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I get asked this question all the time. What’s the difference between indirect and direct investing? Investing directly or indirectly in an asset class is crucial to maximizing returns while reducing fees and volatility in your portfolio. Direct investing can be done on a variety of different levels.
One example, you might directly invest in an asset which may require you to make many and even daily decisions. You may decide to co-invest with a team of experts, which allow you to maximize returns while not having to make decisions day in and day out.
You can also invest directly through the players and wall street, but you’ll be exposed to fees, increased expenditures. And then there’s the volatility. You may be asking, What does this look like? So let’s take real estate as an example.
The real estate asset class has been a very appealing alternative investment for many years. Direct real estate investment is one option, but being a landlord isn’t an appealing thought to many investors. And the time commitment is a common constraint to investing directly. Who can blame them for not wanting to deal with broken toilets, contractors, renovations and evicting, deadbeat renters?
So what are the options for investors interested in real estate who don’t want to get their hands dirty? One popular passive investment option are REITs, that’s Real Estate Investment Trusts. REITs are publicly traded companies that by law must have the bulk of its assets and income connected to a real estate investment and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends. REITs are a popular investment option because they are well known and easily accessible. Additionally, you do not have the headache of a direct real estate investment, REITs are just one example of indirect investing. Directly co-investing in the real estate asset class allows you to typically see a huge contrast in fees and you can avoid the volatility of wall street. Direct co- investing in real estate is growing in popularity. It’s commonly referred to as a private real estate investment fund or syndication.
Private funds specializing in real estate investing offer either debt, equity or a hybrid option. These private funds are generally capitalized from pooled funds raised through private placements. Investors in private funds usually receive regular distributions through the operation lease or sale of real estate and potentially a liquidating distribution of profits upon termination of the fund after a fixed term. As with most private equity and debt products, there are endless variations in strategy, leverage, fee structures, and buy in and buy out restrictions with private funds.
They are also generally only accessible to accredited investors those that have attained a certain level of assets and income, presumably the ability to handle risk. So why go with a private fund instead of a REIT?
With both REITs and private funds, you can get into the real estate market without being a property manager, but with REITs, there are additional drawbacks not normally experienced by private funds.
First volatility. The main drawback of REITs is that they’re publicly traded. This means that their values are skewed by market forces, external to the real estate market and subject to the volatility of wall street. Just like all of their public securities, the value of REITs rise, and fall based on what’s happening in the economy. And their values can be greatly impacted by events that have nothing to do with real estate fundamentals.
And with wall street breaking all kinds of records, experts are already sounding the alarm on an inevitable correction. According to a recent bank of America fund manager survey, a record number over 46% of wall street respondents say stocks are overvalued.
Unlike REITs, private funds aren’t tied to stock market fluctuations. While public real estate products can be lucrative investment, they are highly correlated to the stock market, whereas private funds, which do not correlate result in higher returns with less volatility than a REIT.
REITs grow at slower rates. By regulations REITs can only reinvest a maximum of 10% of their annual profits back into their core business lines each year. This may cause some of the REITs to grow at a slower pace than comparable private funds.
Also REITs may rely on debt. A higher dividend payout by many REITs may force management to undertake higher leverage levels to expand the real estate holdings. That would result in a higher interest rate going out, reduced earnings to you, the investor.
And what about access to management? Investors often align their investment philosophy with that of management who head these companies that they seek to invest in. With most public companies, access to the management team is prohibitive, but with private funds, the team is accessible and available to answer questions about their investment philosophy and mission.
Do you think you could call a mutual fund manager and get them on the phone? Probably not.