Market-Tossed Investors Still Find Value In Real Estate
Brandon Raatikka, Grant Chaput and Meredith Traudt

For market-tossed investors, seeking refuge in hard assets is a common theme during challenging economic times. For investors who are seeking the tangible and tax benefits of owning real estate, many ways to invest remain available, from buying an investment property like a small multifamily building to purchasing an undivided fractional interest in an institutional-quality commercial building.

As gains in stocks melt away and credit disappears, there is a sense of psychological comfort in being able to touch and see a physical asset. In spite of the decline in real estate values, many investors still feel better following the wisdom of Will Rogers, who said, “Buy land – they aren’t making any more of it.” Generally speaking, when stocks decline, inflation rises and credit becomes difficult, people naturally move toward something they can see and hold onto. In many cases, real estate fits the bill.

Real estate investments have long been a favorite of institutional investors. Most sophisticated investors know that stocks may appreciate and may dampen the effects of inflation, but their prices can also be volatile, and they may or may not produce income. Bonds may provide a stream of income, but the nature of the investment leaves them subject to inflation risk. Real estate, by contrast, has the ability to provide the income many investors are looking for, along with capital appreciation, which can help hedge against inflation.

An investment in real estate can help grow wealth, while simultaneously offering tax benefits and potentially flattening out the whipsaw volatility of an investment portfolio. According to William Swayne III of Seattle-based WMS Financial Planners, “Modern portfolio theory shows us that over 90 percent of investment success is attained through proper diversification among non-correlated assets, which would include well-selected real estate.”

So, how does an investor add real estate to his or her portfolio? Given that individual ownership of real estate is not something your broker can simply sign you up for, and that it may require active management, for many the prospect of owning real estate individually can be overwhelming. Many of the nation’s most well-known, wealthy families have built their dynasties through real estate, but some individual investors feel the benefits of real estate investments are out of their reach. They are wrong.

REITs Provide Easy Diversification

Perhaps the simplest and most common way to diversify into real estate is through a REIT. Many investors may be familiar with REITs and understand that they generally own and operate income-producing real estate. In addition to these equity REITs, there are also mortgage REITs that finance the real estate investments of others. Many REITs specialize in geographical areas or in certain asset classes or types of debt instruments, and can range in capitalization from a few million to a billion dollars or more. To maintain REIT status under federal tax law, a REIT must distribute at least 90 percent of its taxable income to its shareholders. Distributions are often made monthly, and are typically taxed at the ordinary income tax rates of the individual shareholders. A $10 billion industry just 20 years ago, total REIT market capitalization topped $190 billion in the U.S. at the end of 2008.

A REIT makes real estate investing accessible to the average investor. Generally, investment minimums are small and in some instances REITs can be placed into an investor’s qualified plan. Because REIT capitalization is usually at least several million dollars, a REIT normally acquires dozens, if not hundreds of assets for income production, which helps to diversify the REIT investment. Furthermore, REITs are passive investments that do not require commercial real estate sophistication on the part of investors. Rather, REIT investors rely on the expertise and experience of the REIT sponsor. As such, the track record of the REIT sponsor in acquiring and managing assets in its portfolio is critically important.

Some REITs traded on stock exchanges act like other stocks: they go up and down in value depending on supply and demand. It is true that many publicly traded REITs have experienced significant price declines in the past year. Depending on individual circumstances, one could argue that these trends may also present attractive investment opportunities, as some REITs are trading below net asset value, and may be well-positioned for a recovery. Declining values have also resulted in yields that are near 20-year highs for some REITs.

Such volatility, however, illustrates the advantages of a lesser-known cousin – the non-traded REIT. Non-traded REITs do not exhibit the kind of share price volatility that can affect traded REITs. Since their shares are not publicly traded, they are not subject to the supply and demand pricing of individual stock offerings. While non-traded REITs may be a good option for investors sensitive to volatility, they must understand that without a public trading market, non-traded REITs are long-term investments and have limited liquidity. The illiquidity allows the REIT’s advisor to “maximize value for the investors” by providing liquidity at the optimal time, according to Sue Speidel, vice president of Chicago-based Inland Real Estate Exchange Corporation.

Owning a Piece of the Pie

While the passive investment opportunities afforded by REITs offer many of the benefits of real estate to investors, there can be additional benefits available to investors who own their real estate holdings directly. A directly owned alternative that may provide tax benefits to an investor is a tenant-in-common investment, also known as a TIC. Like REITs, TICs offer investors two benefits: an opportunity to co-invest in real estate without the day-to-day management headaches, and the chance to purchase institutional quality property that would generally be out of reach. In a TIC investment, an investor purchases an undivided “slice” of a building along with several unrelated investors. Unlike REITs, in a TIC the investor actually takes title to the property in which he/she has invested, and a TIC generally consists of a single property rather than an ever-growing portfolio of diversified assets. Since the investor takes actual title to the property and receives a recorded deed for his/her share of the asset, the tax deferral benefits provided under section 1031 of the Internal Revenue Code are also available.

