CHAPTER 7

INVESTMENT ALTERNATIVES

Equity and Debt

For many individual investors, there are good reasons to avoid direct investment in real estate. These reasons include:

The large amount of money required for a down payment

The risks associated with the landlord-tenant exchange

The illiquidity of real estate in comparison to stocks or savings

The potential risk resulting from possible changes in cash flow

As an individual real estate investor, your knowledge about these limitations is key. You offset the downside with many positive attributes, including:

Leverage through financing, enabling control over an expensive asset

The ability to fund debt service through rental income

Tax advantages unique to individual real estate investors

Long-term growth potential in a historically safe investment

Control over value through insurance and ongoing maintenance

When you study the equation of positive and negative attributes, you may decide that real estate is appropriate, often in combination with a broader investment portfolio. However, if you decide that you are not able or willing to accept the risks of owning real estate directly, you do have a number of alternatives.

EQUITY AND DEBT POSITIONS

All investing can be broadly defined as belonging in one of two camps: equity or debt. This is as true in real estate as it is elsewhere. Well-known examples of equity investments include owning your own home, buying stocks or growth mutual fund shares, or holding investment real estate. In all of these, you have an equity position (ownership) in an asset. If your choices are well timed and properly selected, the value of that equity will rise.

Examples of debt investments include buying bonds (debt instruments issued by the government or by corporations), buying money-market instruments (such as certificates of deposit), or having a basic savings account. When you put cash into a savings account, you are lending that money to the institution, so this is a debt position. You may also purchase shares in income mutual funds, which are given that title because emphasis is placed on income rather than on growth. Income is normally derived from interest paid on bonds that the fund manager buys and holds in the fund’s portfolio.

Risk levels also vary between equity and debt investments. For example, corporate bonds have priority over common stock, which means that in the event that a company becomes insolvent, bondholders are repaid before common stockholders receive anything. So this safety is an important feature that appeals to some investors. Conservative individuals may prefer debt investing because of the priority of bonds over common stocks. They may proceed with their investments by buying corporate bonds directly or by investing in shares of income mutual funds. They may also invest in U.S. government debt instruments—Treasury bills and bonds—which are considered the safest debt investments available. These obligations are guaranteed by the full faith and credit of the U.S. government, the best guarantee available to investors.

In real estate, you can select between equity and debt as well, and as in all markets, risk levels and potential profits will vary. An equity position that most people are familiar with is the purchase of a single-family home to be used as a primary residence. In the same manner, individuals may purchase houses, multiunit buildings, or commercial property for investment purposes. The down payment represents an initial equity position, and equity grows from three primary sources:

1.Payments of principal on a mortgage loan

2.Increases in the market value of the property

3.Improvements made to the property

Equity positions can also be taken in a variety of programs. In a program, many individual investors invest their money together under common management. The pooled funds are invested in larger real estate projects, such as industrial parks, residential subdivisions, or shopping centers. Each individual investor is promised a portion of the periodic profits and, if and when properties are sold, a share of the capital gain. Programs come in many shapes and sizes; many are traded on the public stock exchanges or can be bought or sold without difficulty. However, some programs do not have a secondary market for units in a program, so the only way to dispose of those assets is by accepting a discount.

This type of equity position clearly avoids some of the risks associated with direct ownership of real estate; however, the loss of direct control, tax benefits, and decision-making rights also offset the advantages. Investors who choose to invest in an organized program should be sure they understand their rights, restrictions, and potential profits and risks before investing. One of the more important tests of an investment is whether shares or units can be traded in, and, if so, what is the cost or discount?

Real estate debt investments can also be made through an organized program, and the same caution is advised in selecting a real estate pooled investment or partnership. Debt positions can also be undertaken individually; however, investors need to make sure that they understand the level of risk involved in the second mortgage market before lending money to investors. The potential profit is high, but that high profit comes with higher levels of risk as well.

