Upon reading the title of this week’s article, you may want to question my sanity. But, I assure you there are many benefits long-term investors can realize when real estate is added to an investment portfolio. However, as it is true in many areas, how this is accomplished is the primary key.
I realize there are many investors who use rental homes to diversify their investments as well as to create additional income. As they say in Vegas, this is adding real estate “the hard way”. The stories I hear and have witnessed lead me to believe individual rentals are generally not the best way to add real estate. There is a lack of diversification, since few investors can add more than one or two properties. The concentration of value is generally high with each house or unit. Damage risk is also high, since a single tenant may cause enough damage to wipe out one or two years of profit. When interest rates are low and additional properties can be added, the scarcity of quality tenants also becomes a factor, since many of the tenants can elect homeownership as well.
And, then there are the calls on maintenance issues. To maximize profits, many individual landlords also have to develop great maintenance skills, everything from stopped up sinks to HVAC issues. Do you really see yourself clearing a stopped drain for a tenant when you have reached age 70? Eventually, the properties need to be liquidated, and this can cost up to eight percent of the value due to closing costs and commissions. And when you are ready to sell, it is a gamble whether the home values are up with a strong economy or down due to a recession.
Another option to add real estate as a part of the investment portfolio is through traded and non-traded real estate investment trusts (REIT). Today, there are REITs which offer diversified investments within specific segments of real estate. There are the class A commercial office programs which purchase the best of the available office buildings throughout the country. Others may focus on the healthcare industry, owning hospitals, medical buildings, and related facilities. There are also the strip center, shopping malls, or the apartment programs. While the help of a professional may be needed to determine which area of real estate is best for each investor, there are differences within each REIT that also must be uncovered in order to determine which may offer the best return without excessive risks.
A traded REIT provides liquidity with the ability to purchase or sell the REIT on the exchanges. But, this also adds price volatility, since the price varies with the market daily. A private REIT is generally one that is currently raising capital to build the underlying real estate portfolio. During the period when the program is raising capital, the shares in my opinion should be considered illiquid; even though many providers have a method to repurchase shares from the investors. Due to the illiquid nature of these programs, generally they should be restricted to not more than 20 percent of a portfolio’s value.
There are several factors to consider before purchasing these investments. The first is the coverage ratio of the dividends they are paying. One of the programs we offer is paying a 7.1 percent dividend. I am comfortable this dividend will continue, since the investment is creating sufficient free cash to pay 110 percent of the dividend. However, there are other programs that may be paying a very competitive dividend, but their coverage ratio is less than 100 percent. This should be an alert that the dividend may have to be lowered in the future, since sufficient cash is not being generated by the program.
Another factor to consider is the amount of debt a program is currently carrying and what the prospectus states about the long-term use of debt. If debt is being used while they are acquiring new properties but they plan to reduce or pay off the debt once additions to the portfolio cease, then the profits created through rent collection will be available for dividend payment rather than mortgage payments. Programs which carry high levels of mortgage debt may raise risks for investors since mortgages must be paid before dividends and if rents go down, this may jeopardize the dividend payments.
Historically, to earn a 10 percent return in the stock market, the investor earned 2 percent in dividends and 8 percent in appreciation. In this case, the appreciation was always the difficult part and the part that varied the most. But with REITs, for many the breakdown of their performance is generally 6 or 7 percent income and 3 or 4 percent appreciation. It is a lot easier to average 8 to 10 percent return if during the year the income received is already 6 percent or so.
Adding the right real estate when the market is down should prove to be the best time in the long run.
For assistance with insurance, estate planning, and investment management contact me at Quality Financial Concepts or one of the other Certified Financial Planners in our area. To continue a personal quest for education, you can also view our learning center on our website, www.goqfc.com. There you will find articles on a variety of topics, on-line seminars, calculators, as well as a host of other free tools.