Fundraising Vs. REITs: Which is the Better Investment?
With the return of market volatility, more and more investors are turning to alternative investments such as crowdfunding.
Since I primarily cover Real Estate Investment Trusts (“REITs”) (VNQs) on Seeking Alpha, I am often asked questions about Fund raising. Specifically:
What do you think and how does it compare to REITs?
In case you are unfamiliar with Fundrise, today it is the largest crowdfunding platform for real estate investments in the world.
They have approximately $7 billion in assets under management and over 300,000 users on their online platform.
It’s quite an achievement!
They pride themselves on leveling the playing field and making it possible for everyday investors to secure property traditionally reserved for the rich and wealthy.
If you go to their website, you’ll notice that they like to compare themselves to REITs and make a lot of statements that put them in a good light.
But how much of that is really just marketing?
In short, I would never invest in Fundrise. While I respect what they’ve built, I strongly believe that REITs are better investments in most cases, and especially at today’s valuations.
Below I outline 5 reasons why investors should favor REITs, and near the end I also briefly discuss an alternative crowdfunding site you might want to consider for diversification purposes.
Reason #1: Significant Conflicts of Interest
Most REIT investors understand that external management arrangements create significant conflicts of interest.
This is why externally managed REITs are generally avoided and trade at persistent discounts to internally managed REITs.
Yet, for reasons unknown to me, investors don’t seem to care that all Fundrise vehicles are managed externally.
This means that they receive a commission based on the volume of assets under management, which incentivizes them to grow at all costs, even if it comes at the cost of lower returns.
Internally managed REITs are more successful in aligning interests with those of shareholders because they hire management as employees of the REIT and receive salaries tied to shareholder performance rather than fees based on asset volume.
This is one of the main reasons why internally managed REITs have historically generated much higher returns than externally managed REITs as well as other externally managed private real estate vehicles.
Fundrise falls into the category of externally managed vehicles and therefore suffers from much greater conflicts of interest, and we believe this will eventually be reflected in its performance.
Good examples of externally managed REITs are Office Properties Income (OPI), Global Net Lease (GNL) and Industrial Logistics Properties (ILPT).
They all share a common characteristic: they underperform internally managed REITs due to significant conflicts of interest.
Reason #2: Much higher fees
Fundrise also prides itself on being an inexpensive alternative to other private vehicles. Their fees are usually around 1% per year.
It may be cheaper than other private alternatives, but it’s significantly more expensive than the typical management cost of a public REIT, which is closer to 0.5% according to an EPRA study:
And that’s just the average.
Some of the largest and best performing REITs, such as Realty Income (O), have a management cost of around 0.3%. You can clearly see that as the business grew, its management cost decreased over time:
Publicly traded REITs are much more profitable because they are managed internally by people who are hired as employees of the REIT. Salaries benefit from economies of scale and do not increase solely due to the volume of assets under management.
Fundrise, however, is a for-profit external asset manager. It earns fees based on asset volume and therefore you don’t get the same economies of scale.
Your interests are completely misaligned and unsurprisingly the management cost is also much higher.
Reason #3: Lower Returns / Higher Risks
Fundrise uses the following table as part of its marketing materials. It shows that REITs are more profitable than private real estate, but that private real estate is much safer and therefore offers better risk-adjusted returns:
But is it really true?
Yes, it is true that REITs are more profitable than private real estate. This has been proven by numerous studies which I discuss in a separate article which you can read by by clicking here.
However, it is absolutely wrong to say that private real estate is safer than REITs. It is very misleading to use volatility as the only measure of risk and then compare the volatility of a private asset with no daily quote to that of a public asset that trades daily.
The reality is that private real estate investments are illiquid, concentrated and highly leveraged, and in the case of Fundrise, they are also exposed to the conflicts of interest of an outside manager, and you lack control over their investment.
On the other hand, REITs are liquid, diversified, conservatively leveraged, and conflicts of interest are better mitigated through an internal management structure.
