Most conversations about real estate investment trusts (REITs) are about the traditional type: publicly-traded REITs. However, publicly-traded REITs do not have the best reputation lately. The biggest risk in public REITs is that when interest rates move higher, demand for them starts to drop.
This scenario is likely crossing the minds of many investors as the Federal Reserve contemplates raising rates again in 2018. As the demand for publicly-traded REITs lessens, the conversation shifts to another kind of REIT - non-traded REITs or private market REITs. They offer the same, or even better outcomes, as publicly-traded REITs but without such high threats of volatility. (For more, see: The Impact of Interest Rates on Real Estate Investment Trusts.)
Private Versus Public REITs
Non-traded REITs operate similarly to publicly-traded REITs and are required to file with the Securities and Exchange Commission so their performance reporting is publicly available. They are also subject to the same IRS requirements, including returning at least 90% of taxable income to shareholders.
The difference is that private REIT shares are not traded on a national stock exchange like the NYSE or Nasdaq so their shares are not directly exposed to market volatility the way that public REITs are. According to an analysis by the Real Estate Research Institute, public REITs have a potential annual volatility of 22%. This is higher than the stocks of large companies, which have volatility of 16%.
A paper by Goldman Sachs shows a non-traded REIT has a volatility of about 4%, which is similar to bonds. This is why private REITs can behave more like direct real estate investments. Non-traded REITs are not susceptible to demand-driven price volatility. Instead, the net asset value of the REIT drives the pricing, so investors can be sure they are not paying a price that is higher than the underlying assets.
Investors Can't "Panic Sell"
Another aspect of non-traded REITs is they tend to be less liquid. You cannot buy or sell shares in a private REIT quite as quickly as you would with a public REIT. While non-traded REITs do offer investors opportunities to redeem their shares early, these may require that shares be redeemed at a discount, meaning investors could lose part of their investment. This may be viewed by some as a disadvantage, especially to those looking for short-term investments.
However, for investors with time on their hands, there is one strong reason why investing in non-traded REITs can offer even greater protection than public REITs. The reason is that liquidity in publicly-traded REITs can exaggerate losses. If enough investors pull out of a public REIT, the share price can drop below the value of the underlying real estate. (For more, see: 5 Types of REITs and How to Invest in Them.)
By contrast, losses on a non-traded REIT are controlled by the inability of investors to "panic sell", which is all thanks to limited liquidity. The share value of non-traded REITs dropped only 15% in 2009, while publicly-traded REITs dropped around 67%, according to Texas Enterprise, a research publication by the University of Texas at Austin.
By December 2011, when the private real estate market had fully recovered its loss, public REITs were still below their pre-crisis high. More interestingly, one sector of the real estate market has a history of bouncing back faster than other sectors, especially during the last financial crisis.
According to data from the U.S. Department of Commerce, by 2013 multifamily housing investments had already returned more than 70% of their pre-recession peak, while single-family housing had only recovered a small amount of their recession low.
Multifamily, student housing and senior living properties have long demonstrated to be recession-resistant assets because they remain in high demand even during financial crisis. There are several segments of the population that are increasingly choosing multifamily homes for reasons other than affordability. Aging Baby Boomers, for example, are downgrading from single-family homes to multifamily homes. This demand is expected to persist even when the next economic recession hits, providing investors with downside protection.
An Evolving Market
Perhaps the biggest reason why non-traded REITs are the better investment is due to an evolution in the market. Non-traded REITs were once known for charging high upfront fees, yet this has been changing lately as more work to make their products more appealing to investors. Technology has also played a huge role by allowing more investors access to the private real estate market with as little as $2,000 in hand via platforms like Upside Avenue.
Investors in non-traded REITs can expect to earn high ongoing distributions for years without worrying about what the stock market is doing. This passive income is in addition to a chance to build wealth from property appreciation and any value-add strategies the REIT undertakes. (For more, see: The Basics of REIT Taxation.)