11.

INCLUDING REAL ESTATE IN YOUR PORTFOLIO

The decision to invest in real estate cannot be made in isolation. You must review real estate’s attributes, both positive and negative, while taking a broader look at your entire portfolio, the limitations of your personal resources, risk factors, and your personal temperament and willingness to be involved with investments requiring your personal touch.

Some investors find the idea of investing in rental real estate very appealing. The direct control, tax benefits, potential for positive cash flow, and strong historical record of rising market value make real estate one of the most desirable types of investments. Even when the stock market is weak, people need a place to live. In most regions, real estate prices have performed well even when the overall economy has been poor. This does not mean that every possible market is going to exhibit positive signs; some areas are depressed and will remain so over the long term, so you need to research the market beforehand.

Real estate markets are always very local. The national averages have less to do with value than local factors: demand for rentals, market price of rents versus the cost of real estate, the local job market, and other social and cultural trends. You may live in an area with strong rental demand and low real estate prices, the best possible situation. Or you could live in an area where a lot of vacancies have driven down the market rents, but real estate prices remain high. This occurs if rental units have been overbuilt or if the local economy has changed and workers have left the area.

It would be a mistake to assume that all markets reflect national averages. It would also be a mistake to make an investment decision without first looking at the real estate market in your town. Beyond that, you also need to allow sensible tests to ensure that real estate investing is the right move for you.

ALTERNATIVES TO DIRECT OWNERSHIP

If you want to invest in real estate but are not ready to purchase properties on your own, you have choices. The rather complex limited partnership is of questionable value due to the difficulty in getting out of a deal once you have invested. So if you focus on more liquid choices, you enjoy greater control and get to move money into and out of an investment with ease.

The most obvious way is to invest in shares of stock in real estate builders. These organizations invest in land and build homes and other types of projects. Table 11-1 lists five of the better known real estate builders traded to the public. However, beyond these are many others worth considering as well.

TABLE 11-1. REAL ESTATE BUILDERS TRADED PUBLICLY

Another alternative is the Real Estate Investment Trust (REIT). This is an investment group that pools investors’ funds and specializes in one or more areas: type of property, construction, or mortgage lending. There are dozens of different REITs, and these are worth exploring. One great advantage is that REIT shares trade publicly just like stocks in publicly listed companies.

Organized very much like a mutual fund, a REIT is a conduit organization that pays out its earnings to shareholders. Shares are publicly traded, so you can buy and sell shares whenever you wish. This combines liquidity with a diversified real estate portfolio.

There are many choices in the type of REIT. An equity REIT buys properties and then rents or leases space to tenants, creating an income stream for shareholders. The pure hybrid REIT does not carry any debt on its books, so all income is paid out without needing to pay interest to a lender.

A mortgage REIT, in comparisons, acts as a lender. It grants loans or purchases existing loans on real estate, on a range of properties within its defined submarket, such as residential, industrial, or commercial properties.

The hybrid REIT contains elements of both equity and mortgage REITS. With dozens of possible REIT selections on the market, a starting point is to limit your search to the specific type of property each REIT pursues and also to decide whether to focus on equity, mortgage, or hybrid REITs.

Table 11-2 contains a partial list of REITs.

TABLE 11-2 REITS

In addition to the REIT market, you can also diversify through the purchase of shares in an Exchange-Traded Fund (ETF). Unlike traditional mutual funds, the holdings each ETF has are identified in advance, and management fees are minimal as a result. This so-called basket of securities is easily identified by visiting the Web sites of ETF offerings.

Just like the REIT, an ETF is traded publicly. Shares can be bought and sold in an ETF on the open market just like shares of stock. A partial list of ETFs investing in real estate companies is shown in Table 11-3.

TABLE 11-3. EXCHANGE-TRADED FUNDS (ETFS)

REAL ESTATE AND ASSET ALLOCATION

One underlying premise in financial planning is that your investment assets should be spread among dissimilar markets—so some capital is invested in stocks, some in savings accounts, and some in real estate. This idea—called asset allocation—is often confused with diversification, and in some applications, the two are really the same thing. The difference is an important one, however.

