Real Estate – Alternative Investment Series Part 3
I am not going to lie, I struggled with this article for my alternative investment series. In some ways this should have been the easiest article to write, everyone is familiar with real estate, but admittedly my cynicism made this article difficult. After all, if you look on Facebook or do a quick Google search, everyone will tell you how real estate is a no-brainer, and even a monkey could make money on real estate (ok, I’m done…for now.) However, I decided to put my cynicism aside and do what my personality tends to do best…research.
This post is a continuation of our Alternative Investment Series and will follow a similar pattern to our other posts. If you wish to review those posts, here are links to the series introduction video, Part One – The “Why” of Alternatives, and Part Two – Private Equity.
What is Real Estate?
Quite simply, real estate is any real property attached to a piece of land that is used for either residential or commercial purposes. You can generally “reach out” and touch real estate. While most people think of physical buildings, it can also refer to things in the ground such as crops, mineral rights, water, etc.
Why Invest in Real Estate?
1. Diversification – A reoccurring theme in this alternative asset series has to do with diversification, and real estate is no different. Perhaps the biggest reason for investing in real estate is the historically low correlation to the stock market. According to a chart produced by JPMorgan, from 2008 through the middle of 2022, U.S. Core Real Estate had a correlation of 0.0 to global stocks. What does that mean? Essentially, a 0.0 correlation means the price movements of an asset (real estate in this case) are not related to the movements of the stock market (JPMorgan Guide to Alternatives 4th Qtr, 2022.)
2. Cash flow – According to another chart from JPMorgan, current yields of real estate are double that of the U.S. stock market.
3. Tax Advantages – Depending on the type of real estate, there are different tax strategies that can be utilized, such as 1031 exchanges, pass-through deductions, and depreciation.
Types of Real Estate
There are several types of real estate, but for the purposes of this post we are going to focus on four:
- Residential – This is where people live and can consist of single-family homes, apartments, condos, duplexes, etc.
- Commercial – This is property used exclusively for business purposes, such as office space, gas stations, grocery stores, hotels, etc.
- Industrial – This is property designed used for manufacturing, operations, research and development, warehouses, etc.
- Raw Land – Property used for agriculture such as farming, orchards, timber, or other undeveloped lands.
How to Invest in Real Estate
Another re-occurring theme in this series has been that access to alternative investments for investors has been increasing over the last number of years. In the past, if you wanted to invest in real estate you had to go find a property on your own, be the landlord, commit a lot of cash up front, etc. However, investors have more options than ever on how to include real estate in their portfolio, such as:
1. Investment Property – This is the “traditional” real estate investment option. An individual would buy a home or land and rent it to someone else. The owner of the property is responsible for all management of the property such as finding tenants, collecting rent, maintenance, etc. Some people hire property managers, but just remember that could cut into profits.
2. Real Estate Investment Trusts (REIT) – This is a company that owns and manages a large portfolio of income-producing real estate assets and is an example of a pooled investment vehicle. They usually specialize in a specific type of real estate and can be publicly traded or non-publicly traded. Non-publicly traded REITs are not offered on public exchanges and often have long hold periods, high fees, and no regular liquidity events.
3. Closed-End Funds – A closed-end fund is another example of a pooled investment vehicle. Like non-publicly traded REITs, these funds are not traded on an exchange, however, these funds are perpetually offered and include some type of quarterly share buyback program. Like REITs, fees in a closed-end fund can be high and it is important to understand the liquidity options.
4. Crowdfunding – Crowdfunding has now reached real estate. Again, this is another pooled investment style, but very different than a REIT or a closed-end fund. There is no professional manager choosing which properties to invest in, that’s up to the individual investor to look through the various listings and allocate their dollars to the properties they pick. Often the minimums are lower than REITs or closed-end funds, but an investor really needs to do their due diligence on the crowdfunding platform to understand the fees and property expectations.
5. Syndications – This is essentially a more private or exclusive form of crowdfunding. In a syndicated real estate deal, a small group of investors will hire a professional to go find a property to purchase. Sometimes, the reverse also happens in that a syndicator may find a property and then solicit a few investors to help fund the purchase. In both cases, there is usually a general partner and limited partners. The advantage here is that you can be more selective in the type of property to purchase, but minimums are usually much higher than some of the options above. In addition, due diligence on the syndicator (manager) is critical in this type of investment.
6. ETFs or other publicly traded funds – This is the most indirect way, but also the easiest and cheapest way to add real estate to an investment portfolio. ETFs such as the Vanguard Real Estate Index Fund can be purchased just like any other stock in your portfolio. The advantages are high liquidity and low fees, but it is a more indirect way to purchase real estate and the fund is likely to be influenced by general stock market fluctuations compared to utilizing more direct forms of real estate investing.
Key Things to Remember
As I wrap up this post, there are a few things specific to real estate to consider before adding real estate to your portfolio.
1. J Curve – This point and the next point, is where my cynicism usually lies with real estate. The J Curve is simply the idea that investing in real estate usually follows a J-shaped pattern. However, people on Facebook or leading seminars tend to gloss over this fact and set unrealistic expectations for new real estate investors. If you think about the shape of the letter J, right after starting the letter it “drops” and then goes back up. Real estate is often the same way. There are initial costs in the first few years that often wipe out profits, such as interest expense, repairs, down payment, etc. It can take a while until investors really start to see profits and this can be surprising to new real estate investors.
2. Passive Income (really?) – This is perhaps my single biggest issue with how real estate investing is portrayed. We have all seen those Facebook posts of people who are sipping mai tais on the beach while extolling the virtues of passive real estate investing. Do not get me wrong, if you are purchasing individual investment properties and getting good tenants, it can be relatively passive. However, if you don’t have a property manager, guess who’s getting the call at 2:00 in the morning when your tenant’s heat is not working, or finding new tenants every year, etc. While this may be a bit dramatic, the point is, depending on how you choose to invest in real estate, go in with realistic expectations of how “passive” the investment may be.
3. Leverage – Most people do not have enough cash laying around to purchase properties outright, so they take out loans, this is knowns as leverage. This can accelerate returns but could also put a real estate owner in a bind if they cannot make payments on the loan. If using a pooled investment vehicle, it is important to research how leveraged the fund is so you can understand the risks to you as the investor.
4. Liquidity, Fees, and managers – For the sake of brevity, I’m going to lump these three items together, because quite frankly these items carry across all types of alternative assets. Real estate is naturally illiquid, so while using pooled funds can help the liquidity issue, it could drive up your costs. Make sure you understand your fees, research the manager’s track record, and understand the types of real estate they will be purchasing.
So is my cynicism cured after doing research? Yes and no. Like all investments, there are pros and cons that need to be managed and real estate is no different. I think real estate can be a valuable piece of an investment strategy, just make sure your expectations match reality…that is where a healthy dose of cynicism can help (I think!)
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