Sensible investors know that portfolios benefit from holding a wide variety of asset types because diversification lowers risk. Many experts believe that portfolios should hold up to 20% of their assets in real estate—distinct from ownership of your own home. That begs the question — how should you invest in real estate?
In this overview, we’ll describe your options for real estate investing. There are three main categories:
- Direct investments in real estate
- Investments backed by real estate
- Investments in real estate derivatives
In future articles, we’ll dive into each investment type, with special attention paid to REITs. After reading this series, you’ll have no problem identifying one or more investment vehicles that match your risk tolerance, reward requirements, budget, level of involvement and time horizon.
For our overview, we are excluding corporations with products and services related to real estate, such as home builders, preferring to concentrate on investments tied to actual properties or property indexes.
Direct Investments in Real Estate
This is the gold standard of real estate investing: Ownership and control of an investment property, either alone or in partnership with others. Your name (or that of your company, typically a limited liability company or limited partnership) is on the deed and mortgage, and you have the right to a financial return on your properties. Generally, there are two motivations for direct ownership of investment real estate:
1.Income: You lease space in your properties to tenants who pay you a monthly rent. You might also collect fees for extra services you provide. Failure of a tenant to pay rent might result in eviction. Typical income-producing properties include single-family homes, multi-family homes, apartment buildings, offices buildings, and retail stores. Alternatively, you might own property associated with a business you run, such as a hotel or a self-storage facility, where you collect revenues from renting out short term accommodations or storage space. Some investors rent out specialized commercial properties, such as medical practice buildings and hospitals, industrial properties, warehouses and so forth. Income investing is typically long-term and financed by a mortgage. You can manage the properties yourself, or hire a management agent to find tenants, collect the rents and maintain the property.
2. Capital gains: You earn capital gains by selling a property for a profit. This can occur through a couple of strategies. The first is called “fix and flip,” in which you buy a distressed property at a discount, fix it up and quickly resell it. Your profit is the sale proceeds minus the purchase price and renovation costs. Typically, you finance a flip property with a hard money loan, in which you put up 40% and borrow the rest. You can also borrow from a bank, and if you qualify for a government-guaranteed loan, you might have to put down as little as 3.5%. Success depends on your ability to judge property prices and to contribute sweat equity to the renovation of the property. The other source of a capital gain is an exit strategy, in which you sell an income-producing property after a planned time period. If you hold the property for at least a year before selling it, your profit will be a long-term capital gain that qualifies for a lower tax rate.
Direct investments in real estate have the following characteristics:
| Characteristic | Comment |
|---|---|
| Minimum Investment | High. You typically must pay a down payment of up to 40% of the property value. |
| Liquidity | Low. It can take a long time, sometimes years, to sell a property you own, and it can be an expensive process. |
| Control | High. You own the property, so you control it. |
| Diversification | Low. Unless you own at least 10 to 15 units, you don’t have a diversified real estate portfolio and are therefore exposed to higher risks. |
| Leverage | Medium to high. Leverage is the amount of debt you use for your investments. It varies with the relative amounts of your down payment and your loan. For long-term properties, your leverage decreases as you pay off the mortgage. |
Investments Backed by Real Estate
This category refers to financial instruments whose value is backed by an underlying portfolio of real estate. Your investment buys your shares or bonds issued by a corporation, trust or fund, either public or private. All investments in this category are passive — you have no control of or responsibility for the management of the underlying property portfolios. There are useful metrics for measuring the performance of real estate-backed securities.
Some of these investment vehicles are funds that are tax-free pass-through entities. They pass at least 90% of their income and gains through to investors, along with expenses and tax obligations. This setup avoids double taxation at the corporate and investor levels which is the primary attraction of these investments. Periodically, these funds tally the values of their assets and divide the total by the number of outstanding shares to arrive at the net asset value (NAV). Depending on the type of fund, you can trade shares at the NAV or at a share price determined by supply and demand. Share price need not be identical with NAV, but the two are usually remarkably close.
Investments backed by real estate provide the next investment choices
3. Crowdfunded real estate properties: Real estate crowdfunding is a way to purchase shares or debt issued by a company that owns or is looking to buy real estate properties. You invest by visiting a crowdfunding portal, which is a special website set up to sell crowdfunded investments. You can select the properties that interest you and purchase shares or bonds according to the minimum- and maximum-investment rules. Online portals cater either to the public or only to accredited (i.e., wealthy) investors. The percentage of the company’s equity or debt you own is proportional to the amount you invest.
4. Real estate investment trusts (REITs): These are corporations that issue shares backed by their portfolios of real estate properties. REITs are pass-through entities. There are three types.