A diversified portfolio spreads risks among several different products. For example, a diversified portfolio of stocks includes some blue chips, some small and unknown stocks with good growth potential, and, of course, a division among dissimilar industries. The purpose of diversification is to prevent losses from affecting the entire portfolio. If you own only computer stocks or retail stocks, a single low cycle or bad market season could affect all of the stocks in an undiversified portfolio.

Asset allocation achieves a form of diversification, but it goes much further. It is the process of dividing up investment capital among different markets. This serves varying purposes and also helps you to build a base of safety and growth for a portion of your portfolio while pursuing current income or aggressive growth in another. Many investors have allocated their assets unconsciously, as a matter of common sense. They own their own home and are paying the mortgage over many years. They have a savings account and regularly place money in shares of two or three mutual funds. They also own some stocks directly. This is a popular form of asset allocation. Degrees of capital are found in the real estate market, the stock market, and the money market.

TAILORING ASSET ALLOCATION TO YOUR OWN SITUATION

Asset allocation should be designed with your particular circumstances in mind. No single formula is going to work for everyone, even though some advisers offer ratio breakdowns that everyone should use. To merely suggest that you should invest 40 percent each in stocks and real estate, then keep 20 percent in cash accounts, ignores the reality that you might be better off spreading your money around in different portions. In addition, you may have a particular bias for or against the stock market or even real estate, for example. So the general advice to apply a set formula to achieve asset allocation is hollow. It is a misconception to believe that any one plan will work for everyone.

SPREADING RISK

The idea of allocating resources is not meant simply to spread money around. It also spreads different types of risks, which is one of the more important aspects to asset allocation. For example, it would be unwise to invest 100 percent in real estate, since direct ownership is an illiquid investment. You need to have some cash reserves available, but the only way to get investment capital out of real estate is to either sell or refinance. By the same argument, it would not make sense to place 100 percent of your capital in the stock market, where market-wide changes can lead to losses in an entire portfolio.

KNOWING YOUR OVERALL INVESTING GOALS

Asset allocation helps you to spread your capital among different markets with your overall investing goals in mind. You want to build equity in your home and, possibly, in real estate rentals as well. You also want to minimize your taxes, save for your children’s college and your own retirement, and insure your family against catastrophic losses. Most families have a complex number of financial requirements, some of which are in conflict with one another. For example, you may need life and health insurance, but that means there is not enough cash left over to build an emergency reserve. In such instances you have to make choices. This is where the specific balance of asset allocation becomes essential.

EXAMPLE: You would like to sell your mutual fund shares and use the cash to make a down payment on a rental property. In evaluating the cash flow situation, you are encouraged to discover that rental rates are strong in your town, that occupancy rates are high, and that real estate prices have been rising steadily in recent years. However, if you sell off one-half of your mutual fund assets, you will be able to make only a minimal down payment and, as a result, your mortgage payment will be higher than rental income. This negative cash flow presents a problem, and you are aware of the risk: If you were to lose your job, for example, having negative cash flow on your investment real estate could mean having to sell at a loss. As an alternative, you could sell all of your mutual fund shares and make a larger down payment. Having a much smaller mortgage would enable you to have positive cash flow as a result.

This example demonstrates the tough choices that have to be made and why asset allocation has to be reviewed as part of the bigger picture. In the example, the concern was over cash flow, which is always of great importance in real estate investing. Are you better off keeping some mutual fund shares and dealing with negative cash flow? Or should you transfer the entire amount into a down payment and eliminate the cash flow problem? Or should you conclude that perhaps now is not the time to invest in real estate?

WEIGHING MARKET AND PERSONAL RISK FACTORS

In the previous example, it makes no sense to recommend that you should have a 40-40-20 percentage division of your capital. In fact, with all of the variables at play in the market—prices of property, demand for rental units, and market value trends—you have to make the decision based on an evaluation of the market and of the risks involved. Complicating the problem are the personal risk factors—for example, your family income and whether your spouse also works, your investment reserves and values, your sense of job security—which ultimately determine how the decision is made.

