Deciding Between Paper and Property in Real Estate Investing

March 19, 2009 by  
Filed under Real Estate Investing

Investing in real estate can be extremely lucrative and rewarding, but there are some ways to do so and avoid the headaches of tenants, repairs, maintenance and inspections. Other options include real estate in the form of financial vehicles that will reduce the headaches and still allow you to reap the rewards in an up market.

Real Estate Investment Trusts, or REITs, are the oldest form of investing in real estate via paper. These are essentially mutual funds which invest in actual property and mortgages. REITs are managed by financial professionals, qualify for special tax claims, and are more liquid than simply investing in real property directly.

Equity REITs focus on owning actual properties, and collect income from rents. Mortgage REITs financially back investments in mortgages, earning interest on loaned funds. Hybrid REITs are also available, and include characteristics of both Equity and Mortgage REITs.

REITs are closed-end funds, meaning that there are only a set number of shares available, and must be bought from or sold to other investors through a professional broker.

The biggest advantage to REITs is that they must pay out 90% or more of their taxable profits to shareholders, also known as dividends. This means that the dividends may end up providing quite a high yield. The total value of your shares in a REIT fund includes these dividends and appreciation in the price of shares. About 2/3 of your returns will be from dividends, much like small-cap stocks. However, this also means that interest rate changes directly affect these profits, and increased rates tend to cause REIT prices to fall.

Mortgage-Backed Securities, or MBS, are bonds that are supported by mortgage loans. These MBS back approximately 80% of all home mortgage loans issued on an annual basis.

A specific rate of interest is earned on MBS investments. The biggest difference between these and regular bonds is that principle repayments occur periodically throughout the life of a home mortgage loan as it is paid down – this is sometimes more advantageous to an investor than bonds that pay principal in one lump sum at the time they reach maturity.

These types of real estate investments can reduce risk largely due to the statistical effect of pooling large numbers of these properties and mortgages together. This way, no single property or mortgage can have a great effect on the returns experienced.

One important consideration is the fact that changing interest rates not only affect returns on MBS bonds, but also cause many homeowners to pay off their home loan early to refinance for a lower rate. This will significantly reduce the interest profits seen in this type of investment.

Don’t forget that an Individual Retirement Account (IRA) can be self-directed to add assets of real property. This could include homes, commercial structures and even empty land lots; this option reduces the risk of your retirement funds, and allows you to conserve your cash for more immediate expenses and other investments.

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