Ways to Invest in Real Estate

This is chapter five of a guide on REIT investing. Begin here.

This is chapter two of a guide
to REIT stocks. Begin here.

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There is more than one way to invest in real estate. And like all things in life, there are trade offs. A private real estate owner has complete control over the real estate asset, but it typically takes a few months to sell the asset.

Investing in REITs solves this liquidity risk. But the value of the REIT stock is dependent on variables that are unrelated to the real estate as I argued in the prior chapter.

Private real estate ownership

The traditional way to own real estate was to visit the office of a real estate broker, tour the local community, fall in love with a property and, with a lender’s approval, eventually take ownership of the property.

Another common method was to gather a few investors (what is referred to in the industry as “to form a syndicate”), and to purchase a commercial property as partners. Today, crowdfunding websites such as RealtyMogul and PeerStreet offer similar services with a click of a mouse.

Yet there is a shortfall to the traditional model of private real estate ownership. First, by placing all eggs in one basket, the investor places all bets in one individual asset. Second, it takes at least a few months to sell the asset. And necessity never makes a good bargain.

Publicly traded real estate firms

There are two broad categories of publicly traded real estate firms. In the first category are equity REITs, and in the second category are mortgage REITs.

Equity REITS own, develop and manage real estate properties. They tend to focus on an asset class, such as shopping centers or apartment buildings. Mortgage REITs, on the other hand, invest in mortgages backed by residential or commercial real estate; the principal and interest you pay on your mortgage serves as a revenue stream for the mortgage REIT.  

The risk of owning an equity REIT compared to a mortgage REIT is different. In equity REITs, the value of the property is dependent on the demand for real estate, in the occupancy and location of the real estate portfolio. If there are nearby newer projects, for example, then the real estate value suffers.

In mortgage REITs, the risk lies in the interest rate environment and on the business cycle. For example, homeowners refinancing activity affects the value of mortgage REITs. Furthermore, to value a mortgage REIT is different than to value an equity REIT. To value a mortgage, we estimate when the mortgage will be repaid and whether interest rates will increase or decrease.

Real estate operating companies

Some owners of real estate prefer to stay private. I recently spoke with an investor who owns and manages a portfolio of commercial real estate that consists of 56 industrial properties in Southern California. When I asked him why he does not want to go public, he said that he enjoys managing real estate and does not want to manage Wall Street expectations. He also mentioned the regulatory environment nowadays would be too much of a hassle for him to deal with.

Owners of private real estate companies typically offer a limited partnership interest. The most popular terms in the industry are that the general partner offers a preferred rate of return of 6% to 8% to the limited partners, and any profits remaining above the preferred return are split 2/3 to the limited partner and 1/3 to the general partner. While negotiable, the general partner typically charges both an asset management fee that ranges from 0.50% to 2.00% of the assets under management and a management fee of about 5% of the rental revenue.

Exchange traded funds

Just as you can purchase an ETF that tracks the value of the S&P 500 or Dow Jones, you can easily buy an ETF that tracks that value of the total REIT companies as represented by the NAREIT index.

Popular ETFs include Vanguard Group’s REIT (VNQ), which charges a management fee of 0.12%. Another popular ETF is iShares U.S. Real Estate ETF (IYR) with a management fee of 0.43%.

ETFs, viewed as a passive investments, are becoming popular with investors who are wary of the active management fairy tales of their hefty management fees.

VNX holds 190 stocks with a median market capitalization of $13.7 billion. Since VNX’s inception, the fund returned a total of 8.46% and 14.71% over the past ten years. If you bought $10,000 of VNX in November 2008, it would now be worth $39,740. IYR holds 114 stocks and showed a total ten-year return of 6.99% and a return since inception of 9.55%. If you bought $10,000 of IYR in November 2008, it would now be worth $30,545.

Mortgage backed securities

Since Charles Schwab is now offering mortgage backed securities for investors, it is worthwhile to introduce this asset class as a means to invest in real estate. MBS is a special purpose entity that owns residential or commercial real estate mortgages.

The residential mortgages are often backed by a government agency, such as Fannie Mae or Freddie Mac. The cash flow to the investor is dependent on the orderly payment of mortgages by the homeowners. How to value and understand MBS is beyond the scope of this guide.

Epilogue

I opened this guide to REIT investing with an overview of REITs. We then discussed the pros and cons of investing in REITs. For example, because REITs are required to distribute over 90% of their taxable income, a REIT can grow its assets only by taking additional debt and raising additional equity in the secondary market.  This chapter ended with an overall description of the possible ways to invest in commercial estate.

The next chapter and the one following are case studies of REIT investing. In these mini-case studies, I will introduce the rationale of why I had purchased the REIT stock, what eventually happened to the stock and some of the lessons I learned as a result.