Allocating assets should be the result of evaluating personal and market risk factors and then deciding whether to realign your assets. If you believe the potential in the real estate market is significant and that the likely growth of mutual fund shares is not promising, it could make sense to move assets to real estate investments. But if your family income is barely adequate to meet your obligations today, negative or marginal cash flow could make the risk too high. In that case, a two- or three-month vacancy could destroy your finances, making the prospect of entering the real estate market less desirable. If the market factors are weak as well, it makes sense to wait. Some investors have made the mistake of getting into the market without evaluating their personal circumstances and the market, discovering too late that the timing was bad for such a move. By then, their capital is tied up, and the property cannot be sold without losing money.

THE LEVERAGED ADVANTAGE

Asset allocation involves a division of investment capital among markets with different attributes. It also should involve using money in different ways. For example, when you own stocks directly, you make or lose maximum money when the stock moves several points. If you buy shares of a mutual fund you have to pay a management fee, but your money is diversified among many different stocks. You may also own interest in a balanced fund that invests in both stocks and bonds, so the degree of diversification is more extensive. When you put money in a savings account, you are paid a very small rate of return but your money is safe and insured. In all of these examples, you reduce risk by placing capital in many different places, whether stocks, bonds, or cash accounts. In some types of accounts, you are exposed to market risk. With stocks, for example, you face the risk that market value may rise or fall. In other investments, you have more certainty, but, at the same time, you know you will earn less. For example, money placed in a savings account or certificate of insurance will yield a predictable but low interest rate, and your funds are insured in case of loss on the part of the savings institution.

A WINNING COMBINATION

One attribute of real estate that distinguishes it from most other types of investment is the combination of higher-than-average yield, tax benefits, and insurance. Real estate, in comparison to most other investments, is illiquid. This means that you cannot get money out quickly or easily in most cases. However, the combined benefits make real estate a one-of-a-kind investment choice. Consider the fact that an insured property will grow in value as long as it is well cared for. The values of most investments are largely beyond your direct control. When you buy real estate, you ensure the value of the property—and a lot of its value is based on how you care for the property. For example, assume your rental property is located in a neighborhood where property values are growing at a rate of 5 percent per year. As long as your property is kept in good shape (the lawn is mowed, the paint looks new, the roof is in good repair), you have every reason to expect property value to continue growing by 5 percent yearly. A house on the next block that is poorly cared for and not well maintained is not going to keep up with other properties in the area. So, as the owner, you have considerable control over the investment value of real estate.

THE MAGIC OF LEVERAGE

Another feature of real estate—and one of the most desirable aspects—is the leverage you achieve when you invest. You will probably make only a 10 percent to 20 percent down payment, in most situations, and finance the rest. However, as long as demand is strong for rental units, your tenants pay rent. In a properly planned rental situation, the rent should be high enough to make your mortgage payment and to cover all other expenses for which you are responsible. This includes insurance and taxes and any landlord-paid utilities, as well as the unexpected repairs that seem to come up at the worst possible times.

Some financial planners view leverage as the third use of investment capital. The first two are equity and debt. Examples of equity are the direct ownership of stocks, mutual fund shares, savings accounts, or real estate. Examples of debt include putting money in a savings account (which is lending your money to the bank), bonds, or income-oriented mutual funds. Leverage, as a third use of capital, has a higher degree of risk but more potential for profit as well. The market exposure has two sides. Potential profit is always accompanied with potential loss, so leverage cannot be thought of without also understanding that risk levels change.

GROWING VALUE WHILE YOUR LOAN IS PAID

Assuming that you have planned well and your rental income covers all of your payments, the value of your real estate investment will grow over time without your having to pay out large sums each month to maintain your mortgage. If property values are growing by 5 percent per year in your city, you will make a much better profit than you would placing capital in a local savings account paying 0.5 percent. In exchange, you accept higher risks. However, the cost of your mortgage is paid monthly by your tenant.

Even though the tenant pays your mortgage for you, it is you who are taking all of the risks by investing in the property. These risks include unexpected major repairs, vacancies, or a decline in real estate market values. Every real estate investor lives with these risks constantly. However, by leveraging your capital, you can control several properties for very little market risk. If you have $100,000 to invest, you could buy a single property for $100,000 and enjoy very healthy cash flow, or you could leverage the money and put 25 percent down on four different properties—spreading your risk.

