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Real Estate Investing: Property or
Paper?
Appraisals and inspections, marketing, renters, rehabs... it
can all add up to a huge headache. But real estate investing is
still exciting and lucrative. What to do? Consider investing in
real estate-based financial instruments instead.
REITs
One of the oldest modern forms is a REIT — Real Estate
Investment Trust. REITs are mutual funds that invest in real
estate, actual property as well as mortgage portfolios. Like
other securities opportunities, they sell on the major
exchanges and are professionally managed, receive special tax
considerations, and often have higher yields and greater
liquidity than straight property investment.
There are Equity REITS which invest in and own properties.
Revenues come primarily from rents. Mortgage REITs deal in
investment and ownership of mortgages rather than property with
revenue coming mainly from interest on the loans. Hybrid REITs
do both.
Keep in mind, however, that REITs are closed-end — mutual funds
that have a specific number of shares for sale and once sold
can't be redeemed through the fund. They have to be bought and
sold to other investors as you would corporate stock, through a
broker.
REITs are required to pay out at least 90% of their taxable
profits as dividends to shareholders, so they can be relatively
high yield. In terms of total return — dividends plus price
appreciation — they're similar to small-cap stocks, with on
average two-thirds of the return coming from dividends. They're
therefore sensitive to interest rate changes. As interest rates
increase REIT prices tend to decline.
MBS
MBS (Mortgage-Backed Securities) are a type of bond in which
the paper is backed by a pool of mortgage loans. In the U.S.
lenders make about $2.8 trillion in such loans annually with
about 80% being covered by mortgage-backed securities.
Investors in mortgage securities earn a coupon rate of
interest, like other kinds of bonds. But in contrast to other
bonds, they receive repayments of the principle in increments
over the life of the security, as the underlying mortgage loans
are paid off, rather than on one large payment at maturity.
One of the advantages, one which lends the security some
stability, is the statistical effect of pooling loans. No
single or small number of loans that pre-pay or default wipes
out the investor's entire investment.
But pre-payment of mortgages does occur for a certain
percentage and that introduces some risk. The investor isn't
aware of or interested in which loans pre-pay, but the fact
that some do causes them to be sensitive to interest rate
changes, one of the major influences in pre-pay rate. If
borrowers took mortgages at 8% and rates drop to 5% a certain
number are going to re-finance, causing the original to pay off
early.
So, if interest rates are likely to fall, it's best to avoid
pre-payable MBS. Closed MBS are, in that scenario, a better
alternative.
There are specialized instruments like CMOs — collateralized
mortgage obligations — and REMICs — Real Estate Mortgage
Investment Conduits with similar behavior and risks. ETFs —
Fixed Income Exchange-Traded Funds, too, sometimes are
supported by underlying mortgage-backed securities and trade on
the major stock exchanges. They're designed to track the
performance of specific bond indexes, which track performance
of an underlying bond market, such as MBS.
SELF-DIRECTED IRAs
You can even set up an individual IRA (Individual Retirement
Account) that allows you to add assets in the form of raw land,
single-family homes, apartments and other commercial buildings,
rather than straight cash inputs. This allows you to take
advantage of your knowledge of real estate, while avoiding some
of the downside of actual property management.
Whichever instrument you choose, and there are many others, be
sure to do your homework and get the advice of a financial
professional before investing large amounts. The sharks can
always smell fresh blood in the water.
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