INDIVIDUAL LENDING: THE SECOND MORTGAGE

An individually made real estate debt investment is usually called a second mortgage. This mortgage is called “second” because it is generated later than the first mortgage. But the sequence of events is only one aspect of importance. The terms first and second also define the priority of payment. If the owner of the property defaults on payments, the holder of the first mortgage gets paid back first; if anything is left over, the second-mortgage holder gets repaid.

In cases where property owners default on their mortgage obligations, it is common for little or no equity to remain in the property. So the risks of writing second mortgages are substantial. While default may occur in only a small number of instances, it is a possibility. The situations in which little or no equity is left come about for a number of reasons:

1.Overmortgaging of the property. The granting of a second mortgage may itself cause the zero-equity situation. For example, if a current owner has property worth $150,000 and a $120,000 mortgage, the equity is only $30,000. So if the owner manages to find someone to lend her $25,000, almost all of the equity is gone. The $5,000 that remains would be more than absorbed by closing costs if the owner decided to sell. If the owner cannot afford to keep the property, going into default is one way to solve the problem. In that situation, the first-mortgage lender would be repaid first; the process of foreclosure involves accumulated interest for several months, legal fees, and other costs, so there may be little or nothing remaining for the second-mortgage holder after those fees and costs are paid.

Can the second-mortgage holder file the foreclosure? Yes, but to do so, it will be necessary to come up with enough money to pay off the first mortgage, and in the situation described, it would not be worth much to proceed. Chances are that, whoever forecloses, default will end up with a loss to the second-mortgage holder. There is simply not enough equity in the property to give the owner the incentive to keep up payments or to sell.

2.Lack of maintenance. Some properties end up with no equity because the owner does not keep up with maintenance. In other cases, individuals may buy properties without demanding independent inspections and later discover that there are expensive flaws in the property. The owner may even discover that the cost of making the repairs exceeds the level of equity. So just as a $2,000 car is totaled when it is in an accident causing $3,000 in damages, a house may also be “totaled” when needed repairs exceed equity. In circumstances where properties are simply not kept up, the lack of maintenance will absorb equity in two ways. First, those repairs will have to be made eventually if equity is to be recaptured. Second, as long as the property is kept in an undermaintained condition, its appreciation is not going to keep up with that of other properties, so market value will not continue to grow—at least not at the pace of properly maintained properties in the same area.

3.Destruction of property by the residents. It is also possible that the residents of a property will destroy the interior. A homeowner may trash a home; it is more likely that tenants will do damage. While some forms of damage may be covered under a homeowner’s insurance policy, other types may not be. If the owner causes damage, no insurance payments will be made. If tenants do damage and owners don’t fix that damage (with or without insurance), then equity will drop, possibly to zero in severe cases.

4.Market conditions. Finally, equity can disappear from properties as a result of a low-demand market. While this condition is cyclical in many cases, it is not always possible for owners to wait out the market. For example, if a homeowner is carrying a $120,000 first mortgage on a $150,000 home and also finds an individual investor to grant a $25,000 second mortgage, that leaves only $5,000 in equity. In addition to there being marginal equity, the problem here is that selling the property would cost more than the equity available, so owners would have no incentive to sell; they would not get any cash out of the sale, and they might even have to come up with additional funds to pay the closing costs.

The risk is serious in these circumstances, which is why lenders do not like to see property mortgaged too heavily. Now consider what would happen if property values were to fall. For example, if the property value in this example dropped to $140,000, the owner would have negative equity of $5,000 ($140,000 market value minus $145,000) in mortgages. In order to sell, the owner would have to pay that $5,000 shortfall plus all of the seller’s closing costs (real estate commission, inspection fees, escrow fees, filing costs, and more). Such fees could total $10,000 or more. So in this situation, the owner cannot afford to sell. The market condition makes default more likely and, from the unfortunate owner’s point of view, possibly the best alternative available.

These risks can be mitigated in several ways. Anyone who goes into the second-mortgage market may want to take these six steps:

1.Limit lending so that owners still have equity. If you want to be a second-mortgage lender, you may start out by looking for situations where there is considerable equity available in the property. For example, you may work only with people who have equity of 30 percent of current market value or more, and you may further decide that you will never lend money that will take equity below the 20 percent level.