Most TIC properties are designed to deliver three benefits: capital preservation, income and modest appreciation. Patricia DelRosso, president of Chicago-based Inland Real Estate Exchange Corporation, a leading TIC investment sponsor, notes that many, TIC programs are meeting their income projection targets (some set years ago), even in today’s environment. “Average yields for TIC programs are higher than what an investor could earn in the stock market or in CDs,” she says. Furthermore, every attempt is made to find properties that reflect the market and economic environment at the time an investment is brought to market. As an example, a recent trend in the TIC marketplace has been toward multifamily properties, which are widely viewed as some of the most stable and predictable assets available today.

As with any real estate investment that is not directly managed by the investor, the quality of the sponsor, the quality of the asset manager and the quality of the underwriting is critical to success. TICs are sold as private securities offerings and are only available to accredited investors (generally investors with a net worth in excess of $1 million or a trust entity with net worth in excess of $5 million). The performance of any sponsor offering a TIC must be thoroughly investigated.

TIC with a Twist – the DST

A Delaware Statutory Trust (DST) is an investment structure that also allows individual investors access to institutional quality real estate with their tax-deferred investment proceeds. In general, DSTs and TICs function very similarly from the investors’ perspective. They are both investments in specific, identified properties, and they are both passive investments. However, they each have their own limitations that serve to highlight their differences.1

Unlike TICs, which are generally limited to 35 individual investors per program, a DST does not necessarily need to cap the number of investors it accepts.2 As a result, a DST can be more accessible to a wider pool of investors because it will generally be able to accommodate smaller investment amounts. This may increase an investor’s ability to diversify his/her real estate holdings at a greater level than with a TIC investment where minimum investments are usually greater. Another difference between TICs and DSTs is the actual form of ownership. In contrast to the direct deeded ownership a TIC investor has in his/her property, a DST investor actually owns beneficial interests in a trust, which in turn holds title to the property. The biggest difference is that TICs generally require the co-owners to vote on key property issues, while DST investors rely on the trustee to make those decisions. Despite their differences, the passive nature of both TICs and DSTs provides a tax-deferred exchange and investment strategy for investors who are looking to rid themselves of the tenants, trash and toilet headaches associated with owning their own properties.

Time to Allocate to Oil and Gas Opportunities?

According to a New York Times article published on March 15, the number of oil and gas rigs deployed to tap new energy supplies across the country has plunged to less than 1,200 from 2,400 at the height of last summer’s drilling. Energy executives across the country say that the drop is accelerating further.

With news like this and the historical volatility in energy pricing, why would any investor allocate funds to oil and gas, natural gas or other energy investments? Even though the drop has been good for American consumers — with gasoline now below $2 per gallon, down from a high of over $4 last July — the ultimate result is that it’s becoming unprofitable to drill.

This reversal of fortune has important implications for the future health of the nation’s energy companies, for consumer wallets and for national aspirations to rely less on foreign energy sources. Energy experts and company executives warn that oil and gas companies now cutting back on investments will be unable to respond quickly to a future economic recovery. So, why should investors allocate dollars to this sector of the market?  The answer is one of supply and demand: a glut could rapidly turn to scarcity, sending energy prices soaring again. Already, experts are predicting that lower domestic gas production by the end of the year will require increased imports of liquefied natural gas from places like Qatar.

As the market begins to stabilize and investors are faced with rebuilding depleted portfolios, what role should energy play? “Investors need long-term assets that are diversified and non-correlated. This would make an investment in oil and gas a good option since oil and gas are typically 89 percent non-correlated with the equity market,” says Joe Van Voorhis, executive director of Crown Opportunity Partners, LLC, a sponsor company of oil and gas investment programs. “Furthermore, the fundamentals of the oil and gas markets are strong. The fact remains that we have a growing world population that is dependent on oil. In addition, drilling costs have increased along with difficulties in locating and accessing reserves. This combination of a continuous increase in demand with declining reserves should cause prices to increase correspondingly.”

Typically, oil and gas commodities prices are non-correlated, meaning that they move in a different direction and/or at a different pace than the equity markets. William Cavalier, general counsel and executive vice president of syndications for King Consolidated, Inc., a sponsor company of oil and gas investment programs, says that demand for oil has historically only decreased during severe recessionary periods. This is illustrated by the 1.3 percent decline in consumption over the past year. The decrease in consumption is directly linked to the decline in the price per barrel during the fourth quarter of 2008.

“OPEC cut production levels several months ago, yet the price of oil has not bounced back,” states Voorhis, who believes that a possible reason for this is that only 50 percent of the member nations complied with OPEC’s production cut. According to reported statistics for February 2009, OPEC is 80 percent compliant with its production quota, which may mean that demand will begin to exceed supply. Additionally, well operators have been taking down natural gas rigs over the last several months. Lower rig counts should cause natural gas prices, like oil prices, to increase as the market regains stability.

