The use of “alternative investments” has increased significantly over the last few years. This trend began when investors and advisers started looking for ways to get a reasonable return on their investment dollars without using the traditional equity market. They are looking to try to get away from volatility that has become all too common.
Interest rates are near 30-year lows, and the U.S. economy is stumbling along, growing at somewhere in the neighborhood of 2 percent per year. It’s not exactly a robust economic recovery, but still enough economic activity to keep the threat of rising interest rates in the back of most advisers’ minds. This, in turn, sends shivers down the spine of anyone thinking of investing in long-term fixed-income products. The inverse relationship between interest rates and the price of bonds would have a very negative impact on certain portfolios. In particular, portfolios with fixed-income products that are not held to maturity will not fare well.
What is an investor to do? The answer could be alternatives. Alternatives come in many forms. They include products such as commodities and real estate. Real estate is the area that most people have some understanding of and are likely to consider. Investing in real estate generally offers some appealing benefits. Benefits include fairly predictable income (rent), some form of tax benefit (deprecation or the tax deduction of mortgage interest), and some stability.
So when do you buy real estate? Like anything else—when it’s cheap. Real estate is cheap when demand is down, and demand is down when the economy is weak. Not only does the weak economy make real estate less expensive, but it also results in lower interest rates. The question you have to ask yourself is: “If I buy now, can I hold on until things turn around?” Locking in a low rate mortgage loan would help keep the costs down and make the property more affordable until it’s time to sell. Real estate generally goes up in value when inflation begins to make itself known. So, depending on your economic outlook for the next few years, now might be a good time to invest in real estate.
Making a direct investment in real estate is straightforward. You find a piece of property you like, get a mortgage from the bank, pay a bunch of fees at settlement, and you’re done. You’re a real estate investor. It sounds relatively simple, and it can be just that simple. Simple, however, does not mean that it will be successful. Obviously, I have left out a lot of the details, expenses, and risks involved in this type of investment. These include maintenance, renting, taxes, insurance, and security. All of these additional items can turn what was a good idea at some point into potentially one of the worst decisions you ever make. Direct investments in real estate are serious business and are not for the casual investor. In my opinion, direct investments in real estate can have the highest payoff of the options, but they also carry the highest level of risk.
The second option is to put your money in one or more publicly traded REITs. The REIT managers will invest your money in various properties that they deem appropriate. They will manage the properties, take care of all the expenses, and look for appropriate times to sell the properties at a profit. REITs pay out 90 percent of the profits they earn every year in the form of a dividend. The dividend that you receive from the publicly traded REITs can and will change over time, but a range of 3.5 percent to 5.5 percent is a reasonable expectation.
These publicly traded REITs offer something that direct investing does not: liquidity! You can buy and sell any time the equity markets are open. You can also pick and choose the type of properties you want to invest in. There is a lot to choose from, so do your homework. Different types of properties react differently to changes in the economy. There is a lot to understand here, and I won’t try to make you an expert. But I will give you one rule to keep in mind: The shorter the term of the tenant, the faster the property price will react to changes in the economy. For instance, hotel REITs whose tenants usually stay only a night or two tend to react faster than REITs that invest in buildings occupied by big stores with 15+ year leases. Another issue to keep in mind is that the price of REIT shares is more correlated with general economic trends than with actual property values. When the REIT price is higher than the actual property values, the shares are considered to be selling at a premium. When the price is below what is considered the actual value, they are trading at a discount.
The third option to look into is a non-traded public REIT. This is a lesser-known product but is still an option open to the retail investor. They are similar to the traded REITs in what they are trying to accomplish: income with the chance of capital appreciation. They are offered by a number of different companies and have specific types of properties they invest in. They tend to pay a higher level of current income than the traded REITs, generally in the range of 5 percent to 7 percent, plus they may provide capital gains when the REIT looks to close out. What they don’t offer is liquidity. Investors should only look to invest in non-traded REITs if they have a time horizon between 5 to 10 years. One of the features of the non-traded REITs is that it is hard to determine if you are buying at a discount or a premium because they don’t get valued until after they stop taking in investors.
To sum things up, making an alternative investment in real estate could prove to be a good addition to your portfolio. It may help smooth out the ride from these volatile markets and add a little potential income to allow you to continue to diversify. As with any investment you make, do your homework. The devil is in the details. If you cannot take the time to learn the details, then seek the advice of a qualified adviser who understands the nuances of investing in real estate. There is a lot to know, but the benefits could be well worth your time.
Timothy S. MicKey, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth and @TimothySMickey, and on their Facebook page.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.