By Daniel Cohen
The market value of all real estate in the world is more than 200 trillion dollars which is more than triple the size of the value of all stocks and almost double the value of all bonds. Considering this staggering value, it may seem unusual that most financial advisors and their clients have little to no money invested in real estate aside from that invested in their own homes. Maybe there are good reasons to avoid most real estate investment offerings. It might also be that most financial advisors have too little experience in the business of real estate and the specialized field of real estate investing to offer the right kind of advice to their clients.
As Seen on TV
Real estate investments can be either active or passive. A popularized example of active real estate investing is buying a home or condo, fixing it up, and then selling it for a profit. There are all sorts of TV shows popularizing this “flipping” activity and fortunes have been made flipping properties. However, in times of declining home values, big losses can occur with this short term trading strategy, especially if debt is used to buy the property. Don’t give up your day job to become a home flipper unless you have the
capital to get through the down cycles in the market.
Before 2008 many people felt you couldn’t lose with real estate. A recent Morningstar report estimates that the long term return of home values is one percentage point over inflation. So if inflation has been 3%, then home values would have grown by 4%. But keep in mind, this estimate is before factoring in the carrying cost of the property like insurance, maintenance, property taxes, etc. so the actual return on owning a home is likely less than inflation.
Call the Landlord!
Another popular form of active investing in real estate involves buying a home or condo and renting it out for the rental income. The owner is the landlord and is responsible for finding a suitable tenant and handling problems that occur. Unexpected repairs, vacancy, collection problems, and other issues all affect the return of the investment property.
The biggest risk of investing in a single home or condo is losing your single tenant and not being able to re-rent for an extended period of time. In this case, there will be a negative cash flow as the expenses of owning this property must continually be paid. This risk is reduced if the investor owns multiple properties or a multifamily property. Borrowing money to buy the property is common and adds to the risk and bank financing has to be factored in to figure the total return on the investment.
Many people don’t want to be actively involved in property investment management. The good news is there are various ways to invest in real estate without the day to day hassles of being a landlord or the risk of losing the tenant or tenants in your property.
The Risk in REITs
Investing in publicly traded Real Estate Investment Trusts or “REITs” is the simplest and most popular passive alternative. REITs are required to pay out ninety percent of their income to shareholders so they are a good source of stable income. REITs can be diversified into multiple types of properties and can specialize in sectors of real estate like apartments, offices, or storage. Some diversify geographically while other specialize in certain regions. The potential downside of REITs is that they exhibit much the same volatility and risk as the stock market. A widely held diversified REIT would have lost more than 50% of its value during the 2007 to 2009 selloff in the market.
There are many non-traded REITs and a recent SEC investor alert warned investors about the risks of investing in them. They include lack of liquidity, meaning you cannot sell them when you want to, and high fees – as much as 15% upfront as well as other ongoing costs. Distributions may come from principal rather than income which is misleading to investors. The lack of share price transparency means that you don’t know what your position is really worth, and conflicts of interest may exist among the managers of the REIT and its service providers. For these reasons, it might be wise to avoid non-traded REITs.
Another passive way to invest in real estate is to participate as a limited partner. The partnership raises money from investors to buy either a single property or a group of properties. The investors are the limited partners and the organizer of the partnership is the general partner. The general partner is responsible for finding the property for the partnership to own and then to oversee the investment. The general partner will report to the limited partners and make income distributions to them. Limited partnerships can focus on any type of property and can target income producing property or property to be developed depending on the goals of the limited partners. These partnerships are not liquid like publicly trades REITs but may provide the stable income and long-term appreciation many investors desire.
Government regulations have placed limits on investment partnerships and who can invest in them. Limited partnership investments are often limited to accredited investors – people with $1,000,000 or more in investable assets or an annual income of $200,000 or more. There have been discussions in Washington about loosening regulations to allow more individuals to participate in these types of private partnerships.
Cost Transparency is Key
It’s crucial to know exactly what all of your investment costs are. Many limited partnerships have been organized by a small group of related individuals and the costs are kept to a minimum. However, there are partnerships formed by firms that require a high cost to participate. The types of fees to watch out for include acquisition fees, asset management fees, service fees, distribution fees, performance fees, and disposition fees. Some general partners charge a combination of these fees while others charge all of them. Therefore, it can be prohibitively expensive to participate in certain partnerships, so beware of all the upfront and ongoing costs before investing. You and your financial advisor or accountant should review the offering and figure out the total cost before committing to invest.
For investors with a relatively small amount to invest, the best choice to get exposure to real estate investing may be to accept the general market volatility and invest in a broadly diversified, publicly traded REIT. For larger investors who qualify as accredited investors, you may want to consider a limited partnership if you can find one with a reasonable fee structure and a general partner you can trust.