With sky-high equity valuations seemingly becoming the norm across the broader market, you may be looking at more ways to diversify your portfolio and protect against downside risk.
Alternative investments, including real estate investment trusts (REITs) that fall outside of the traditional investment asset classes of publicly listed stocks or bonds, may help with portfolio diversification. These types of investments may also give you access to high-quality real estate investments that have the potential to produce stable income, with the added perk of potential tax benefits.
What is a REIT?
A REIT is a company that owns income-producing real estate assets. Its investments can encompass anything from properties, across all traditional asset types, including residential, retail, office and industrial, to more diverse sectors, encompassing timber, data centers and lab space. REITs also include companies that own real estate loans.
There are a number of requirements to qualify as a REIT, one of which is that REITs must pay out at least 90% of their taxable income to shareholders, making them a frequent choice for investors seeking passive income.
If you’re an individual looking to invest in REITs, you’ll come across public and private options. And within public options, there are two primary types: listed and non-listed REITs.
Understanding the differences between the different REITs and knowing how they’re valued will help you make the investment that’s right for you.
What’s the difference between public and private REITs?
There are two broad categories of REITs: public and private.
Private REITs are generally closed to outside investors, and operate similarly to a large institutional fund, where access is given only to exclusive investors such as institutions or high net worth investors.
These REITs aren’t regulated by the Securities and Exchange Commission (SEC), so they are typically exempt from that oversight and protocol. This also means private REITS don’t have to disclose details regarding their holdings, so investors who are given access to invest in a private REIT should be aware of such limitations to transparency in this opaque private market.
The onus is on the investors to learn as much as possible about the fund’s management, strategy and holdings.
Finally, even if an investor meets a private REIT’s financial requirements, the minimum investment can be as high as six figures, limiting the ability to participate to few.
Public REITs are open to most investors and may have no minimum investment requirements, though some give access only to accredited investors.
Another feature of public REITs is that they must meet SEC filing requirements, which means disclosure of properties and financials is mandatory, therefore providing transparency into your investment. With oversight and protocol of the SEC, these public REIT disclosures may make them comparatively safer for investors.
Two types of public REITs: Publicly Listed and Public Non-Listed
Within the public REIT market, there are two primary types: listed and non-listed REITs.
Publicly listed REITs
As the name suggests, publicly listed REITs are listed on an exchange just like where stocks and ETFs are listed. They are available for investors to purchase using their regular brokerage accounts. According to the National Association of Real Estate Investment Trusts, or Nareit, there are more than 200 publicly listed REITs that trade on a national stock exchange in the U.S. alone. Modiv became a publicly listed REIT in February 2022.
Given SEC oversight, publicly listed REITs tend to have favorable governance standards, and are required to be transparent about their asset holdings and financials, which enables investors to make logical buy and sell decisions. Investing in a REIT tends to offer more diversification and less risk than owning commercial real estate directly, as you can leverage a portfolio of multiple real estate assets for a typically small entrance price while benefiting from a seasoned management team’s knowledge and experience to operate the portfolio and identify new investments. For these reasons, many investors buy and sell only publicly listed REITs for their transparency, diversification and flexibility.
Public Non-Listed REITs
Another option for investors are public non-listed REITs.
These vehicles are registered with the SEC but the shares are not available to trade on a national stock exchange, hence the “non-listed” part of their name. However, they must still comply with the Securities Exchange Act of 1934, which imposes public reporting obligations for public companies ensuring transparency and boosting investor confidence.
Some public non-listed REITs allow only accredited investors, so it’s important to check each REIT’s requirements. The Nareit online database gives investors an extensive resource to search REITs by strategy and account minimums.
Finally, because public non-listed REITs aren’t listed on a stock exchange, they tend to not offer the same liquidity found with publicly listed REITs. Investors should also understand a REIT’s underlying holdings, how they’re valued, limitations on liquidity, and past and forecasted performance.
How are REITs valued?
Publicly listed REITs are subject to price and valuation volatility. This is due to the fact that they are traded on a stock exchange and the price is determined by how much a buyer is willing to pay and not necessarily the intrinsic value of the company or underlying real estate. However, public non-listed and private REITs are valued based on their net asset value (NAV) — what their real estate asset portfolio is actually worth.
In addition to net asset value, public and private REITs are also valued using a discounted cash flow (DCF) model and dividend discount model (DDM). Investors may use these methodologies to determine whether REITs may be undervalued or overvalued.
- A DCF analysis calculates the present value of projected future cash flows. The future cash flows are discounted by an interest rate considered to be an acceptable return on investment. DCF is commonly used to determine equity valuations of non-REIT companies, as well.
- REITs are required to pay out at least 90% of their net earnings to shareholders as dividends, which may make a dividend discount model an appropriate way to value shares. Like the DCF analysis, DDM calculates the present value of the REIT’s expected future dividends. In both the DCF model and the DDM model, the interest rate used for discounting is subjective. The assumed interest rate used in both the DCF model and DDM model can have a significant impact on valuation so investors are cautioned to review the assumed interest rate and confirm that it agrees with their view of an achievable rate of return.
- NAV is essentially the estimated market value of the REIT’s holdings. Several factors determine a REIT’s NAV, including net operating income (NOI), capitalization rate, assets, liabilities and shares outstanding. A third-party professional firm can also help to calculate NAV and issue a recommended valuation range to reduce the subjectivity of NAV.
- For public non-listed REITs, FINRA has issued guidance on providing an estimated NAV that provides consistency among sponsors and transparency for investors. The two approved options are the Net Investment Methodology and the Appraised Value Methodology. Modiv uses the Appraised Value Methodology, which is based on industry best practices and is conducted quarterly by an independent, nationally recognized third-party valuation expert. Modiv’s valuation is based upon the estimated market value of the company's assets, less the estimated market value of liabilities, divided by the total shares outstanding.
Can NAV deviate from the share price?
The NAV calculation’s subjectivity can open it up to dissenting opinions. Is the estimated asset value too high? Is the projected NOI too low? Are interest-rate movements going to change everything?
Those are just a few of the many questions that can affect the NAV — and they can affect it substantially. In March 2020 at the onset of COVID-19 and during a time of significant equity market volatility, U.S. REITs were trading at NAV discounts as high as 30%. By the end of the first quarter of 2021, they listed at a 2.1% premium, as stock valuations have increased and the sector has benefited from momentum following the vaccine roll-out.
Bringing it all together
Understanding REIT types and valuation methodologies are key first steps in selecting the most appropriate REITs or REIT funds. From there, your specific investment goals and circumstances will dictate the right decision for you.
A publicly-listed REIT might be best if you want to be able to buy or sell at a moment’s notice, while a privately-held REIT may be the answer if you don’t want to deal with high volatility and don’t need immediate access to your money. Public non-listed REITs may offer protection from market volatility and provide opportunities for long-term appreciation, but often have limited liquidity and onerous fees.
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The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.