Pros and Cons Of Owning the New Market Sector: Real Estate

The key is to know exactly what you’re getting into to avoid surprises.

Real estate has long been an essential part of a well-diversified investment portfolio, but now it’s even more essential.

As of last year, equity investments in pooled real estate vehicles became an official sector under the investment classification system used by Dow Jones Indices and MSCI Inc. Thus, these investments, known as real estate investment trusts (REITS) became the 11^th sector in this industry classification system

used by investors around the world.

Real estate is the first new sector added since the Global Industry Classification System, created in 1999, established the 10 original sectors.

This new status reflects the meteoric growth of REITs in the global economy. Over the last 25 years, the total market value of REITs listed on the planet’s equity exchanges grew from $9 billion to more than $1 trillion — nearly 4% of the total capitalization of the S&P 500, according the National Association of Real Estate Investment Trusts (NAREIT).

Even before the new status, REITs were in a growth cycle. And currently, on average, REITs are yielding as much as 4.5% annually — twice the yield of the S&P 500.

Becoming an official sector is expected to continue propelling REIT growth in general because now, to check off the box on all 11 sectors, investment managers buying shares for mutual funds and exchange-traded funds must add real estate to their investors’ portfolios, usually through REITs.

For all of these reasons, it's a good time for physicians to consider adding real estate to their long-term investment portfolios. Atop all this, there’s a pressing reason to do so now: to achieve diversification amid a perilous bond market.

Historically, investors have sought to diversify their stock portfolios with bonds. But the bond market is beset by the problem of rising interest rates and is forecasted to continue. This means new bond issues must pay higher rates to attract investors seeking to protect their bond holdings from the ravages of rising rates.

If you own several long-term bonds that pay 2%, while new issues pay 4%, your bonds are worth less on the secondary market because no one will want to buy them — you can however, keep them until maturity and sustain damage from inflation. This is what’s happening after a 30-year bull bond market characterized by historically low interest rates.

As rates are now rising, ending the party, investors seeking to offset the risk to their portfolios of volatility inherent in stocks must turn to something other than bonds. One option is real estate, which has long been known as a desirable alternative investment — an alternative to stocks and bonds, known as traditional investments.

REITs are protective diversifiers because, unlike bonds, they have the advantage of pricing power during inflationary periods; landlords can raise rent to keep up with inflation.

There are different ways to own real estate as an investment, each carrying different inherent levels of risk, liquidity and transparency that you should understand before investing.

There are 5 basic ways:

• Owning real estate directly. This requires loads of cash up front and the willingness to suffer the disadvantages of low liquidity — the inability to sell the property quickly because of market factors. You don’t have to worry about the transparency of the owner entity involved because you are the entity. These investments aren’t suitable for most individuals — even the wealthy — and the low liquidity can pose significant risk. If you need your money back in a hurry, you might have to sell cheap and take a bath.
• Investing in private equity funds or hedge funds that own property throughout the country or the world. “Private” means they aren’t publicly traded and, to some extent, make their own rules. As a result, these funds can be fairly opaque — and highly illiquid; it might take years to get out. And management fees can be onerous. Managers get rewarded for beating benchmarks, so they have every incentive to increase leverage — i.e., to borrow money to make investments to turbocharge returns.
• Privately-traded REITs. These are often sold by salesmen who call you or come to your door, earning high commissions that are indirectly taken out of your investment. This reduces your net returns in the long run. The non-public nature of these investments typically reduces transparency. Liquidity can also be a problem. Typically a mutual fund can never buy more than 5% of the total shares of any particular holding, but private equity/hedge fund REITs can acquire excessive concentrations of 1 or 2 holdings, increasing risk.
• Actively traded mutual funds that own exchange-listed REITs. These investments are highly transparent, but investment managers can effectively lower net returns for existing shareholders through excessive trading, resulting in a high turnover ratio. And if you want to sell your shares because values are rapidly going south, you must wait until the stock market closes at 4 p.m., and take the price it gives you.
• REIT ETFs (publicly traded). As with mutual funds, you merely own shares. Yet there’s low turnover in these passively managed investments, and fees can be extremely low because there’s little management per se. Also, as ETFs are traded on exchanges like stocks, you don’t have to wait until 4 p.m. to sell; you can get out at any time during the trading day.

Thus, ETFs tend to be the most transparent, lowest risk, lowest cost and most flexible option. Yet, depending on individual proclivities, cash reserves and risk tolerance, some high-net-worth individuals may, after carefully investigating risks and clarifying the rules and dynamics, be attracted to the higher-cost, less opaque options if they have the resources available and are able to tolerate illiquidity.

The key is to know exactly what you’re getting into to avoid surprises.

David Robinson, a Certified Financial Planner®, is founder and CEO of RTS Private Wealth Management, an SEC-registered advisory firm in Phoenix, Ariz., that provides fiduciary services to help clients achieve their financial goals. He specializes in helping wealthy individuals — such as physicians, executives and professional athletes — prepare for the future by creating custom financial plans that employ a holistic approach, including growing/protecting wealth, managing taxes, identifying insurance solutions, preparing for retirement and managing estate plans.