2.Select possible borrowers carefully. Whom will you work with? You may limit the potential field of borrowers in several ways. For example, some people work solely with retirement fund managers and offer second mortgages as part of a formal retirement program. Because people deposit funds into such programs and cannot withdraw those funds without penalty, this is a fairly safe venue for second mortgages, especially when an individual’s account is professionally managed.

3.Check credit thoroughly, just as other lenders do. If you work directly with individuals who want to borrow money, insist on getting a current credit report and ask for a written loan application. Also check out the individual’s credit history, current job status, and other important information. Go through the same steps a conventional lender goes through to ensure that the person applying for the loan is likely to maintain a repayment schedule.

4.Limit the amount of second mortgages. You can also limit lending risks by placing a ceiling on the amount you are willing to lend through an individual second mortgage. If there is a default, this will limit your losses. For example, you are better off lending $10,000 to each of five different people than you are lending $50,000 to one person.

5.Lend money only on owner-occupied residential properties. Risks of default are lowest for owner-occupied homes. People are less likely to default on their own homes than on investment property. So another way to limit risks is by restricting your potential field of borrowers to the lowest-risk individuals: homeowners.

6.Reduce risk by purchasing second mortgages at a discount. A variation on the theme of granting second mortgages is buying those mortgages from other lenders. For example, a current second-mortgage holder might want to get out of the situation and free up cash to use elsewhere. As a purchaser of second mortgages, you can advertise that you will buy them at a discount. Depending on how badly the current owner wants out, you may be able to get a deep discount—perhaps more than 50 percent—and buy loans at a fraction of the amount owed. In some cases, this strategy involves greater risks: The mortgage holder may believe the debtor is going to default on the loan, so you risk a higher rate of defaults when you buy loans at a discount.

You can also create a second mortgage on a discounted basis when someone wants to get out of an equity position with a co-owner. For example, if someone owns property in joint tenancy and one person wants to leave, that person may be seeking a way to get his equity out of the property. This is difficult if the other person does not want to sell. So in a divorce or a parting of the ways between people who are cohabitating, the situation may be impossible. One person wants her money, and the other does not want to sell. In such a case, a second mortgage can be sought. In this situation, it is quite likely that a discount will be accepted. For example, if the individual’s equity is $20,000, you may offer him $15,000. The remaining owner will be obligated to repay the $20,000 loan and also to agree to the terms, and the departing owner will get $15,000. The difference of $5,000 is your discount.

DEBT INVESTING IN POOLED PROGRAMS

In the past, real estate limited partnerships were very popular, primarily because they helped people to avoid paying income taxes. Up until the early 1980s, an individual could deduct multiples of the investment basis. For example, in a 3-to-1 program, an investment of $10,000 created a tax deduction of $30,000. Because tax rates were as high as 50 percent, such tax shelters were popular among people in the higher tax brackets. In this example, a $10,000 investment produced a tax reduction of $15,000 (50 percent of $30,000).

That all changed in the mid-1980s, when new rules were put into effect. Today, investors can never deduct more than the amount they have at risk. For example, if you invest $10,000, the maximum deduction you are allowed to claim is $10,000. The amount at risk is the combination of cash and recourse loans (loans that program sponsors can demand be paid).

Another important change that was made in the 1980s and is still in effect is the passive-loss rule. Investors are not allowed to deduct losses from passive-investment programs. These are defined as any program in which investors do not have daily control. By definition, limited partners are also passive partners. The general partners in such programs make investment decisions, manage the properties, and also tend to earn more profit than limited partners.

Limited partnership equity is very difficult to sell once you go into a program. Ownership of units in a partnership usually ends only when the properties are sold and the whole program is shut down. If you want to sell before that happens, you probably will have to accept a deep discount from the program general partners or from a company that specializes in buying up units from current investors.

One solution to the liquidity problem of limited partnerships is a variation that trades on public stock exchanges. These master limited partnerships may be a combination of several traditional partnership programs, put together to resolve liquidity problems for a large pool of investors.