There is no doubt that REITs are safer.
Investing in a concentrated, illiquid and highly leveraged property can sometimes lead to higher returns, but you cannot claim that it is safer than a diversified, liquid and prudently leveraged investment.
The low volatility of private real estate is a lie. It’s just not traded daily. If you tried to sell your property every day, you would constantly receive different offers, and because you are heavily in debt, your equity value would be very volatile. Much more than that of REITs. Remember that it is equity value that is traded in the case of REITs, so you need to make adjustments to have an apple to apple comparison.
So, in short, you can expect to receive higher returns with less risk by investing in REITs in most cases.
Reason #4: No liquidity, no control
We mentioned it briefly before, but I want to repeat it one more time because it is important.
Generally, the main advantage of private real estate is having control over your investment, but the main disadvantage is that you run out of cash.
On the other hand, some people would say that the main advantage of REITs is liquidity, but the main disadvantage is that you don’t have direct control over your investment.
With Fundrise, you combine the worst of both worlds: you have no liquidity and no control over your investment. You are completely at the mercy of this single asset manager whose interests are not aligned with yours.
Reason #5: REITs are much cheaper
Last but not least, REITs are heavily discounted today.
Their price to net asset value is the lowest in years, with many REITs trading at 30%, 40% or even 50% off the value of the real estate they own, net of the debt.
Here are some examples for you:
- AvalonBay Communities (AVB), the premier apartment REIT, is expected to trade at a 25% discount to NAV.
- Simon Property (SPG), the blue-chip retail REIT, is expected to trade at a 40% discount to NAV.
- STAG Industrial (STAG), the blue-chip industrial REIT, is expected to trade at a 30% discount to NAV.
This means that you are accessing real estate at a steep discount in the REIT market.
It also means you’ll pay a huge premium over REITs if you decide to invest through Fundrise instead. This would likely result in higher risk and lower returns in the long run.
My real estate investment strategy
Most of the time, I favor REITs over private real estate because I strongly believe they offer higher returns with less risk.
But on rare occasions, I can invest in private real estate if and when I can’t get something in the REIT market.
To give some examples:
- Estonian real estate: I am very optimistic about the outlook for the Estonian real estate market. Estonia is fast becoming the Luxembourg of Northern Europe, attracting wealthy European business owners and investors thanks to the OECD’s #1 rated tax system. However, there are no REITs in Estonia and therefore I end up buying private property and also use a crowdfunding platform called EstateGuru for additional exposure.
- Farmland: Today, there are only 2 agricultural land REITs (LAND; FPI), and both present problems. LAND is too expensive and FPI is not a purely agricultural investment in farmland, as it is also developing an asset management business. But I want to own farmland in my portfolio. It has historically generated higher returns than most other asset classes, despite being one of the safest investments. I could try to buy property on the private market, but I’m not an expert in farmland investing and wouldn’t be able to build a well-diversified portfolio by geography and culture. Therefore, I use crowdfunding platforms. There are a few and my favorite is FarmTogether.
I don’t use Fundrise because there is nothing exceptional about it. They mainly invest in office buildings, apartment communities and shopping malls. There are many REITs you can buy to gain such exposure with the added benefits of liquidity, diversification, lower management costs, better alignment of interests and a much lower valuation in today’s market.
It really seems to me that the main appeal of Fundrise is the perceived safety and stability that comes with illiquid private assets. Investors fear volatility and it drives them to look for less volatile alternatives.
But as we explained earlier, you just get a false sense of stability due to the lack of citation. In reality, the volatility is just as high, if not higher.
Fundrise is trying to appeal to unsophisticated investors who don’t know any better. But if you’re experienced enough not to be phased by volatility, REITs are a much better investment in most cases, especially at current valuations. If you want to reduce your volatility, you can always add private assets to your portfolio (eg Farmland crowdfunding), but Fundrise is not the best option in my opinion.