Are REITS (Real Estate Investment Trusts) a sound vessel – or a sinking ship?

REITs, or Real Estate Investment Trusts, have been hot product for investors the last few years, a sophisticated and risk-adverse method of leveraging a rising and rebounding real estate market. Simply put, REITs are companies or funds that own or finance income producing real estate, leveraging the benefits of the real estate sector without having to own – or manage – individual properties. But lately, cracks are appearing in the impenetrable hull of REITs, based on concerns and loss of profits amid Fed rate hikes. So are REITs still worth it, a safe and fruitful investments going forward?

REITs were first modeled after mutual funds, a hybrid investment that’s traded on major stock exchanges, sometimes as public non-listed funds, or even privately owned entities. They’ve grown precipitously in the United States, reaching every state and supporting one million U.S. jobs, and have spread to several countries across the world.

REITs offer indirect real estate ownership for steady income streams and long-term capital appreciation, but with flexibility and diversification where regular property ownership fell short. REITs collect rents or sell properties for profit, regularly paying out that income as dividends to shareholders, who can pocket the income or choose to reinvest, and sell shares as they see fit for liquidity many other real estate assets don’t offer. Investors are then responsible for paying their own income taxes on the profits. Essentially, REITs allow investors to buy stock in real estate, while the fund or REIT purchases blocks of property and property shares, called Equity REITS, or mortgages with Mortgage REITs.

To qualify as a REIT, the company or fund must have at least 75 percent of its total assets invested in real estate, and derive at least 75 percent of its gross income from rents, profit from sales, or mortgage financing. REITS need to have at least 100 shareholders with no 5 shareholders holding more than 50 percent of shares.

While most REITs trade ownership stakes in apartments, hospitals, hotels, commercial property, strip malls, nursing homes, office space, storage units, student housing, and care facilities, there are also trusts that invest in mortgages or mortgage securities for residential or commercial properties.

While REITS offered steady positive income streams and great returns for investors – increasing about 10 percent annually on average - over the last half decade, they’ve stumbled recently, raising concerns that they won’t translate well to a rising interest rate environment. And with the Fed assuring a series of rate hikes over the second half of this year and into 2016, dividend payouts have faltered as analysts and investors start to sour on REITs. In fact, shares of seven of the nine REITs listed on the New York Stock Exchange actually turned in negative returns this summer, a far cry from a spectacularly profitable 2014. Through June 30, that’s a 5.4 percent decline on the U.S. REIT index, and a fragile 1.23 percent gain on the Standard & Poor's 500 Index.

Part of the decline in profitability is due to tangible losses caused by rising rates, as trusts with commercial and other long-term leases but adjustable financing can’t raise rents to compensate for increased expenditures. That’s why hotels, multi-family housing, and apartments are considered a safe bet as rates escalate because it’s easy to increase tenant rents periodically, offering flexibility that long term commercial properties don’t allow. But financial analysts think the market is also playing a wait-and-see game with REITs, putting caution before risk as they watch the Fed’s every move.

So are REITS here to stay? The most balanced advice you’ll probably read is that REITS are now showing their downside amidst these unique and temporary market circumstances. For some, buying and owning individual properties as private investors may offer far more control and long-term income potential. Or, several investors can come together to pool resources and own a few rental units together. But for those who want to park their money in real estate without every buying a garage and aren’t scared away by negative growth or stagnate income in the foreseeable future, REITs may still be a sound bet.

Which is the better investment, real estate or stocks?

Is it better to invest in the stock market or buy real estate?

That's the century-old debate, rekindled every time we have a Bull or a Bear market, a boom or a bust. There are plenty of fancy charts and statistics to support both arguments but in essence, there is no once correct answer. I know, someone who's made their career as a real estate broker should probably sing the praises of owning a home as the one and only investment you should ever make. And for many people, it is. Even 94% of millionaires cite real estate as a significant part of how they obtained and held their wealth.

However, so much of the data used to make these arguments and foster comparison is situational, and therefore a case can be made for either/or. For instance, are we talking about residential real estate or rental properties? Are we mistakenly only counting home price appreciation? And is there a mortgage involved, or are we assuming the house is owned outright? With our stock investments, will we be reinvesting the dividends? Are we trading stocks ourselves or enlisting a financial planner? What’s our risk tolerance and tax position? All of these things factor in to the argument, but at the risk of letting the air out of the balloon well before the party has started, I’ll give you the answer we’ll arrive at by the end of this blog. The average earnings over time for real estate and stocks pretty much mirror each other, an ideally you should invest in both

First, for the sake of defining and clarifying these two different classes of investments, let me present each of their inherent advantages and disadvantages. Then, I will propose some widely accepted statistics for purposes of comparison.

Investing in stocks.

Advantages:

Liquidity.

