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Comparing Nontraded REITs and Exchange-traded REITs in a Real Estate Investment Strategy

An article by Leo Wells

What is a REIT?
These days many investors in search of greater portfolio diversification are considering nontraded or exchange-traded REITs as part of a real estate investment strategy. Before evaluating the relative merits of these two kinds of REITs, prospective investors should have a good understanding of REITs and their history.

Established by Congress in 1960, REITs provide ordinary investors with an opportunity to share in the ownership of large commercial properties previously available mostly to institutional investors and wealthy individuals. REITs may be an appropriate choice for investors as a key component of an overall real estate investment strategy, offering the potential for reduced risk and higher returns by providing added diversification to an investment portfolio.

A REIT, or real estate investment trust, is a corporation with the primary business of owning and managing real estate properties such as office buildings, apartment buildings, hotels, warehouses, health care facilities, shopping malls, or golf courses. While many REITs invest directly in these properties, some types of REITs also can invest in real estate-related loans, such as mortgages. Additionally, a hybrid type of REIT can invest in a combination of real properties and mortgages.

Investors looking to pursue a real estate investment strategy may choose to purchase REIT shares. The REIT's management team uses those pooled investment dollars to buy and manage an array of properties on behalf of the investors. Collectively, all shareholders indirectly own a small portion of each of the properties that the REIT owns and operates.

As mentioned, there are two primary kinds of REITs: nontraded REITs and exchange-traded REITs. Each has unique characteristics. The right choice depends on the individual investor and the objectives of his or her real estate investment strategy.

Exchange-traded REITs
Exchange-traded REITs are listed on a public stock exchange and are sometimes referred to as "publicly traded REITs." Shares of an exchange-traded REIT may be bought and sold any time the exchange is open for business. An exchange-traded REIT offers the ability to redeem shares at any time and the potential for income and growth. If the REIT is performing solidly, investors can potentially sell their shares at a profit. If the REIT is not performing well, an investor's shares can potentially be sold without an exit fee at prevailing market prices, which could be less than the original purchase price.

However, individuals in the process of crafting a real estate investment strategy should also consider the element of volatility that exchange-traded REITs may bring to their portfolios, as this type of REIT typically acts like an equity investment. As with all publicly traded securities, share prices for this type of REIT can fluctuate on a daily basis, providing the potential for both high yields and significant losses in a short period of time. Nevertheless, exchange-traded REITs may be an appropriate option as part of a real estate investment strategy for the investor who wishes to have day-to-day control over his or her investment. Also, investors may potentially mitigate some degree of market volatility by purchasing shares of a REIT mutual fund.

Nontraded REITs
As the name implies, nontraded REITs are not listed on any public exchange but instead must be purchased through a registered financial advisor or financial institution approved to offer the product. Nontraded REITs may be desirable as a component of a real estate investment strategy for investors interested in the opportunity for income and the potential for long-term growth, but they provide only limited redemption options during the initial term of the investment. Most nontraded REITs have a limited share redemption plan whereby investors may redeem shares under extenuating circumstances, the specifics of which are outlined in the fund's prospectus. Otherwise, investors continue to own their shares of the REIT for the duration of the investment hold term, which is also established in the fund's prospectus and is typically eight to ten years.

The share price for nontraded REITs generally remains fixed throughout the term of the investment, and, at the discretion of the board of directors, shareholders are paid regular distributions, typically on a quarterly basis. A real estate investment strategy that includes nontraded REITs may appeal to investors who are looking for a long-term investment vehicle that provides income and a potential hedge against inflation while avoiding the equity markets' volatility.

Nontraded REITs may issue multiple offerings, which enables the REIT to raise additional funds when necessary to build a portfolio of properties that is of sufficient size to achieve what the board of directors considers to be optimal diversification. For example, a REIT specializing in office buildings might seek to diversify its portfolio by the number of tenants who lease properties, by the number of industries represented by the tenants, by the geographic locations of the properties, and by the length of the lease terms signed by the tenants. Such a diversification model is typically designed to help protect the assets of investors.

At the end of the investment hold term, the REIT's board of directors must determine an exit strategy, which must usually be approved by the shareholders. The board may elect to begin an orderly liquidation of the REIT's properties and distribute the proceeds to the investors, or they may choose to list the REIT on a public exchange and thus convert the nontraded REIT to an exchange-traded REIT. The board could also elect to sell the REIT's assets to another REIT, or merge with another REIT. Alternatively, the board may ask the shareholders to vote on whether or not to extend the life of the REIT as a nontraded investment vehicle.

In the case of liquidation, it is hoped that property values will have increased over the lifetime of the REIT such that investors will realize a capital gain on the final disposition of the properties in addition to the income they received over the duration of the investment. It is not unusual for investors to receive a return of principal throughout the REIT's life cycle. In the case of going public, it is hoped that shares of a well-managed nontraded REIT will be worth more than the initial purchase price once the REIT is listed. It is important to remember, of course, that there is no guarantee that either of these desired outcomes will actually occur. As with any investment, an investment in a REIT (whether nontraded or exchange-traded) involves risk.

Conclusion
A real estate investment strategy that includes REITs can offer an excellent way for investors to diversify their investment portfolios and receive income. Before investing in a REIT, however, investors should conduct careful research to determine whether a nontraded or exchange-traded REIT (or some combination of the two) is the best fit for their real estate investment strategy. Does the investor's strategy focus on long-term or short-term goals? Is the investor seeking an income opportunity or total return? These are among the considerations that will help determine which option is best for them. Investors should discuss their investment objectives with their financial representatives in order to develop a real estate investment strategy that is in line with their goals.

About the Author
Leo Wells is the founder, president, and sole director of Wells Real Estate Funds, Inc. A 30-year veteran of the real estate brokerage, sales, and management industries, Leo Wells founded Wells Real Estate Funds in 1984 and pioneered a disciplined real estate investment philosophy for investors across the nation. For more information, please visit www.wellsref.com or contact articles@wellsref.com.

Wells Real Estate Funds is affiliated with Wells Investment Securities, Inc., Distributor. Investing in real estate has various risks, including lack of liquidity and devaluation of the properties in the portfolio based on economic factors. Additionally, properties that incur vacancies may be more difficult to sell or re-lease. Discuss your investment strategy with your financial representative before investing in any product. REITs are over-weighted in the real estate sector, and any negative or positive economic development affecting the real estate sector will have a greater impact on investor results.

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