While we are all aware of the need for oil to fuel our cars and heat and cool homes, most consumers do not realize the extent to which energy is utilized for other industries. According to Cavalier, oil plays a significant role in agriculture production, specifically in the production of fertilizer. “Fertilizers account for nearly 30 percent of agriculture production costs and 30 percent of all energy used in agriculture, with oil being the largest component of fertilizers,” says Cavalier. “Because oil is energy dense, easy to transport and not perishable unlike some other forms of energy, and comprises 5 to 10 percent of the world gross domestic product, investors may be wise to invest in it.”

Adding support to the argument that oil prices will increase over time is the concern that one of this nation’s significant sources of oil, Mexico, is in a free fall in oil production and may stop exporting to the United States. Even with the growing focus on alternative energy, oil will remain strong in the short term as most experts believe that alternative energy costs more than oil and will not be able to meet a fraction of the new demand, let alone compensate for the decline in oil reserves. Cavalier continues, “This is why we need everything: oil, gas and alternative energy. Investors cannot have a properly aligned portfolio without an energy component and a macro view on oil supply.”

The Time to Invest is Now

So, how should an investor participate in the energy market? Cavalier suggests, and others agree, “Investors should mimic the economy and place a minimum of 5 to10 percent of their net worth in oil investments now.” 

One choice for investors who want exposure to the oil and gas investment world is royalties or long-term equipment leasing. Both are good options as they tend to maintain value despite price fluctuation and holders of these investments often continue to receive monthly distributions simply for owning the royalty rights. Van Voorhis believes that “maintaining investor confidence is critical during difficult economic times and although the monthly revenue checks may be smaller, they are still coming, which is more than can be said about the performance of some stocks.”  Kathy Heshelow, an advisor with CapWest Securities and author of Investing in Oil & Gas: the ABCs of DPPs (Direct Participation Programs) agrees with Van Voorhis and states, “While I personally favor, and the lion’s share of my clients prefer, drilling programs due to the potential for generous tax write-offs in the first year and favorable potential cash flow in subsequent years, royalties could provide a more conservative alternative for an investor who isn’t as interested in the tax benefits.” Heshelow stresses that careful due diligence on all of the programs and the sponsors is essential.

Proper Due Diligence Must Be Conducted

When deciding on an oil or gas investment like a royalty, Van Voorhis states that, “it is important to buy into a field with a good steward of property.” Investors need to know the region in which their particular oil and gas investments are located as well as the history of their wells and the operator’s performance, to ensure consistency and longevity.

While oil and natural gas are by far the most prevalent forms of energy investment, several alternatives are coming into the market. Biomass, biodiesel, ethanol, wind, and solar power are in their infancy but are speeding forward. According to Jack Zedlitz, director of corporate communications at GreenHunter Energy, Inc., a publicly-traded energy company specializing in renewable energy and clean fuel assets, “The public understands the severity of oil supply problems and our dependence on oil. This consciousness coupled with the fact that the current presidential administration is the most supportive of producing alternative forms of energy in U.S. history should help increase the desirability of investing in the companies that produce alternative energy.” According to Clay H. Womack, CEO of Direct Capital Securities, Inc., a managing broker-dealer for real estate and energy offerings, “incentives from the new administration in the form of tax credits will help these producers of alternative energy forms be profitable.”

According to Womack, history is a good indicator of long-term success, “if a company is the first mover in the market, they are probably just in it for a quick buck.” However, Zedlitz points out that “some of the future major players in the alternative energy industry are now setting themselves up and spreading their roots.” Womack is clear: “Investors must be cautious. It is important to investigate a company’s management team, and truly believe in that team before investing.” Zedlitz also underscores the importance of investigating the management team of energy companies and their business strategies before investing. Companies that will research and develop new technology would typically be a more risky investment than would a company that employs existing technology. Investors must understand this and decide on the level of risk they are willing to accept.  

Rethinking Investment Strategies

Grappling with where to turn in any market, and particularly in challenging markets, is keeping investors and advisors awake at night. So why should real estate, an asset that has recently taken a battering, remain a valued portion of a diversified portfolio? 

According to DelRosso, “Real estate retains value because it is a hard, tangible asset, and there’s only a finite amount of it.” 

“Patience is the new planning strategy,” says Renee Brown, principal of Minneapolis-based Wildwood Wealth Management, a Registered Investment Advisor. “As a long-term hold asset, real estate simply doesn’t allow clients to make the type of emotional decisions that often times are counterproductive to their goals,” she says. Brown recommends that her clients consider 15 percent of their asset allocation be comprised of real estate, and depending on the client, up to 20 to 25 percent in a difficult economy to blunt the effects of volatility.

The markets will continue to toss investors and advisors alike into the throes of uncertainty. An investment in commercial real estate may provide a source of relative calm as part of an overall diversified portfolio.

Brandon Raatikka, Grant Chaput and Meredith Traudt are with FactRight, LLC, a due diligence service founded by members of the Real Estate Investment Securities Association (REISA).

1 For more information on the limitations on TICs and DSTs, see IRS Revenue Procedure 2002-22 and IRS Revenue Ruling 2004-86.

2 For securities reasons, however, DSTs generally limit their programs to 99 or 499 investors depending on the size of the program.




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