investment and would like a 1031 eligible investment with institutional properties.
Delaware Statutory Trust
Eligible for 1031 exchange
The Delaware Statutory Trust (DST) is structured similarly to a TIC in that it provides a fractional ownership of interests in real estate based on the equity placed by investors. It is also structured for investors to use a 1031, 1033, or 721 exchange. However, unlike a TIC, owners do not directly hold the title to the property. The owners hold a title to the real estate through a beneficial ownership of the trust. This makes the structure completely passive where investors have no ability to vote on any decisions. The trust and managers make decisions on behalf of the investors.
The DST differs from the TIC in that it allows up to 499 investors for each DST rather than a maximum of 35 in the TIC. This allows investors with lower net worth to find a DST that has a low minimum investment of $25,000 to $50,000. This accommodates the ability to diversify across multiple investments.
The IRS has also placed guidelines for a DST to comply with 1031 exchange. One regulation is the inability to make any material change to the leases unless there is a tenant bankruptcy or default. Another is that the DST may not refinance during the hold period. This limits the DST to either using large national tenants with contracted leases or using a “master lease” on multi-tenant properties. The master lease allows the master tenant to sublease to individuals, however they must pay a contracted rent to the trust regardless of the performance of the actual tenants. This allows for the tenants that occupy the properties to be changed without affecting the 1031 exchange requirements for DST.
As with a TIC the primary drawback of the DST is the inflexibility of the investment. Owners do not have direct control over the day-to-day operations, nor do they have the ability to refinance the property. Should this need to happen the trust would need to convert into an LLC which disqualifies the 1031 status of the investment. The DST is suited for investors with net worth greater than $1,000,000 (excluding primary residence) who do not need direct control over the investment and are targeting stable income during the hold period.
Not eligible for 1031 exchange
The final structures we will preview are the Limited Liability Company and Limited Partnership. These structures create a pool of investors into a fund. This fund then invests into real estate assets. Like a REIT the funds are completely passive and allow for a third-party manger to make acquisitions, manage the properties, use financing, and dispose of the assets when they feel appropriate. Also like a REIT, the LLC and LP are not 1031 compliant. Unlike a REIT each of the investors is a partner and not a shareholder and elect a managing member who is responsible for the management of the real estate assets in the fund.
In general, a fund will target a total asset amount under $150,000,000 with equity up to $50,000,000. This makes them more likely to purchase higher risk assets and provide the potential for higher returns. They also target smaller investments that are not viable to REITs. Like a REIT they are designed to provide a return of capital plus a preferred return each year. After this is achieved, the managers may participate in the profits. LLC’s and LP’s are limited to 499 investors.
These funds are appropriate for highly sophisticated real estate investors that understand the risk-reward relationship of the investments in the fund. They do not allow for control of the management and therefore are illiquid in the short term. It is likely that a fund is structured to provide a risk-adjusted return that is not correlated to the stock market or other indexed investments. This can benefit the investors in an economic downturn, but also creates more risk for the investors.