Almost all investors look for ways to diversify their portfolios. Real estate holdings are certainly one of those investments that offer investors a chance to grow their assets while also earning income. When many people think about how to invest in real estate, they picture themselves as being a landlord: owning and renting out residential or business properties.
Purchasing and managing individual rental properties— commercial or residential— does offer an investor a variety of benefits involving growth, income, and preferential tax treatment. However, owners are left to their own devices to assess the suitability and condition of individual properties as well as macroeconomic factors such as the tenor and direction of the real estate market itself. In other words, determining risk in this sector is a critical step in the investment process, which can sometimes present challenges for individuals or small partnerships.
One common alternative to this method is to invest in a Real Estate Investment Trust (REIT).
An REIT is effectively a company that owns and operates real estate. REITs often invest in commercial real estate and rental properties. They operate in the same way as a mutual fund. A pool of investors puts money into the REIT and enjoys a share of the profits. Below, we'll give you an in-depth look at the structure, mechanics, and investment side of an REIT.
In short, an REIT allows individuals and entities to invest in a diversified portfolio of real estate holdings that are managed by a team of industry professionals.
How Does an REIT Work?
Consider shopping malls, for instance. These retail facilities are located in densely populated areas throughout the United States and abroad. One particular shopping mall may be owned by a single individual, yet it's more likely that the shopping complex and many other similar properties are owned by a large public or private business organization. There are also small, private REITs owned by families or investor groups. Finally, a number of buildings may be owned by a publicly traded corporation, which is in turn owned by its shareholders.
Like common stocks, you can purchase shares of a public REIT on the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations system (NASDAQ). Exchange-traded REITs are fairly liquid and most pay quarterly dividends. Here are some key differences between a large REIT and a DIY approach:
Professional Management: An REIT is run by seasoned real estate professionals who often have decades of experience in buying, selling, and operating entire portfolios of personal residences or commercial buildings. This real estate expertise relieves the individual investor from making critical decisions such as when to buy, sell, or perhaps renovate an existing property. REITs have teams of individuals who specialize in the various aspects of real estate investment. That team may include economists, analysts, and entire units of construction and maintenance workers. Naturally, these are resources that can't be tapped by real estate investors of lesser scale.
Many individual residential or commercial landlords step into owning properties without a lot of time spent in the industry. This lack of insight could be a detriment to the successful ownership and operation of a rental property business— especially when the intricacies of commercial real estate pursuits come into play. It's much more difficult and costly to manage a commercial property than it would be to draw on experience as a homeowner and rent out a single-family dwelling, for example.
Diversification: On the REIT side, you can access a portfolio of commercial or residential properties with a very minimal dollar commitment. In some cases, investment can take the form of a few shares of the trust— or a block of many. Spreading those dollars out between numerous developments including multi-family homes or office blocks in various geographic locations across the country, you are now minimizing the chance of realizing a loss or depleted income based solely on the experience of a single rental property. If one holding performs poorly, the REIT's return on investment and dividend payouts can be buoyed by the many other properties in the pool. This advantage of a managed trust speaks to the power of diversification.
If you bought one rental property in one particular city, as an investor you'd be subject to the dynamics of the regional (and possibly national) real estate market. There may be a major employer that shuts down, for instance, causing the loss of a current tenant and potentially delaying the time to fill that vacant unit with a new tenant. As you might expect, this scenario would hinder or completely shut off the income stream from the property while the fixed costs of a mortgage, maintenance, insurance, and taxes remain. It's a lesson often learned by many landlords who put their real estate eggs in one basket.
Capital Access: REITs have many options to raise capital. In some cases, they may own properties outright, and that position serves as collateral for securing more bank debt. Alternately, open-ended trusts can issue more shares of stock that can be purchased by individuals and/or institutions and used to fund operations. These strategies create capital to help meet expenses while new tenants are secured or spaces are converted to mixed-use (a combination of office and retail space, for example) purposes. With larger market capitalizations, REITs have greater resources to further leverage the corporation or issue secondary offerings of stock to help fill temporary shortfalls in funds from operations.
Risk Exposure: You could become one of a few partners who decide to invest in a strip mall. Whether it's new construction or the purchase of an existing structure, a fully occupied building maximizes revenue. In this scenario, rental income exceeds income and generates profit. One drawback may be the financial condition of the anchor tenant in the building. Suppose that retail sales have declined due to the dominance of ecommerce, and the tenant that occupies the most space and pays the highest rent can't renew the lease. At this point, expenses now exceed income, and personal capital or bank loans might be needed to pay the bills until a new tenant can be secured. With tight credit markets and a significant amount of personal dollars tied up in a major, illiquid investment, funding the mall's operations could be a problem for real estate microbusinesses.
REITs as an Investment Option
Investing in REITs generally depends on the objectives of the individuals or entities that purchase these trusts. The trusts fit numerous investor profiles, and adding them to the mix depends on what the investor hopes to achieve. Before purchasing REITs, investors will consider two major factors: time horizon and risk tolerance.
