The Retirement Gamble – A Frontline Video

This video underscores the value of financial literacy by focusing on the experiences of those who’re now grappling with the looming economic challenge of retirement. A series of interviews and first-hand accounts highlight the increasingly important role that money—and, in particular, knowing how to manage it effectively—plays in shaping our day-to-day lives. [Read more…]

REITs & Investment Property

Having examined the pros-and-cons of buying a home as an investment, let’s take a closer look at the ins-and-outs of buying income producing real estate directly (with the aid of a lender, title company, escrow service and real estate agent) versus acquiring it passively through Real Estate Investment Trusts, or REITs.

Chances are, you live near one or more of the following: a hospital, apartment building, industrial site, high rise office complex, assisted living facility, mobile home park, shopping center, hotel or bank. Unless these places are deliberately sough out for the purpose of running errands, such properties are seldom given much conscious thought. For many, these varying generic properties are just sort of there and are often ignored. When you think about it, this is downright peculiar given that, nationwide, there’s a staggering abundance of commercial real estate. It’s literally everywhere. What’s more, its dense global footprint is even visible from space at night. Whether you’re surrounded by skyscrapers in a bustling metropolis, strolling the cozy temperature controlled confines of a shopping mall, heading into town to grab a quick cup-o-joe or are running to the nearest bank, much of the property surrounding you is zoned for commercial use. Nonetheless, it seems that many Americans are only peripherally aware of how this vast segment of the real estate industry works. Of course, this raises an obvious but generally unasked question: who owns commercial real estate? Well, it’s generally owned and managed by private and publicly traded companies that, in turn, lease it to businesses operating in every sector of our economy.

Mention the word tenant, and most people think of a person. It so happens that tenants aren’t always people; often times, they’re businesses. Although residential and commercial real estate are identical in the broad sense that both relate to land and whatever buildings or improvements stand on it, there are important distinctions between these two dissimilar categories of property. Luckily, it’s easy to tell them apart. Basically, residential real estate satisfies the property needs of citizens whereas commercial real estate accommodates the property needs of businesses. Believe-it-or-not, knowing a thing or two about commercial property can be quite lucrative—particularly if you know how to put this knowledge to work. In the 1960s, sweeping changes were made to real estate laws that opened up whole new vistas of economic opportunity for small investors looking to add commercial real estate to their investment portfolios. Before legislation allowed for the creation of real estate investment trusts, ownership of commercial properties was off limits to all but the wealthiest and most sophisticated industry elites. Nowadays, anyone with a few measly bucks and a brokerage account can amass an impressive and broadly diversified portfolio of income producing commercial real estate. How is this possible? Interested in the answer? Read on.

Many people are understandably perplexed by commercial real estate’s dual status as both an indispensable factor of production in the business world and an illiquid (that is, hard to monetize) form of financial capital in the real world. Commercial real estate has enormous and mostly impenetrable barriers to entry. If the idea of scraping together enough money for a 10% down payment on a single family home sounds intimidating, imagine having to accumulate enough cash to come up with a 10% down payment on something as pricey as a mid-size shopping mall or office building that’s attractively priced at, say, $75 – 100 million. Alas, money isn’t the only barrier preventing a casual individual investor from pulling off such a lofty acquisition. Engaging in multiple rounds of intense buyer-seller negotiation and eventually consummating such a mammoth purchase requires a rare blend of industry expertise and costly legal representation. Pulling off such a high-level purchase requires a rare blend of resources and talent. Needless to say, one can’t easily become a serious player in the well-heeled world commercial real estate. And yet, strangely, based on your day-to-day experience as a consumer, you’ve probably seen commercial venues in your neighborhood swap business tenants with the speed and ease of runway models wiggling into and out of glamorous outfits. Case in point: if you’ve seen a Sears or K-Mart permanently close its doors and reopen months later as a Home Depot or Best Buy, then you’ve witnessed this extraordinary phenomena first hand. Interestingly, despite the many legal and financial barriers that tend to prevent commercial properties from quickly or easily changing ownership, such spaces frequently change business tenants. Conveniently, this seemingly irreconcilable dilemma is neatly resolved by the property management business model. Simply put, were it not for the existence of property management companies and the essential role they play in the marketplace matching business tenants with needed commercial spaces, our economy would lack the resilience and flexibility it needs to quickly adapt to changing market conditions. You see, our economy is like a beating heart. As it rhythmically expands and contracts, businesses open or close and national employment levels alternately rise and fall. What’s more, regardless of the overall economic climate, this frantic activity occurs simultaneously and is broadly influenced by what phase the economic cycle is in. While it’s certainly true that some businesses own the properties they occupy to serve their customers, given commercial real estate’s hefty price tag and the fact that a company’s Chief Financial Officer can usually deploy its capital more productively elsewhere by re-investing it or plowing it back into the business that generated it in the first place, it’s often in a company’s best financial interest to sign a lease and pay property management companies rent instead of purchasing real estate outright. Of course, this allows companies to devote more of their precious time and energy to improving their own operation. Similar considerations apply to individuals who must decide whether to buy or rent their primary residence.

