When it comes to building an investment portfolio the key is to diversify your asset allocation in order to maximize growth— even during the tough markets. For that reason, it’s integral to have complementary investments — ones that are stable or even rise when others are getting clobbered. One alternative investment is real estate. However, owning a bricks-and-mortar rental property isn’t realistic for everyone. Thankfully, there are other ways to invest in real estate without owning property.
#1: Real Estate Investment Trusts (REITs):
The most common (and popular) way to get exposure to real estate returns is by adding REITs to your portfolio. A REIT is a fund or company that earns income through its investment in real estate. Investors can choose public REITs (either as ETFs or as mutual funds) that are bought and sold through the open market and subject to all regulatory reporting rules. There are also private REITs, which are not traded on an exchange and have fewer regulations and more risk (for potentially more reward).
Adding REITs to your investment portfolio can help with diversification. Quite often, by adding a REIT, an investor will get similar returns to stocks but with a very low correlation. In other words, you may get equity-like returns but without the same up-and-down pattern of an equity index; when stocks go down, chances are the REIT will be up. That’s because the underlying asset in a REIT are the rents collected on the basket of rental properties owned — and the value of the rent collected does not go fluctuate on a daily or even monthly basis.
The key with REITs is to buy what you can understand and to be selective. Look at the quality of the investment — and focus on the long-term track record of overall growth and consistent cash flow. Quite often there is an added attraction with a possible higher return with private REITs, but private REITs aren’t as heavily regulated as publicly-traded assets and, as a result, can come with much more risk.
#2: Mortgage Investment Corporations (MICs)
MICs are alternative fixed income investments and, over the last decade, these investments have reported sustained double-digit returns. MICs must keep 50% of their holdings in mortgages backed by residential real property (or in CDIC-insured holdings), so the majority of risk revolves around residential mortgage default rate — a rate that is notoriously low in Canada (almost never rising above 1%).
But not all MICs are created equal. While 50% of holdings must be in residential mortgages, what constitutes as “residential” can be quite broad — and this can seriously impact both the risk and the reward of a MIC.
For instance, residential debt can include first and second mortgages. If you hold a first mortgage you have priority if a default occurs. This makes second mortgages more profitable, but much riskier. Residential debt can also include construction loans or bridge financing for residential new-builds or repairs—a much riskier form of debt given its commercial nature. The reason why all these other forms of debt are allowed is because it’s classified as “residential” under the Income Tax Act. Then there is the risk of a MIC being over-leveraged or too geographically concentrated in its holdings, as well as its own internal policies that limit the maximum percentage (or total dollar amount) that can be invested into any one asset.
To minimize risks when selecting REITs, be prepared to do your due diligence. Ask for addresses to holdings, investment policies and scrutinize the independent audit of the MICs financial statements as well as the funds annualized returns (since inception).
#3: Syndicated mortgages
A syndicated mortgage is where several investors combine funds to create one financial instrument: a mortgage. When you invest in a syndicated mortgage, you are pooling your money with others to create a mortgage that will be registered and secured directly with the land or building that’s associated with that mortgage.
Syndicated mortgages, also known as private lending or private mortgages, became very popular as real estate prices started to climb, about a decade ago.
Quite often, it’s the developers and builders that are using syndicated mortgages to take a project from conception to completion. Traditional lenders won’t offer mortgages on this phase of the investment as it’s considered too risky — and that should tell you something.
Quite often, developers will rely on syndicated mortgages to cover soft costs: consultant fees, zoning permits, architecture costs and even marketing and sales expenses. All this is to say that the mortgage you’ve provided is funding the initial stages of a project not the actual building of the project. This is a problem if a project gets delayed or goes bankrupt—and this does actually happen.
Proponents of syndicated mortgages will argue that the risks are mitigated because the private mortgage is registered against the land, but investors need to keep in mind that if something should go wrong, you won’t be paid first. As a syndicated mortgage-holder you are second in line, behind any bank loan against the project. Once that debt is cleared, you may see some money.
#4: Real estate ETFs and mutual funds
Probably the easiest and most common way to invest in real estate without owning property is to add a basket of funds that concentrate on real estate holdings. For investors real estate exchange-traded funds (ETFs) are a collection of equities or bonds that are grouped into a single fund and offer exposure to real estate, as an asset class.
Some financial analysts argue that by holding a broad-based ETF or mutual fund, most investors already have exposure to real estate — and that’s true. But by adding a real estate ETF of fund, an investor can maximize their exposure to this alternative asset class and, hopefully, maximize their investment returns.
For example, the Vanguard Real Estate ETF (VNQ) includes some of the most notable REITs within its fund, like Simon Property Group (SPG) and Prologis (PLD). Holding this ETFs gives an investor exposure to real estate returns, but with less risk than investing directly in a REIT, and certainly less risky than actually buying property.
#5: Real estate mutual funds
Real estate mutual funds are more like REITs. While both offer a basket of holdings, they differ based on how they are structured. A real estate REIT is an actual company, while a real estate mutual fund are simply investments pooled together and overseen by an investment manager.
As a diversified asset, these funds are designed with the intention of mitigating risk but providing solid returns based on the real estate market cycle. That means that they are vulnerable to the risks inherent in real estate, but this is good news for investors who understands that real estate market cycles are, quite often, not correlated with equity market cycles.
Like a real estate ETF, a mutual fund that focuses on property allows investors to diversify their portfolio and also allows an investor to select an investment strategy that suits their needs. For instance, some real estate funds focus on growth, while others focus on income. The key is to investigate the holdings and to select a fund that suits your investment needs.