Real Estate Investing
- Property or Paper?
Real Estate Investing - Property or Paper?
Appraisals and inspections, marketing, renters, rehabs... it can all add up to a huge headache. But real estate investing is still exciting and lucrative. What to do? Consider investing in real estate-based financial instruments instead.
One of the oldest modern forms is a REIT - Real Estate Investment Trust. REITs are mutual funds that invest in real estate, actual property as well as mortgage portfolios. Like other securities opportunities, they sell on the major exchanges and are professionally managed, receive special tax considerations, and often have higher yields and greater liquidity than straight property investment.
There are Equity REITS which invest in and own properties. Revenues come primarily from rents. Mortgage REITs deal in investment and ownership of mortgages rather than property with revenue coming mainly from interest on the loans. Hybrid REITs do both.
Keep in mind, however, that REITs are closed-end - mutual funds that have a specific number of shares for sale and once sold can't be redeemed through the fund. They have to be bought and sold to other investors as you would corporate stock, through a broker.
REITs are required to pay out at least 90% of their taxable profits as dividends to shareholders, so they can be relatively high yield. In terms of total return - dividends plus price appreciation - they're similar to small-cap stocks, with on average two-thirds of the return coming from dividends. They're therefore sensitive to interest rate changes. As interest rates increase REIT prices tend to decline.
MBS (Mortgage-Backed Securities) are a type of bond in which the paper is backed by a pool of mortgage loans. In the U.S. lenders make about $2.8 trillion in such loans annually with about 80% being covered by mortgage-backed securities.
Investors in mortgage securities earn a coupon rate of interest, like other kinds of bonds. But in contrast to other bonds, they receive repayments of the principle in increments over the life of the security, as the underlying mortgage loans are paid off, rather than on one large payment at maturity.
One of the advantages, one which lends the security some stability, is the statistical effect of pooling loans. No single or small number of loans that pre-pay or default wipes out the investor's entire investment.
But pre-payment of mortgages does occur for a certain percentage and that introduces some risk. The investor isn't aware of or interested in which loans pre-pay, but the fact that some do causes them to be sensitive to interest rate changes, one of the major influences in pre-pay rate. If borrowers took mortgages at 8% and rates drop to 5% a certain number are going to re-finance, causing the original to pay off early.
So, if interest rates are likely to fall, it's best to avoid pre-payable MBS. Closed MBS are, in that scenario, a better alternative.
There are specialized instruments like CMOs - collateralized mortgage obligations - and REMICs - Real Estate Mortgage Investment Conduits with similar behavior and risks. ETFs ó Fixed Income Exchange-Traded Funds, too, sometimes are supported by underlying mortgage-backed securities and trade on the major stock exchanges. They're designed to track the performance of specific bond indexes, which track performance of an underlying bond market, such as MBS.
You can even set up an individual IRA (Individual Retirement Account) that allows you to add assets in the form of raw land, single-family homes, apartments and other commercial buildings, rather than straight cash inputs. This allows you to take advantage of your knowledge of real estate, while avoiding some of the downside of actual property management.
Whichever instrument you choose, and there are many others, be sure to do your homework and get the advice of a financial professional before investing large amounts. The sharks can always smell fresh blood in the water.