When you’re under contract on a new house, it’s easy to fall in love with its potential. But before you linger on cloud nine too long, you’ll need the reality check of a home inspection.
How To Invest In Real Estate Without The Headaches
Dated: November 7 2018
Among all of the asset classes available to the average investor, physical real estate stands alone with its beautiful simplicity. After all, the tangibility of such property — and its straightforward path to income generation — is unique in today's landscape of digital ticker symbols and complex investment vehicles.
In spite of the attraction that real estate might hold for many Americans, one point should be clear: This asset class is not bulletproof. It is very possible to lose money in the property market, and depending on an investor's savvy and geographic location, it may even be likely.
Further, the time commitment associated with property management often forces investors to make an unpleasant choice between sacrificing a large chunk of monthly cash flow or many hours of their own time.
Fortunately, there is a viable alternative: securitized real estate investing. This piece will examine many of the common pitfalls that investors in physical properties deal with, and take a closer look at the alternative offered by real estate investment trusts (REITs) and real estate limited partnerships (LPs).
What investors get wrong: Valuation and aggravation
The first and most obvious evaluation of whether a real estate investment will be successful involves the economic relationship between the purchase price of a property and its capacity as a cash generator. This relationship is best defined by a metric known as capitalization rate, or as it's often used informally, “cap rate.”
While factors such as supply and demand, personal financial stability and economic cycles can impact the final return on these investments, the cap rate offers an objective, big-picture distillation. It's calculated as follows: Net operating income (“NOI”), divided by the purchase price (whether actual or proposed.)
A low cap rate may indicate that the seller was able to charge a premium for their property relative to its income potential, whereas a higher rate may favor the buyer under certain market conditions. What is interesting is how few buyers of physical real estate even take into consideration this simple metric when making investment decisions.
It is surprisingly common for investors to incorrectly evaluate their property. Purchasing a property that costs too much and then seeing stagnant appraised values or rental rates can be disastrous on an investment as large as a house or commercial property. It also may be difficult to forecast the exit on a real estate investment as rental market dynamics, construction starts and interest rates often dictate when and whether investors can sell properties at a profitable level.
Those are some of the financial implications. There are other, more mundane challenges to this type of investing that often get overlooked. Hassles in negotiating with tenants and the time commitment and cost involved with property management should also be primary considerations.
I'm talking, of course, about the dreaded Four T's: taxes, tenants, termites and toilets. Each of these variables is mostly self-explanatory. The tax consequences of owning property can be significant, depending on your local tax codes. Tenants themselves can be unreliable — they're people! Vacancies can occur. Sometimes the rent is late. And renters don’t always treat the properties with the same level of care as an owner; hence, the need for security deposits.
Termites can be looked at as the literal pests they are … or as a metaphorical proxy for the wear-and-tear that happens to any property. And toilets — the cost of maintaining the dwellings that house your tenants — represent a significant expense. Your pocketbook and your schedule need to be prepared for the investment in real estate before you make it.
Real estate securities as a viable alternative
Real estate can be — and historically has been — an asset class capable of delivering more than satisfactory returns. It's a stable, diversifying allocation to almost any portfolio, if managed properly. So, how can an investor with concerns about an inflated market in their area or the aggravation associated with management get in the game? Enter the real estate security, which can be simplified into two basic forms: (1) real estate investment trusts and (2) real estate limited partnerships.
Real estate investment trusts, or REITs as they're known in industry parlance, are investment vehicles in which a collection of investors pool their resources to invest in real estate (usually commercial) at scale.
REITs can take two forms: publicly traded and non-traded. Publicly traded REITs are listed on the public markets and are freely accessible to any investor interested in gaining exposure to the sector. Non-traded REITs are not listed on an exchange and are predominantly available to investors who satisfy suitability requirements via financial adviser relationships.
There are pros and cons to both forms, however, that’s a topic we won’t have time to focus on in this piece. One positive worth noting is that REITs, both publicly traded and non-traded, are managed by professionals who address all four of the above-listed T's on behalf of investors.
Real estate limited partnerships, or “RELPs,” also provide investors with passive exposure to the commercial real estate sector. A RELP, as the term implies, is a legal entity formed to invest in real estate. The structure traditionally involves one General Partner, an experienced real estate manager responsible for acquiring and/or developing real estate on behalf of the partnership, and a group of limited partners who provide equity or debt financing to the partnership. Limited partners rely on the expertise of the General Partner in making investment and property management decisions, as well as securing financing and performing leasing activities on behalf of the RELP. Their passive investment status means that they simply enjoy the economic benefits that the partnership earns.
Unlike REITs, RELPs tend to be reserved for accredited investors who are better suited to accept illiquidity risk in order to gain access to more sophisticated investment strategies. They also come with higher minimum investments, as there are regulatory limits to the number of investors each partnership may accept.
Make no mistake: Despite their relative lack of friction, REITs and RELPs are investments in property. The underlying assets are there, just as real as the house you were thinking of buying next door. If you wish, you can easily obtain a detailed summary of the holdings of any given real estate security and go see them for yourself.
The funds that pool investors' money are diversified portfolios of real estate properties, often acquired and managed under terms more favorable than those that might be accessible to an individual investor.
A selling point
In case there is any confusion about the viability of real estate securities as an income investment, consider this: To qualify for favorable tax treatment as a REIT, these entities must pay out at least 90% of their after-tax earnings to shareholders each year. Limited partnerships, because of their pass-through tax status, are also incentivized to distribute most, if not all of, their earnings to investors.
These vehicles are true proxies for real estate, with real properties, real rents and real appreciation to boot. The only thing they're missing is the stress involved with active property management.
That's not to say investing in a single real estate property can't work out. It has for millions of Americans in the past and it may for many more in the future. Real estate securities, however, represent an excellent way to diversify into this asset class without the enormous outlays of capital or hassle of the traditional method.
Those who are unfamiliar with securitized real estate but want to further explore this investment option should do so with the guidance of an experienced financial professional. Understanding the investment manager, valuation metrics and property types within these securities are critical for success.
Source: Healey, CFP®, MBA, Patrick B., 2108, November 7, How to Invest in Real Estate Without the Headaches
Katie Yancey, REALTOR | The Glover Team, Inc. | United Real Estate Premier
My name is Kelly Combs and I am a native of Fredericksburg, Va., born and bred. I grew up in the 80’s when Fredericksburg was a small rural town, and I had the joy of evolving from a child to an adu....