It’s very easy to sell off your whole position in stocks, almost instantaneously.

Low acquisition costs.

Anyone can invest in stocks because they have such a small acquisition price – you can buy just one share if you wish. There are fees involved but they are not prohibitive.

Easy to diversify.

By investing in mutual funds or other vehicles, you can diversity your stock holdings over different classes of stocks. You can also mirror the S &P 500 or buy only blue chips to minimize risk and foster stability.

Low management.

Once you buy your stocks, you can choose to hold them without additional cost or maintenance. There is no additional time or money investment if you don’t want.

Reinvesting dividends.

This is the big advantage to investing in stocks, as you can choose to cash out your dividends or reinvest them. By reinvesting, or buying more of the same stock, you speed up the curve of your investment and take advantage of the principle of compounding.

Some tax advantages.

Depending on your financial situation, stock capital gains offer may offer some tax advantages. Additionally, IRAs, 401ks, etc. can also help reduce the tax load on stock holdings.

Disadvantages:

Human error.

Investing in stocks is more are subject to fear, groupthink, fickle emotions, and human error – not to mention greed and fraud.

No Control.

As a stockholder, there is nothing immediate and direct you can do to improve the company or even help them make good decisions, other than possibly voting for the Board.

Short-term fluctuations.

Stocks are subject to extreme short-term volatility.

Investing in Real Estate.

Advantages:

Leverage.

The huge advantage to owning real estate is that you can leverage other people’s money – i.e., the bank’s – to acquire an asset. For instance, you may only have to put 20% or even 10% or less of your own money down to acquire a whole asset. Yes, you have to pay interest for the privilege of using the bank’s money (a mortgage) but you still benefit when it appreciates or cash flows.

Control.

You can decide where you want to buy real estate and actively improve your own property to increase its value. You can do maintenance, redecorate, improve your landscaping, or even add an addition on your own time and dime, all of which adds value.

Paying it off.

Even if you use a mortgage (most people do) to acquire your real estate, you can pay it off to reach the point where you own the asset outright. In fact, you can accelerate payments much faster if you wish, by adding extra towards principal or just paying the whole thing off earlier if desired. 

Tax benefits.

The government doesn’t want to be in the business of housing 300 million Americans so it long ago made the decision to offer huge tax advantages to promote home ownership and investment. Owning a home will allow you to get mortgage interest write offs: you can deduct the interest on up to $1.1 million in mortgage indebtedness on your primary home, you can also sell your primary home for tax free profits up to $250,000 for singles and $500,000 for married couples if you live in the home for the last two of a five year period. And if you own rentals, all expenses associated with managing your rental properties are also deductible towards your income.

Real estate is local.

If you own a home in California, so what if the real estate market crashes overseas, or even if homes are loosing value in Detroit? It doesn’t affect your investment at all. In fact, real estate has regional, local, and even micro markets that are largely independent. So by purchasing a good house in a good neighborhood, you’re ensuring your investment.

You have to live somewhere!

I come across many articles and blogs about investing in real estate v. stocks, written by brilliant economists and analysts. But the one thing they’re often missing in the debate is a tangible reality for everyone: you have to live somewhere. That means that if you don’t purchase your own real estate to live in, you’ll have to rent. So unless we’re talking about buying rental properties or commercial real estate, there’s an opportunity cost if you don’t buy real estate and have to rent to live.

Disadvantages:

Not liquid.

Selling real estate is not fast nor easy compared to selling stocks, which you can unload at any time.

Maintenance.

Owning real estate requires maintenance and physical upkeep, which takes time and money.

Acquisition and surrender costs.

There are costs incurred when you sell a property and closing costs and often fees related to your mortgage.  

***

So now that we’ve outlined the pros and cons of real estate and stocks, what’s our final answer to the question, which is better? 

Like I mentioned, there are many studies that analyze gains in the stock market versus real estate. Most all of them are situational, so don’t apply to everyone. Some forget to factor in dividends, others don’t account for the tax implications, and even more don’t account for rental income – or the opportunity cost of having to rent - just appreciation.

But by far the best study I’ve found is an analysis of economist Robert Shiller’s theories and research that led to his widely accepted historical housing index. If we use Shiller’s indices for real estate and Dow Jones stock market gains and put them head to head, we’re offered a snapshot that speaks to the general trend; real estate and stocks generally mirror each other over the long term and both yield approximately similar gains as investments. So the real question becomes not, “Should you buy a home or buy stocks?” but “Which is right for you based on your life circumstances and financial situation?” One thing we can be certain of is that for the average person, a balanced and prudent financial future includes both.

There are 3 schools of thought when it comes to real estate: The New School, Old School, and Right School.

There are three schools of thinking when it comes to real estate: the Old School, the New School, and the Right School.  I’ll explain all three. 

