Real Estate Investing: Direct vs Indirect

By Brad Thomason, CPA

Like many assets, there are both direct and indirect options for owning real estate.  Direct ownership is just that: you own the property itself (irrespective of how you acquired it, or whether you have someone else leasing and/or managing it).  Indirect ownership is available through a variety of means including REITs, mortgage paper, and funds that invest in pools of properties.

When considering how to approach a real estate investment, there’s an important point to understand:  the underlying asset may be the same, but the way you own it adds other variables to the equation.  These variables can end up having a big impact on how your investment performs, even if the real estate involved is largely identical.

One of the strongest points in favor of indirect ownership, especially when the investment is in some sort of pool of properties or property-backed debt, is diversification.  When you own a REIT share or a bond that’s been issued against a pool of assets, then you have an undivided piece of the whole, versus exposure to a specific property within.  So, if in a pool of 300 properties, one burns down and it turns out after the fact that there was not enough insurance coverage, the loss is relatively small when spread across the whole.  Conversely, if you were the sole owner and that was your only property, the same set of events would wind up being a pretty big deal.

But diversification, like any other form of protection/insurance, comes at a price.  In this case that price is denominated in terms of diminished yields.  Several large investment firms like Blackrock and Rialto have recently floated debt offerings against pools of real estate assets that they are managing or working-out (i.e. foreclosures, and distressed mortgages), which have coupon rates between 1.5% and 3%.  A number of publicly traded REITs have dividend yields right now between 2% and 4%.  Offerings of this type have a lot of internal diversification, and offer investors the chance to invest in something other than stocks and bonds, to facilitate further diversification/asset-class allocation within their own portfolio.  But the yields, while comparable to current corporate bond offering, may fall well short of what many need to earn on their capital to make their financial plan work.

By comparison, most of the direct-own investors that we work with expect (and routinely receive) much higher returns on their real estate holdings.  Those who buy individual properties to use as rentals often net between 9% and 14%; and that’s for all-cash deals with professional management.  Mortgaged deals, and self-managed properties can do even better.

Buyers of discounted notes usually avoid deals that don’t have the prospects for at least a 20% gain.  Such opportunities are less abundant than houses with good rental prospects, but they are by no means rare if you know where to look.

A little simple math will demonstrate that a blended portfolio with representation from these two types of real estate assets can substantially outperform the indirect offerings.  Or most other investments, for that matter.  Moreover, for higher-net worth individuals who can afford to purchase 3 or 4 rental houses and keep 2 or 3 note deals in the works, the diversification concern is largely ameliorated; without the decreased yield that’s part of a managed offering.

Not everyone is comfortable with direct ownership, and that’s fine.  Even if they are, the indirect route is comparatively easier.  Either can be a valid choice depending on what you are trying to accomplish via the investment.

But informed investing is always a good idea, and given the size of the current disparity in this space, it is unusually important to make a conscious assessment.  The convenience cost for indirect investing in this particular case can be quite high.  For many investors, higher than they feel like they can stomach – even if they find that their initial reaction to the prospect of direct ownership was less than enthusiastic.

Most people need a pretty good reason to leave that extra 5% to 15% on the table.  The problem we see is that most investors don’t realize that’s what they are doing.  But for the ones who are informed and take the time to weigh the options, the difference can be substantial.

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