Real estate: Know your investment options

April 16, 2014

Real estate purchases can be made on an individual basis or in a diversified form through partnerships or real estate investment trusts.

 

With prices still down, I would like to add some exposure to real estate in my portfolio. What are my options for doing this?
Real estate purchases can be made on an individual basis or in a diversified form through partnerships or real estate investment trusts.

A single purchase of a medical office building, rental house, or apartment building carries the risk of lack of diversification. You are limiting yourself to the economic climate for real estate in the particular geographic area where you buy. Additionally, you become a landlord, dealing with the day-to-day nuances and nuisances of property ownership. You may not be familiar with the specific area and the unique rental opportunities/problems that exist. The main advantage of single ownership is one of ultimate control: You make all the decisions.

With the U.S. stock market’s recent bull market run-up, investors are seeking other potentially profitable investment vehicles. One area attracting considerable attention once again has been investment real estate. While real estate combines the advantages of potential appreciation with rental income, the problem with buying investment property, as mentioned previously, is that you become the landlord. You are responsible if the plumbing breaks down or the heat doesn’t work. Busy physicians tend to not want to deal with these situations or the responsibility of finding renters and collecting rent. A favorable alternative, therefore, is to have exposure to real estate markets without day-to-day management responsibilities.

Real estate investment trusts (REITs) are publicly traded stocks that invest in office buildings, apartment complexes, industrial facilities, shopping centers, and other commercial spaces. In order to avoid paying corporate income taxes, REITs must pay out a minimum of 90% of their earnings to shareholders in the form of dividends. Investors generally receive dividend income along with the potential for stock price appreciation.

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The REIT industry has been very volatile in terms of its market cycles. It enjoyed a great run-up in the early 1970s only to experience an enormous downturn during the 1973–’74 recession, when many REITs actually went bankrupt due to massive overbuilding that exceeded market demand.

The industry recovered and prospered until the real estate markets again became overbuilt in the late 1980s and early 1990s. Of course, the real estate markets were hit hard in the period from 2006–’09, with many single-family homes seeing current values quite a bit off their pre-2007 values. Many analysts now believe that REITs are still attractively priced.

An alternative to individual REIT ownership is mutual funds that invest in publicly traded real estate-oriented stocks, offering a diversified portfolio of real estate sector securities, geographic diversification, and professional management. Many of these mutual funds include REITs within the portfolio to take advantage of their relatively high-dividend yields. Often included in many fund portfolios are stocks of home and industrial builders as well as the suppliers to those industries. To further diversify, global real estate funds invest in real estate-related companies around the world.

As a general rule, REITs and real estate mutual funds tend to perform better as occupancy and rental rates rise. Conversely, they tend to underperform during periods when there is an oversupply of rental real estate on the market.

With this in mind, investors may wish to assume some real estate exposure beyond home ownership that can be integrated in an overall diversified portfolio to take advantage of dividend income and appreciation potential.

On the other hand, if you are considering an individual real estate purchase as an investment, have your accountant go through a cash flow and tax projection. Only in this way will you know the tax ramifications and expected returns of an investment that you will probably hold for a long period of time.

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I am retired, but still don’t like paying taxes on interest, so my broker suggested municipal bonds. Do you agree?
Tax-free investment income is limited primarily to interest generated from municipal bonds. The investor receives this income free of federal taxes. Many states also exempt municipal bond income from state taxes, further enhancing the attractiveness of the bonds. Keep in mind the risk/reward tradeoff. Because of their relative low risk and tax-free status, municipal bond interest rates are lower than interest rates for comparable corporate bonds. The determining factor will be your specific tax rate. Although everyone wants to pay less in taxes, what really matters is how much of your investment income you actually keep after taxes.

Very often, the taxable investment proves to be the better alternative. Whenever someone suggests you purchase a municipal bond, you should determine what the comparable taxable bond is yielding before making a decision.UT

 

Like this article? Check out these other recent installments of Money Matters:

Save estate tax costs with exemption portability

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