Different Ways to Invest in Real Estate
The investment allocation decision, which refers to how your money is spread across different asset classes, has a bigger impact on the returns you earn over time, and the risk involved, than just about any other investment decisions. The two best-known asset classes are equities and fixed income, and investors typically hold some of both in proportions that vary depending upon each person’s circumstances and risk tolerance. Diversifying your investments so that you “don’t have all of your eggs in one basket” is so important that diversification is often called the “free lunch” of financial markets.
Investors can further diversify beyond stocks and bonds by including real estate as an alternative investment in their portfolio. Homeowners are already real estate investors, and owning a home can be a powerful wealth-builder over time. Here, we focus on commercial real estate, which allows investors to diversify further and can hold up well when inflation rises. The market value of all the commercial real estate in the U.S. is roughly the same as that of all U.S. Treasury securities, so it is not a minor asset class.
Different Ways to Invest in Real Estate
There are many types of commercial real estate, such as office buildings, warehouses, shopping malls, hotels, self-storage facilities, data centers, apartment buildings, and even cell phone towers. And there are different ways investors can access these types of real estate properties:
Public REITs, mutu al funds, and ETFs
Private REITs, and Real Estate Private Equity Funds
A Real Estate Investment Trust, or REIT, invests in commercial real estate properties. REIT shares are traded like stocks and are thus easy to buy and sell, and they offer exposure to commercial real estate with a reasonably small investment. Some REITs specialize in a particular type of real estate; others invest in a diversified array of property types. Certain REITs invest in the mortgages on properties rather than the buildings themselves and are therefore similar to bond funds. Some REITs specialize in “green” properties that seek to minimize energy consumption and reduce waste (such as buildings that have been LEED-certified).
At least 90% of a REIT’s income must be distributed to investors yearly through dividends. REITs receive income from rent generated by the properties, except for mortgage REITs, where income flows from payments on the mortgages held.
Real Estate Mutual Funds
Real estate mutual funds own shares of companies that develop and own real estate and shares of REITs. Like REITs, these funds may focus on a specific segment or invest across a range of property types. As with other mutual funds, most real estate mutual funds are actively managed; in other words, the fund managers analyze real estate companies to make their investment decisions (some real estate mutual funds track a real estate index; in this case, the stocks held in the fund match what is held in the index). Like all mutual funds, buy/sell orders for real estate mutual funds are completed at the end of the trading day, at the fund’s Net Asset Value (NAV).
Real estate Exchange-Traded Funds (ETFs)
Like real estate mutual funds, real estate exchange-traded funds (ETFs) hold stocks of real estate companies and may also hold REIT shares. Like REITs, ETFs trade on a stock exchange and can be bought and sold throughout the day, and like both REITs and mutual funds, real estate ETFs provide exposure to real estate with a fairly small investment.
Like stock and fixed income ETFs, most real estate ETFs track a chosen index; they do not select real estate companies based on an investment manager’s analysis. Since most ETFs do not involve active management, they tend to charge low fees. However, they must hold whatever is in the index they track, for better or worse. Real estate ETFs may focus on a specific commercial real estate segment or a broad range of property types.
REITs versus Real Estate Mutual Funds and ETFs – Key Differences:
The primary differences between REITs and Real Estate Funds are:
Income – REITs must distribute at least 90% of the income from their properties to investors each year and are seen as income-generating investments. Real estate mutual funds and ETFs also usually pay dividends but may also seek to provide returns from an increase in the value of the fund’s properties.
Trading/Liquidity – REITs and REIT ETFs trade like stocks and thus can be bought and sold throughout the day. Real estate mutual funds trade at the end of the day but are still quite liquid.
Taxation – Most dividends from REITs, mutual funds, and ETFs are taxed as ordinary income. When real estate mutual funds sell properties, the increase in the value of those assets may be taxed as capital gains. Income from REITs held in a mutual fund is classified as Qualified Business Income, lowering the taxes owed on it.
REITs, as well as real estate mutual funds and real estate ETFs, tend to throw off income and, therefore, may be best held in tax-deferred or tax-free accounts such as IRAs and Roth IRAs.
Direct Ownership of Real Estate
Many people own rental properties. For doctors and other professionals in private practice, owning the building where your practice is located can make sense—you pay rent to yourself and take any interest & principle, depreciation, and many more expenses against the property, which has tax benefits. Of course, suppose you buy a property, whether commercial or residential and rent it out. In that case, you will most likely need a property manager to find tenants, collect rent, and handle maintenance, as you won’t want to do all that in addition to your professional job.
Real estate and IRAs?
Investors can hold property (a house, an office building, etc.) in a self-directed IRA —an IRA that is not associated with any brokerage firm, bank, or investment company. The custodian that handles record-keeping and IRS reporting for the IRA must accept alternative investments (not all of them will). There are several rules to consider before pursuing this. For example, investors must hold the property for investment purposes only; family members cannot use it. You must pay cash for the property, and you must pay all ownership expenses out of the IRA.
Holding property in an IRA would shield the income flowing from the property from taxes. However, it could create liquidity problems if you have reached the age where you must take minimum distributions (RMDs) from your retirement accounts and you do not have enough liquid assets to meet that RMD, and you (or the IRA administrator) would have to get a third-party valuation for the property every year to determine your RMD. If your heirs inherit an IRA with property, they would have to obtain annual valuations no matter how old or young because they will need to take an RMD from the IRA.
Private REITs and Real Estate Private Equity Funds
Private REITs and private equity real estate funds are not listed on any stock exchange. They can provide accredited investors with exposure to a few properties – as small as just one property – so you typically know exactly what the private REIT or fund holds before you choose to invest. However, private REITs and real estate funds may not be as diversified as public REITs, mutual funds, and REIT ETFs. Private REITs must distribute 90% of their taxable income to investors yearly and may offer higher yields than public REITs, but it is difficult to find reliable performance data on private REITs.
Private equity real estate funds sell limited partnership (LP) interests to raise capital to invest in real estate and often borrow money to create leverage. The general partner often referred to as the sponsor, provides some equity, identifies the real estate opportunities, manages the investments, and earns fees that are often (but not always) based on the fund’s performance. The LPs typically receive distributions from the Fund before the sponsor does.
Five types of private equity real estate funds are defined by their risk/reward profiles:
1) Core – uses little or no leverage and focuses on stable, high-quality assets with high occupancy rates in prime locations. Most of the return from these funds comes from rents, while appreciation is a minor component.
2) Core-plus – buys slightly risky assets in prime locations or high-quality assets in secondary locations using equity and borrowed funds – up to 50%. Returns come from rental income and some appreciation in property values.
3) Value-add – acquires properties to improve or redevelop and may be involved in new development. They use up to 70% leverage, and returns are based on the appreciation in property values.
4) Opportunity – redevelops poorly run, outdated buildings or builds on vacant land. They may offer high returns but have the highest risk. Returns come from appreciation in property values, much of which is realized at the end of the investment period.
These funds distribute income to investors only when cash is available, such as when a property is sold. IMPORTANT: private REITs and equity real estate funds are usually illiquid; investors must usually commit to locking up their capital for several years.
Real estate can be a good source of investment returns and diversification, and there are many ways to gain exposure to this alternative asset class. Do your due diligence if you choose direct ownership or private real estate funds. Your Gold Medal Waters advisor can help you to think through any investment opportunity to understand its risks, how it would fit into your portfolio, and how it could help you to reach your financial goals.