YOUR TOLERANCE FOR RISK

The idea of risk tolerance has to be kept in mind when you consider highly leveraged approaches to real estate. You may be able to locate properties to buy for little or no down payment; you may also discover that some owners are willing to finance your purchase without having to go to an outside lender. In both of these cases, there is probably something about the property that you need to understand before finalizing the deal. A no-down-payment property is available because the seller knows it is the only way to attract a buyer. Seller financing often means that the seller knows a conventional lender would never approve a loan. It may be that the foundation does not meet minimal standards (post and beam instead of full construction, for example) or that some other condition offsets claimed equity in the property. In such cases, offering seller financing might be the only way a seller can get rid of the property without having to spend thousands of dollars to fix a problem.

ACCEPTABLE VS. TOO MUCH LEVERAGE

Leverage of capital is an advantage because you can make a finite amount of capital go further. By controlling more properties, you increase your potential overall return. At the same time, the risks rise as well, and this inescapable fact cannot be ignored. Your personal risk tolerance ultimately determines how much leverage you can stand. Most people who buy their own homes understand that living with a long-term mortgage is a form of acceptable leverage. But once you begin adding rental properties, the degree of exposure may become daunting. If you want to own several rental properties, it also means having several mortgages and being “at risk” to a greater degree.

TAX ADVANTAGES OF REAL ESTATE

A review of cash flow has to be performed on an after-tax basis because the tax advantages to owning rental property are significant. The tax advantages include the deduction of depreciation, a noncash expense that you calculate based on the value of improvements (remember, the land cannot be depreciated). The benefit to deducting real estate losses varies depending on your overall tax situation and effective tax rate and on whether you pay a state income tax as well as federal tax. However, it is possible to find yourself in a situation in which you have positive cash flow every month but you are still able to report a tax loss and reduce your taxes.

Those who rent out part of their home or who convert a primary residence to a rental property also gain advantages. As a landlord, you can deduct insurance, utilities, repairs, and other expenses that you cannot deduct on your primary residence.

If you own rental property and you sell it at a profit, you can defer the tax on any gain by going through a like-kind exchange. A like-kind exchange allows you to continue investing in properties and upgrading without having to pay any tax until years later. For example, you could sell a single-family house and replace it with a duplex, and then move up to a small apartment complex; you could make a profit on each subsequent sale, but as long as you meet the requirements for a like-kind exchange, you can defer the tax for many years.

Tax advantages are substantial for real estate investors, not only in year-to-year deductions but also in the ability to defer taxes for many years. These advantages should be a part of your cash flow analysis, which should always be performed on an after-tax basis. The tax advantages of investment real estate are among the more compelling reasons for individuals to become investors. As a form of asset allocation, dividing capital among investments producing taxable income and others producing tax advantages is a worthwhile strategy. The higher your tax bracket, the greater the advantage is to writing off real estate losses each year.

EXAMPLE: Your combined federal and state tax rates are 46 percent. Writing off the maximum allowed real estate loss of $25,000 each year produces an overall tax reduction of $11,500, or $958 a month. This savings can make a big difference in your financial picture. You may discover that you have a small pretax negative cash flow but a substantial after-tax positive cash flow.

SUITABILITY TESTING: IS REAL ESTATE INVESTMENT FOR YOU?

With every form of investing, the question of suitability needs to be addressed. Does real estate investment suit you? The need for tax deductions, long-term growth, security, and other attributes are all important in your selection of investments; at the same time, each choice has to be suitable for you individually.

Suitability refers to your knowledge as an investor, as well as to considerations of liquidity, financial strength, and personal goals. Tests of suitability can be used, either by an outsider or by yourself, to determine whether a particular investment is the right choice for you.

Knowledge. You are suitable for an investment if and when you understand exactly what risks and rules apply; so if you are a novice, taking high-risk positions in options or commodities would be unsuitable for you. By the same argument, you would not want to enter into a long-term real estate transaction if you did not understand how the market works. If you do not know how to assess supply and demand for both housing and rentals, then you take tremendous risks by simply assuming that a real estate investment makes sense. By knowing your facts ahead of time, you can make more informed decisions, and profits will be more likely as well. So as a test of suitability, you should understand the market before you commit money (this applies to all forms of investing, and not just to real estate).