Old School:

Much of our financial advice comes from our parents, or parents’ parents, who pass down ultra-conservative, Depression era thinking when it comes to money.  Real security came through getting an education and having one good job for life, as was the notion that you should pay down your mortgage and own your home outright as quickly as possible.  Often, people kept the same job for life and bought a home with a large down payment with the intent to stay there for 30 years and never move or refinance. 

Debt was considered bad and to be avoided, at all costs.  During the Great Depression, banks called notes due and repossessed homes at farms at alarming rates.  Your bank deposits and savings were not federally insured and when currency became devalued, many people lost their life savings.  There were no credit cards, auto loans, student loans, or other debt vehicles to contend with.  Many “old timers” considered the safest investment packing a coffee can with money and burying it in the back yard, or holding on to gold, or having slow and steady government bonds.  The fear of loss was far greater than the hope for gain. 

The way to get ahead was to “grind” and “pull yourself up by your boot straps.”  The ultimate goal was to work a very long time so you get a secure pension and have your home paid off in retirement.  These lessons of financial conservatism were instilled in the children of those who experienced the Depression, the Baby Boomers. 

New School:

As the world changed, so did our thinking about money.  Our parents’ advice about money no longer seemed relevant for the new rules of the game.  College graduates entered the work world competing for $10 an hour jobs with $100,000 in student loans.  People changed careers and jobs 5 or 6 times in their lives, and companies certainly had no loyalty, downsizing, outsourcing, and replacing seasoned workers with newer, cheaper employees.  Additionally, most people moved or refinanced frequently, especially when interest rates were favorable and the real estate market was white hot. 

Homes were not just places to live in, but slot machines – a chance to benefit from rising markets and cash in as the equity went up.  Gambles like this were essential to get ahead, as the rising cost of living and wages that didn’t keep pace made it almost impossible to amass a big nest egg or be financially comfortable.  If the investments didn’t work, there was bankruptcy, short sales, loan workouts, and the chance to start over again without the debt following you around the rest of your life.  But if it worked, the pay-off was huge.  Few people worried about paying off their mortgage because it was rare to stay in the same house for 30 years, and that money could be used better elsewhere. 

The way to get ahead was to work hard but to work smart and take risks – the computer age and booms in technology and Internet companies created far more wealth than “keeping your nose to the grindstone.”  Set backs and losses were just an inevitable part of the process of success, and debt was seen as a necessary vehicle that allowed you to risk someone else’s money, not your own.

 

The Right School:

Since everyone is different, there is no one right answer for managing finances and real estate that applies to everyone.  Each situation is unique and should be treated as such - there is no one correct answer for every situation.  Any investment is just a balance of risk and reward, and that applies to your real estate and mortgage choices.  Before making any big moves, weigh all factors and gauge your risk tolerance.  This approach finds a hybrid between Old School and New School methods. 

For instance, a lot of people should have been WAY more conservative with their real estate strategies when the market was hot.  The prevalent thinking was short term, whipped into a frenzy of greed and fear of missing out.  People bought homes they couldn’t afford and treated them like ATM machines, empowered to fail by stated income loans, no money down programs, a frenzy of greed (from consumers to realtors to lenders to banks) and an ever-expanding bubble of rising prices.  A healthy dose of Old School wisdom would have helped prevent the catastrophic real estate collapse that’s taken 5 years to crawl out of. 

Then again, peoples’ thinking is often counterintuitive.  They buy when they should sell, and sell when they should buy because of the aforementioned impulses – fear and greed – instead of any conscious business strategy and clear rationale.  The last couple years (and now!) too many investors and potential homebuyers have sat idly on the sidelines.  Instead, the masses wait for real estate to be “popular” and “hot” and “safe,” again, which means you’re at the top of the roller coaster and it’s the exact wrong time to buy!  Instead, savvy investors take advantage of down markets and apply long term thinking to cash in.  Sometimes, the most dangerous investment is the one you don’t make!     

Which school of thinking is right for you?  That depends on a lot of factors, of course.  How close are you to retirement?  Do you have a family and children to support?  Does your income allow you to amass savings and fund retirement investments?  How well is your money diversified?  Are you prepared for medical emergencies or long-term care?  What is your risk tolerance?  Are you prepared to be a landlord?  How about your tax situation? 

 Sit down with a team of trusted advisors to collect all the information you can so you can make informed choices, not react impulsively.  Your financial planner, tax advisor, insurance agent, mortgage planner, and yes, your Realtor, should all be part of this team.  Set your financial goals and map out the best plan to get there based on the RIGHT school of thinking.      

The lessons Warren Buffet wants to teach you about real estate.

The world’s third richest man has something he wants to tell you.  He’s practically imploring you to listen as he dispenses a parcel of the wisdom that’s made him the third-richest man in the world.  We hardly need to check his resume to convince us to listen, but the billionaire Chairman of Berkshire Hathaway and Svengali of investing has this message for you:

Buy real estate.