Time horizon takes into account the time period the investor has before an asset will be used for a specific purpose. In the case of an individual investor, that purpose may involve a milestone like retirement. A this life stage, the retiree may sell the asset to hold liquid funds that are less risky than REIT shares. That personal event may be decades or months away, and an individual will typically construct their investment portfolios accordingly.
Risk tolerance considers the investor's feelings about fluctuation in or an outright loss of money in the trust. REITs, like all other risk-bearing investments, offer no guarantee of principal since there are never assurances that the trust's assets will hold their value. In a worst-case scenario, gross mismanagement could cause the trust to become insolvent. Therefore, investor risk appetite involves individual attitudes about losing money in light of one's current financial standing— and the time required to recover potential losses.
When it comes to investment objectives and asset classes, individuals or organizations will primarily have two goals, or a combination of both. With REITs, these outlooks boil down to growth of principal and/or current income. Here's some more detail:
Growth: While public and private REITs don't fall into the "high growth" category like a tech stock would, real estate historically offers solid returns for limited risk. This is especially true for long-term investors. For example, the financial crisis of 2008-09 saw real estate and stock market values plummet along with the prices of many REITs. Where one investor may be inclined to avoid REIT investment during down markets, another individual with a longer-term time horizon may sense opportunity. By following the market credo of buying low and selling high, these investors bank on improvement in underlying property values and a recovering economy that allows tenants to more easily pay rent.
Income: REITs are a popular vehicle for income-seeking investors, especially in the current interest-rate environment where historically low yields prevail on U.S. Treasury and investment-grade bonds. The reason REITs are favored by income investors is that the trusts— whether publicly traded or privately held— must pay out 90 percent of their earnings in order to qualify for special tax treatment from the IRS. Therefore, you may encounter REIT dividend yields that are much higher than any bond or income-producing stock. Some REITs may not be more volatile than common dividend-paying stocks within the S&P 500 Index. Therefore, all types of REITs might be suitable for an income-oriented investor's portfolio.
Investment Alternatives to REITs
Depending on the investor's objective, there should always be comparisons and contrasts to similar securities when choosing the appropriate investment vehicle. Diversification, as mentioned, helps spread risk across a spectrum of investments that may not move in lock-step with each other. This concept provides balance to an efficiently constructed portfolio. Here are a few alternatives to REITs that can serve the same investment purpose as the trust:
- Corporate bonds- These securities represent debt obligations of the corporation. They are rated based on the creditworthiness of the organization, with an "AAA" rating typically representing the least risky issues. Interest is paid to bondholder every six months, and there is usually a strong secondary market for investment-grade offerings.
- Municipal bonds- These bonds are issued by quasi-governmental agencies or pure governmental entities like states, counties, or municipalities. Ratings also correspond to creditworthiness, but the key difference between these and corporate issues is tax treatment. Semi-annual interest or coupon payments are almost always free from federal tax, with some "triple-tax-free" bonds exempt from state and local tax as well.
- Blue-chip stocks- Usually more volatile in nature than bonds, blue-chip stocks nonetheless represent investment in companies, many of which may be recognized as household names. Because of their perceived financial strength and large market capitalization, many investors turn to these equities for a chance at capital gain and modest dividend income.
Real Estate Investment Alternatives to REITs
There are many ways to invest in real estate, and recent changes in the economy and legislation have opened up these opportunities for more investors. Property investment could take some of the following forms:
- DIY real estate - As mentioned, anyone with sufficient capital or good credit can purchase a commercial or residential rental property and use profits to purchase more buildings or units. Many investors who may have an aversion to corporate stocks or bonds favor this approach because property ownership involves familiarity. The business can be scaled (or not) to the comfort level of the investor.
- Real estate syndication - Real estate syndication allows first-time or seasoned individuals to invest in projects without having to finance the whole deal by themselves. This opportunity gives investors a chance to grow assets and further diversify their portfolios alongside vehicles such as stocks, bonds or mutual funds. The ability to log in and remotely follow the progress of construction or rehabilitation projects is a unique feature of syndication.
Benefits of Real Estate Syndication
Like an REIT, syndication is a type of real estate crowdfunding, in that a pool of investors contribute funds to buy, develop, and maintain profit-producing properties. Syndication offers more control over the investment opportunities you are a part of. You're not blindly investing in a trust that operates at arm's length, you're choosing which specific properties and projects you want to invest in.
Real Estate Investing with Gatsby Investment
Gatsby Investment offers accredited investors a unique opportunity to participate in home flips, multi-family properties, and development projects in the white-hot Los Angeles real estate market. With relatively low minimum investments placed in a deal-by-deal offering, you actively monitor the progress of each individual project in which you have ownership. Our crowdfunding platform allows you to be flexible in both dollars invested and the type of opportunity you wish to pursue. And our solid track record gives you insight into the successes that other investors have historically realized with Gatsby Investments. That historical record of high returns and the stability of the real estate market, particularly in LA are just some of the reason investors are opting for a syndicated investment program with Gatsby Investment. Contact us today for more information.