Equity REITs own and manage properties
Mortgage REITs hold a portfolio of mortgage notes
Hybrid REITs own a mix of equity and debt
REIT shares can be publicly traded (publicly listed and traded on stock exchanges), public non-traded(unlisted and publicly traded via brokers) or private (unlisted and traded via private placements). The Nareit website publishes REIT Watch, a detailed monthly compilation of the publicly traded REIT industry. Our website is dedicated to educating the public about REITs.
5. Mortgage-backed securities (MBS): These are bonds that are backed by pools of mortgages. They offer a range of returns (and risks) depending on the characteristics of the mortgage pools. Investors receive monthly interest and principal payments generated by the pools. The three main players in the American market are the government sponsored-entities Ginnie Mae, Fannie Mae, and Freddie Mac.
6. Funds: This group includes the following pass-through entities:
Real estate investment funds: These are professionally managed funds that invest either directly in real estate properties or indirectly in REITs. They differ from REITs in that they are geared more toward share appreciation than income.
Real estate mutual funds: These are funds that own the shares of corporations within the real estate sector, including REITs. Shares of an open-end mutualfund trade at their NAV after the daily close of the stock market. The mutual fund company issues new shares and redeems existing ones. A closed-end mutual fund is like an exchange-traded fund (see below). Balanced funds are mutual funds that hold a variety of asset types, including shares of real estate corporations.
Real estate exchange-traded funds (ETFs): Like mutual funds, ETFs own the shares of real estate corporations and REITs. They trade at their share price on public exchanges, just like normal corporate stock. You can trade shares whenever the market is open — you don’t experience the delay associated with mutual funds. ETFs have a fixed number of shares that can increase only through a secondary public offering.
Real-estate-backed investments have the following characteristics:
| Characteristic | Comment |
|---|---|
| Minimum Investment | Low. You can buy a single share of a fund. |
| Liquidity | Low. It can take a long time, High for publicly traded funds, low for other funds. You can trade public funds in real time or at end-of-day. Private fund shares are difficult to sell. |
| Control | Low. You control what investments to make, but have no control over the underlying real estate or mortgage portfolios. |
| Diversification | Low to high. Funds, MBS and REITs are backed by many properties. Crowdfunding is not diversified unless you invest in at least 10 to 15 properties. |
| Leverage | Variable. ETFs and REITs can use leverage. You can increase the leverage by purchasing shares on margin. Crowdfunding typically is not leveraged. |
Investments in Real Estate Derivatives
A derivative is a
7. Real estate index funds: These are funds based on indexes with values that track some assets related to real estate markets. For example, the MSCI US REIT Index tracks the performance of domestic equity REITs. The amount each REIT is represented in the index mirrors the REITs size, so the largest REITs have the largest presence. A fund based on an index attempts to replicate the performance of the index. These funds are passively managed — they only change holdings when the composition of the index changes. Index funds can hold various assets, including futures and options (see below) in their attempt to mimic an index’s performance. Real estate indexes need
8. Real estate index futures and options on futures: These are contracts that derive their value from a real estate index. Index futures are a bet on index prices between the purchase date and the expiration date. Options on futures give you the right, but not the obligation, to purchase a futures contract at a set price. Typically, real estate futures and options are tied to a specific index, such as the S&P Real Estate Select Sector Index or an index of home prices within a metropolitan area, such as the S&P/Case-Shiller Metro Area Home Price Indices.
9. Real estate swap contracts: These are complex derivatives that exchange one asset’s cash flow with those of another asset. For example, the NCREIF Index tracks different real estate sectors. An investor could buy a swap contract in which returns from the NCREIF Office Property Index are exchanged for returns from the NCREIF Retail Property Index. There are many types of swaps that sophisticated traders use to shift risk. You can enter into a swap contract without spending any money. You mark your profits or losses on each swap reset date in the future.
| Characteristic | Comment |
|---|---|
| Minimum Investment | Low. Contracts can be entered for free (swaps), for a few hundred dollars (options) or thousands (futures). |
| Liquidity | High for publicly traded derivatives. Low for swaps and other private derivatives. |
| Control | Low. You control what investments to make, but have no control over the underlying real estate assets. |
| Diversification | High for derivatives based on indexes. |
| Leverage | High, especially for option contracts. |
Summary
As we’ve seen, there are nine main ways to invest in real estate, and we didn’t even touch upon investments in home builders and other sectors tied to real estate. The gold standard for real estate investing is the direct purchase of properties. However, most investors do not have the capital to acquire enough properties to properly diversify their risk. Fortunately, there are other real estate investment vehicles capable of providing adequate diversification, profit, liquidity and risk management. And while you grow your portfolio, you can benefit from the tax advantages of passive income without the responsibility of managing the underlying properties.
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