Of course it goes deeper than that, as there’s a right way to buy real estate and a lot of wrong ways.  Thankfully Buffet, always generous with sharing his philosophies, has left enough breadcrumbs for us to decipher his formula.

The biggest breadcrumb recently came in his annual letter to Berkshire Hathaway shareholders; a highly anticipated forum to pick his brain about the year’s fortunes, the market, and always-general advice about money the average person can chew on.  In this year’s letter, Buffet makes no mystery about his thoughts on real estate, "Home ownership makes sense for most Americans, particularly at today's lower prices and bargain interest rates."

So let’s pretend we had Warren Buffet in front of us and could ask him the basic questions about real estate and finance most Americans have.  I’ve assembled his answers from his annual letters but also interviews and articles.

Why buy now?
He’s oft quoted as to why now is a great time to buy, "It's a way, in effect, to short the dollar because you can take a 30-year mortgage and if it turns out your interest rate's too high, next week you refinance lower. And if it turns out it's too low, the other guy's stuck with it for 30 years. So it's a very attractive asset class now."

Is it better to buy real estate now or stocks?
"If I knew where I was going to want to live the next five or 10 years I would buy a home and I'd finance it with a 30-year mortgage... It's a terrific deal."

How about buying rental properties?
"If I was an investor that was a handy type and I could buy a couple of them at distressed prices and find renters, I think it's a leveraged way of owning a very cheap asset now and I think that's probably as an attractive an investment as you can make now." He’s also said, "If I had a way of buying a couple hundred thousand single-family homes I would load up on them."

What should we be cautious of when buying rental properties?
In this year’s shareholder letter, Buffet tells the story when he was a young man and bought a recently foreclosed 400-acre farm in north Nebraska.  He knew absolutely nothing about farming but had a family member who did ready to step in, and he did know about money.  What he understood was that there was value to the property as an asset because of the goods it could produce, and that those goods would increase in value as time went on.  He factored a humble 10% profit but the real boon was long term.  Now, the property is worth 5 times what he paid and profits have been much higher than expected.

So “focus on the future productivity of the asset,” Buffet advises.  In terms of real estate, that equates to the inherent value of the property in the market, not how much the property price will change in the short term.  “I thought only of what the properties would produce and cared not at all about their daily valuations,” Buffett said. “Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard."

With all the changes in the economy and the recession, is real estate still a sound investment?
Buffet still lauds home ownership as delivering on its basic benefit: that homes increase in value over time, and insists that still applies, in fact, more than ever.  "It's a totally sound premise that houses will become worth more over time because the dollar becomes worth less," he said at a Congressional hearing on the financial crisis.  But that doesn’t mean there won’t be fluctuations, and the recent real estate bubble was caused by overconfidence that prices would never go down, the ease of getting multiple homes, loans without proper income documentation, and no-money down loans, leading to greed in every sector that eventually serves as the pin that popped the bubble.

Is it better to wait cautiously for the perfect time to buy real estate?
If there is one thing Buffet teaches us it’s that there are micro markets within any market, and always deals to be had so there is no wrong time to buy, but there’s definitely a right time to buy.  Starting back in 2008 he admitted that buying when prices are low always feels risky and unpredictable because no one can tell what prices will do in the short term, but that’s exactly the best time to get in.  Once consumers wait until there’s some stability and predictably to the price curve, the bottom – and the best deals - are already over.  Luckily, we’re still in an ideal buying environment as prices are still low and interest rates are great, but that won’t last for long.

"If you wait for the robins, spring will be over," says Buffet.

Should people stretch to buy their dream home?
That’s the perfect formula for failure, according to Buffet.  Too often during the financial crisis homeowners spent more than they could afford, with volatile adjustable payments and stretched to every dollar of their income just hoping for short-term gain.  That’s the recipe to lose money.
"A house can be a nightmare if the buyer's eyes are bigger than his wallet and if a lender -- often protected by a government guarantee -- facilitates his fantasy. Our country's social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford."

So what three factors are most important when buying real estate?
Warren Buffet believes the three most important elements to buying a home as a great investment are: a fixed mortgage, affordable payments, and holding on to it for the long-term.  By keeping payments affordable (and stable) and looking to keep it for the long haul, you basically allow the asset to bear fruit for you.  "If home buyers throughout the country had behaved like our buyers,” Buffet says, “America would not have had the crisis that it did."

Does he practice what he preach?  
Warren Buffet, The Oracle of Omaha, is worth around $50 billion dollars according to recent Forbes estimates, but still lives in the 5-bedroom home in Nebraska he bought 52 years ago for $31,500.  That sounds to me like a he takes his own advice!