A real estate partnership can be organized in one of two ways. Some programs have identified the properties the partners intend to buy, and the partnership is formed to raise capital to make that investment. A blind pool is a partnership that intends to invest in a range of properties or specific types of property but does not identify any one property it will purchase. Cautious investors will purchase units in a blind pool only if they know the track record of the general partners and if the partnership is committed to a time period, after which all holdings will be liquidated and the partners paid off.

For many investors seeking a combination of management, diversification, and liquidity, the partnership alternative is not going to provide a satisfactory outcome. For many investors, the desired liquidity is more likely to be found in mutual funds or the real estate investment trust markets.

THE POOLED INVESTMENT MARKET

The concept of pooled investments has wide appeal. Diversification in real estate is quite difficult for an individual who cannot afford to purchase and manage an array of dissimilar types of property. So alternatives like limited partnerships, real estate exchange-traded funds (ETFs), and other pools solve the problem. At the same time, pooled investments lack the tax advantages found in individually controlled properties, so one of the primary advantages is missing.

Even so, some investors are happy to give up the advantageous tax status of individual ownership to escape the higher market risks of owning property and needing to use leverage. The greater risk is the big problem. However, with limited partnerships, the lack of a secondary market is very unappealing, and with mutual funds (other than ETFs), the lack of concentration on real estate does not allow individuals to use those pools to allocate capital.

A solution is found in the real estate investment trust (REIT). This is a pooled real estate investment with shares that trade on public stock exchanges. They are entirely liquid, and you are able to move capital in and out. The REIT is a pool organized by a management team to invest in specific types of properties, taking equity or debt positions or a combination of both.

The equity REIT is designed to limit activity to equity positions. Most equity REITs carry no debt, so cash flow is simplified for those owning shares. Management pools the capital of many investors to purchase large-scale real estate projects. These may include shopping centers, office and industrial parks, or residential subdivisions, for example. An equity REIT may identify a specific project or a portfolio of projects that it owns or intends to buy, or it may be organized as a blind pool, limiting activity to equity but without naming or specifying a project.

The construction REIT finances the development of projects and takes a debt position. Even though the debt is secured through equity in properties, debt REITs are generally considered to have higher risk than equity REITs. In an equity REIT, fully paid real estate cash flow requires no debt service, so risks are limited to management’s handling of tenants, maintenance of properties, and ability to identify strong markets. In comparison, construction REITs can run into trouble if a developer or construction company runs over its budget or does not attract tenants in time to begin making payments.

The hybrid REIT is a combination of equity and debt positions. A balance between the two may involve partially funding projects that are owned and under REIT management, or keeping equity and debt positions separate. A specific REIT’s management determines its policies, and investors should be sure to understand a REIT’s investment and portfolio policies before placing capital in that REIT.

The REIT itself does not report or pay taxes; it is a conduit for investors, meaning that all profits are passed on to investors to be reported individually. This is a convenient method for investors, since one of management’s tasks is to keep track of reportable profits and losses, capital gains, and interest, and to calculate each investor’s share. The REIT’s management reports to each investor so that the investor can report the proportionate income or loss on her tax return.

While construction REITs (also called mortgage REITs) may be appealing to some investors, they are not the only way to pool investment capital in a real estate program. In fact, equity and hybrid activity is far more popular in the market. A larger debt market is found in the large secondary-market agencies: the Government National Mortgage Association (GNMA, or Ginnie Mae), the Federal National Mortgage Association (FNMA, or Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac). These programs and more specialized similar ones are operated as independent agencies of the federal government, and all organize mortgage pools for investors.

A mortgage pool works much like a mutual fund. But instead of building portfolios of stocks or bonds, mortgage pools contain mortgage debts, usually on single-family homes. Conventional lenders (banks and mortgage companies, for example) underwrite loans to individual borrowers, then sell the debt to one of the big programs. The original lender continues to service the loan (collecting monthly payments, collecting impounds, making insurance and tax payments, and responding to customer questions). However, the debt is picked up by one of the large mortgage agencies.

