The Investment Scientist

How to invest in real estate: Part I

Posted on: August 31, 2012

house for sale

House for sale

I encourage my clients to invest a substantial portion of their assets in real estate for the following reasons:

  1. Real estate, like fixed income, provides a stable income stream – if managed well.
  2. The property value itself generally keeps up with inflation

According to David Swensen, the famed Yale Endowment investment manager, real estate has characteristics of both stocks and bonds; therefore, it should be an important component in any asset allocation.

There are many of ways to invest in real estate. The most straight forward way is through real estate investment trusts (REIT), which are investment firms that specializes in real estate. These firms must distribute 90% of their rental incomes to qualify for that designation. Once qualified, rental incomes are not taxed at the firm level, thereby saving investors from double taxation.

There are publicly traded REITs and privately held REITs. The distinction is that publicly traded REITs are subject to much closer scrutiny by the Securities and Exchange Commission; therefore, they are presumably safer as far as fraud risk is concerned.

In a recent book, Swensen argues that small investors should avoid privately held REITs altogether since the potential for monkey business is high. He gives an example where investors are charged exorbitant fees for mediocre returns.

As far as publicly traded REITs concerned, there are hundreds of them in the US. I recommend using an index approach rather than trying to pick winners. Picking REIT winners is like stock picking; the odds of success are abysmal.

The biggest risk of a REIT index fund is volatility. During the 2008/09 financial crisis, the index was halved in price, even though its dividends remained about the same. It has since more than recovered in price. However, many investors who can not take the volatility sold at or near bottom.

For the majority of arm’s-length investors – that is, investors who don’t want to get involved in the real estate business – a publicly traded REIT index fund is the best way to go.

For investors who don’t mind some work, they can consider private real estate investment partnerships or investing directly in real property. I will discuss the pros and cons of those approaches in my next article.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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