Liquidity. The need for cash is ever present. It does not mean that you need to have a large sum of cash on hand or in a savings account; it does mean, however, that you need to be able to put your hands on cash on short notice, if the need arises. It makes sense to set up an emergency reserve for unexpected expenses or in case you lose your job, for example. With real estate, you can get cash out only by selling or refinancing. Real estate is not a liquid investment, and illiquid choices are not suitable for you if you may need to get back some of the cash in the future.

Liquidity also refers to the ability to quickly sell your interests in the market if and when you want to. Stocks are highly liquid because shares can be sold at today’s market price with an online trade that takes only seconds. To sell real estate, you need to list the property and find a buyer. A lengthy closing process could take months. So, as a second test of suitability, you need to make sure you understand that you cannot get cash out of a real estate investment quickly or easily.

Financial Strength. Perhaps the most important test of suitability is financial strength. If your real estate investment is likely to produce negative cash flow that you cannot afford, then it is not a suitable investment for you. If the solution is to offer a higher down payment or to seek markets with better market rents, those are possible solutions, but investing money in a property that produces negative cash flow or in a weak market where vacancies are possible could be disastrous to your financial health. Real estate investors need to be able to survive periods of vacancy or to cover unexpected repair expenses that may arise. Therefore, investment real estate is suitable only if you can carry potential cash flow through periods when rents are not coming in or when expenses exceed the normal monthly budget.

Your financial strength is also measured by your credit. If you have an excellent credit rating, you will not have any problems financing real estate investments—assuming that the numbers work. Lenders apply ratios to determine how much you can afford based on your current income and debts in order to determine whether you qualify for a loan for investment real estate. This naturally limits the number of properties you will be able to purchase with financing. The higher your income and the more asset value you hold, the easier it will be to finance several investment properties. But if your income is relatively low or you have a high level of personal debt, it is going to be more difficult to gain approval of a loan application.

Personal Goals. Finally, your personal goals have to dictate the decisions you make in managing your overall portfolio. For example, if you want to invest your money so that you don’t have to worry about it, you probably need to pick mutual funds or other managed accounts. Real estate demands constant care and attention. Furthermore, to legally claim a deduction of a loss, you have to remain an active participant in managing your properties. So if you plan to invest money and then travel for half the year, real estate will not meet your goals.

With personal goals in mind, the timing of investments is a secondary test of the suitability question. For example, if you plan to invest in real estate today to fund a child’s college education, how long will you need to keep the properties to make a required profit? How long do you have until those tuition bills will need to be paid? Is it a good match? If you estimate that you will need ten years for real estate values to rise enough (based on recent market trends, for example), that tells you that you need to commit capital for the next decade. However, if your child will be going to college in five years, then real estate is not suitable.

MAKING THE DECISION TO INVEST IN REAL ESTATE

Including real estate in your portfolio is a big step. Most people are content with a fairly standard portfolio—a savings account, an IRA and other retirement savings, mutual fund shares, and perhaps a few individually owned stocks. If the typical investor is also buying the family home with a thirty-year mortgage, this collectively represents a well-diversified portfolio. Why expand beyond this and add investment real estate? One major reason has to do with today’s perceptions of the stock market. The market appears to be at higher risk than it did a few years ago, and many previously dedicated stockholders want to have more direct control over their investment capital. This disillusionment with the traditional markets is transitional, and as the market trend changes, so will attitudes toward placing money at risk in stocks. Even so, there will always be investors who are attracted to the direct control of real estate.

Direct control, insurance of your asset, tax benefits, and historical market trends—all these factors, in combination, make real estate one of the best investments available. The tax and record-keeping requirements are complex, and you probably will need professional help to make sure you are keeping records correctly. But with that out of the way, you face the potential for strong profits over many years.

Real estate is a market worth taking a look at—whether or not you decide that it is for you. If you study the market and understand the risks and rewards before you commit capital, you could become one of the thousands of investors who have found an alternative that improves overall investment return while generating current income from an asset that increases in value over time.