Mortgages are put together into portfolios based on various criteria, such as type of property, age of the loan, interest rate, or dollar amount. These portfolios are then offered to investors in units of $5,000 or more. Investors are paid an average interest rate based on the portfolio mix, allowing for the cost of management, defaults, and other fees and expenses.

Mortgage pools allow individual investors to own shares of first mortgages, which are secured by equity in the property and are generally a fairly safe form of debt investment. However, the individual does not have to worry about collecting past-due payments, managing debts, or dealing with borrowers. That is all done as part of the service by the agency. For many, a mortgage pool is a convenient and safe method of generating current income in a diversified portfolio, without the headaches or risks associated with granting mortgage loans directly. And because the loans in the portfolio are first mortgages, they are collectively in first position in the event that any one loan in the portfolio goes into default.

EXCHANGE-TRADED FUNDS (ETFS)

Another alternative to direct investment, offering maximum liquidity, is the exchange-traded fund (ETF). This is an organization set up much like a traditional mutual fund, with some notable differences:

Shares trade on exchanges just like stocks, meaning they can be bought and sold immediately during market hours. In comparison, traditional mutual funds can only be traded directly with fund management and may involve delays and fees.

The ETF comprises a “basket of securities” that does not change. There is a common theme to this basket, which may be regional, equity versus debt, or by type of property. In comparison, a traditional mutual fund is not usually limited to real estate and may buy and sell shares at any time, so the portfolio is continually changing.

ETF fees should be much lower than those for the traditional mutual fund because no ongoing management is required. The portfolio is fixed and only changes when one of the components is no longer in business or declines in value.

IMPORTANT TAX RULES AND LIMITATIONS

One of the most important advantages of direct investment in rental property is the exceptional tax rules. Individual investors can deduct losses. In comparison, investors in passive programs cannot claim deductions; their tax-basis losses have to be carried over and applied against future passive profits or used only when properties are sold.

This has to be included in the overall analysis and comparison between direct ownership of property and pooled investment programs. If you want to escape the need to manage cash flow, tenants, and financing, pooled investments are compelling. But the tax advantages of direct ownership are often among the top reasons for buying rental property directly.

In Chapter 11, you will study the tax rules that apply to the direct ownership of real estate. Here are four rules for investing in pooled programs and partnerships:

1.Income is taxed as it is earned. You will earn interest in mortgage REITs or mortgage pool programs, and it is all taxed each year as it is earned. So even if interest is not paid out, the year in which it is earned is when the tax liability occurs. Dividends paid in REIT and partnership programs are taxed in the year in which they are paid or credited to each investor’s account. Capital gains are taxed in the year in which property sales are completed, so if a program’s management sells right at the end of the year, your capital gains will be taxed in that year, even if the funds are not paid out until the following year.

2.If earnings are reinvested, the tax liability remains. Some programs allow you to reinvest your earnings in additional partial shares of ownership. This is usually the case with mutual funds, and it makes a lot of sense to generate compound earnings by leaving funds on deposit. However, you will have a tax liability in the year in which those earnings occur.

3.Capital gains and annual income are calculated and reported by the program. One big advantage of investing in managed programs is tax simplicity. You don’t have to keep books and records for what can be a complex series of transactions. The management of the REIT, partnership, or mutual fund is responsible for all of that, and each investor receives a year-end summary that lays out each type of earnings. The bottom-line number is reported in the appropriate place on each investor’s individual tax return.

4.Under current tax rules, there are no exclusions or special advantages to investing in pooled programs. Individually owned property is attractive because losses can be deducted; this is not the case when you are not directly involved in managing the investment. All of the current net income will be fully taxed. This includes interest on debt positions and dividends or net operating income on equity positions. It also includes capital gains when equity positions are closed.

No matter what form your investment programs take, you will have to depend on reliable data, and the types of information you’ll require depend on a sound bookkeeping system. Chapter 8 shows you how to create and maintain a simple but effective system, and how to use that system to support the study and analysis of cash flows and profits.