There are hundreds, if not thousands, of books written and dozens of videos produced on how to get wealthy by investing in real estate. The answer to the question, “Is there a best way to invest in real estate?” depends on whether you want to be an active or a passive investor.
Active investors are generally interested in controlling their investments, personally. They don’t trust that anyone will do a better job watching their money than they will. Many of these
investors have a job that gives them the personal freedom they need to find suitable properties to meet their investing goals.
Most active investors look for properties they can understand and control. These investors are prone to invest in single-family homes or small rental properties like duplexes, triplexes or
fourplexes. Most of the time they look for fix-and-flip opportunities where they can buy a less-
expensive property in a modest-income neighborhood. These investors generally have a little
money to invest, which they’ve saved up, and they have decent credit, which allows them to borrow from their local bank or credit union to get the cash they need to purchase the property and fix it up.
Sometimes these investors seek out Airbnb opportunities where they can purchase a condominium or other rental property and rent it out on a nightly basis. About two-thirds of all
books written on real estate fall into the category of beginners buying single-family homes and renting them out. They all promise untold riches from taking this approach.
The truth is, most real estate investors don’t want the hassle of finding a fix-and-flip home where they run the risk of purchasing some “dog” property where they spend too much money renovating the property only to find that the tenant pool for these types of rentals are low-income families, many of whom don’t appreciate the effort spent to make this property rentable.
Even if they do find a good tenant to rent the place, they’re stuck with a real estate investment that produces minimal monthly income with the only hope that nothing goes wrong with the property and they can get a reasonable appreciation over some period of time so they can make a profit. Some active investors have a knack of finding and fixing up these types of properties, but for the real estate investor with a good, high-paying job, and more money than time, these types of real estate investments aren’t the answer.
Many wealthy passive investors often leave the decision-making of what to invest in to their financial advisor, who is either a Registered Representative (RR, agent or stockbroker) of a Broker-Dealer or an Investment Adviser Representative (IAR) of a Registered Investment Adviser (RIA). Although most of these advisers understand the securities industry, they are woefully uneducated when it comes to real estate investing.
I once met with a very successful IAR and asked him what he would advise if a client came to him said he wanted to invest in real estate. His answer was that he would suggest several Real Estate Investment Trusts (REITs) to invest in, but he would advise the client to not place more than fifteen percent (15%) of his portfolio holdings in REITs and that no one REIT should consist of more than five percent (5%) of his total portfolio holdings.
There are several reasons why an IAR would recommend REITs when a client wants to invest in real estate:
(1) the REIT is a security which means it is traded on one of the major exchanges, i.e., the New York Stock Exchange (NYSE) or NASDAQ. If it is a security traded on one of the exchanges, the investment qualifies as Assets Under Management (AUM) for which the IAR gets paid either a commission or an annual fee, depending on whether they are an RR or an IAR;
(2) REITs provide diversification when using a typical asset allocation model. Diversification means that there is not a strong correlation between the REIT and the other securities in the portfolio, i.e., mutual funds or exchange-traded funds (ETFs);
(3) a REIT is liquid because it trades on an exchange. It can be turned into cash, if the investor changes his mind or the IAR has discretion to invest in something he thinks is more promising.
The problem with most REITs is not that they are a bad investment, it’s that they aren’t a true
real estate investment. REITs are a security. They act like a security. They move with the market and the market is often fickle. The REIT owns real estate from which it derives its income, but you don’t get the benefit of actually owning the real estate asset. To avoid being taxed as a corporation, subject to double taxation, a REIT has to receive 75% of its income from real estate holdings and must distribute 90% or more of its taxable income to its shareholders.
The income distributed to the shareholders is taxed at ordinary income tax rates, not the more favorable long-term capital gains tax rates. Additionally, REIT shareholders don’t participate in the depreciation allowance provided real estate investors, which means income is not sheltered by the paper losses real estate provides.
If you truly want to take advantage of the benefits of investing in real estate, i.e., leverage, cash flow, appreciation and long-term capital gains, you need to invest directly in real estate, not in a REIT.
There are some drawbacks to investing directly in real estate. Your stockbroker or investment
adviser won’t likely be able to assist you. For the most part, they don’t have a clue about how to invest in real estate. They can’t tell a good real estate investment from a bad one. If you’re a passive investor and want to invest in real estate, the best approach is to find a good real estate syndicator who truly understands real estate and knows the best property types to invest in and the best markets to invest in.
By the way, not all real estate syndicators are created equal. Some syndicators are glorified marketing companies who have the ability to present themselves as professionals but they have very little experience actually finding the properties and doing the work required to make a real estate investment successful.
There are basically two types of real estate syndicators; those who find fix-and-flip large rental properties and those who work with real estate developers and builders who acquire the land, get the property entitled, build the project and get it rented up.
From my perspective, the best real estate syndicators team up with a successful developer/builder who knows how to find excellent locations and has the ability and expertise to build a quality project. These developer/builders are hard to find, but they have the potential to generate tremendous value to those with whom they invest.
To give an example of what I mean. Three years ago, our development/construction company
teamed up with a real estate syndicator. In round numbers, the 240-unit apartment development was situated in an excellent infill site in a very good market. The construction cost was $70 million. The initial investment from the investors was $17.5 million and the debt was $52.5 million. The property took two years to build and one year to lease up. Now the property is valued at roughly $100 million. If the property were sold today, that would represent an annualized internal rate of return of over 30%.
The property hasn’t been sold yet, so no one knows the final return. Naturally, the syndicator
shares in the profit since it guaranteed the loan and took the brunt of the day-to-day decision- making. Regardless, the investors should experience a handsome return with very little time commitment.
Not all investments work that well or generate that level of return and the risks of developing and constructing a property from ground-up are significant, but the returns can be amazing. Is the property liquid, meaning can you convert your investment to cash in just a few days, the answer is no. are there inherent market risks, the answer is yes. When the Federal Reserve raises interest rates 11 times in less than two years, the rise in interest rates impacts the cost to the investors.
However, since the property has been held for over a year, the investors qualify for long-term
capital gains when the property is sold, which means the tax rate most people would pay is 15% on the gain compared to 37%, which is the top federal tax rate for an individual plus there may be state income taxes to pay.
And, if there is income generated from the rental of the property during the holding period, much of that distributable income is sheltered from the payment of taxes because the depreciation write-off offsets most of the reportable income. On the backside, when the property is sold there may be depreciation recapture, depending on the amount of depreciation taken.
The bottom line is this, real estate, if done properly is a great investment for passive investors. Although there are syndication fees associated with an investment like this, the returns can be significantly better than investing in a REIT and much more efficient for a high net worth investor than trying to go it alone as a house fix-and-flipper.
So, from my perspective, the best way to invest in real estate, if you’re a high net worth investor, is to find an experienced syndicator who has experience as a real estate developer and contractor and team up with them. They understand what it takes to make a real estate investment successful.
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