Curiously, although home values attract nationwide attention and are breathlessly discussed, people seldom regard their homes as a steady and reliable source of cash; and rightly so. For starters, a house isn’t easily bought or sold. Real estate agents, closing costs and the nettlesome prospect of having to deal with bankers and wade through reams of complex legal documents tends to discourage people from trying to squeeze money out of their homes. Fortunately, such procedural obstacles are mere speed-bumps when applied to the well-heeled world of commercial real estate. From an investment standpoint, is commercial real estate as desirable as residential real estate? You bet, perhaps even more so. For aspiring capitalists, the idea of owning a geographically diversified portfolio of income producing commercial properties in a variety of industries would be a dream-come true… Think back to your favorite real estate board game; you know, the one you played as a kid. To help jog your memory, it’s got a colorful foldout board, lots of pretend money and an assortment of die-cast player icons in the shape of a destroyer, thimble, wheelbarrow, a beat-up old shoe and a banker’s top hat. No-doubt, owning a vast portfolio of income producing commercial real estate would be like owning the most desirable properties on the Monopoly board. Imagine how it’d feel to rattle off a long list of prestigious Fortune 500 companies as personal tenants. No-doubt, if you found yourself in such an enviable position, you’d be primed to collect obscenely large rent checks on a regular basis. Better yet, were you to find yourself in such a lucrative circumstance, you’d probably also have oodles of spare cash to hire a team of industry professionals to help you manage and maintain your properties. As the “silent partner” in this happy little arrangement, your most pressing obligation would be to saunter on over to the mailbox every now and then to collect and deposit your portion of the rental income. Suppose there were a way for you to make this dream scenario a reality? Would the prospect of doing so interest you?

Before we get too far ahead of ourselves, however, I should emphasize that there are many subtle differences between how the economics of real estate operate in the game of Monopoly versus the real world. For starters, the financial benefits of owning investment property aren’t limited to the collection of rental income. As Monopoly fans will readily acknowledge, the amount of money that changes hands when someone lands on someone else’s property is fixed. To ease flow of play and keep the rules of the game simple, rental rates never change. For a board-game, that’s convenient. In the real world, landlords generally raise rents over time at a rate of anywhere from three-to-five percent a year. The idea is that property managers want to compensate for inflation and maintain the purchasing power of the money they collect from tenants. Meanwhile, by financing the bulk of a property’s purchase price with a fixed interest rate loan, inflation will slowly reduce the “real-dollar” cost associated with carrying an astronomical amount of debt in the form of a mortgage. After all, it’s a very safe bet that borrowed money will, 20 or 30 years hence, be repaid with depreciated dollars. Also, whoever succeeds in obtaining the deed to Park Place in the real world will surely enjoy years of future appreciation as the value of the underlying commercial property appreciates. To further encourage entrepreneurial risk-taking and stimulate investment, commercial property owners enjoy an expansive range of tax breaks, courtesy of Uncle Sam. Tax breaks on real-estate? You betcha, and for investment property owners there are oodles of them. Though homeowners occasionally crow about the mortgage interest and property tax deductions they receive, investment property owners are treated to a far more expansive range of taxpayer subsidized goodies. In addition to the tax perks that a residential homeowner gets, property owners get to deduct the full value of the building or structure that’s erected on their property. This nice little value-add is parceled-out in equal installments over twenty seven and a half years. Moreover, property maintenance expenses–which includes outlays for a new roof, upgraded fixtures and necessary improvements–also lower an investment property owner’s tax liability. But wait, there’s more. That growing cushion of equity that investment property owners gradually accumulate is heavily subsidized by business tenants that dutifully pay rent. In theory (and often in practice) it’s a handsomely profitable arrangement for commercial real estate owners.

If you’re looking for the biggest bang on your investment buck, you could do a lot worse than own commercial real estate. Problem is, this type of property is difficult to acquire. Such real estate is out of reach for most hobbyist investors. Even if the price tag weren’t an impediment to breaking into this industry, there’s the tedious prospect of dealing with tenants, collecting rents, accounting for expenses, maintaining facilities, and, from time-to-time, renovating properties. Individuals are understandably reluctant to tend to these burdensome and ongoing operational responsibilities. To be sure, nobody could do this on a part time basis. But does this mean you should abandon all hope of owning commercial property? Absolutely not. Fortunately, such properties are lumped into large pools that are divvied up into millions of tiny pieces so that ordinary individuals, university endowments, pension funds, foreign central banks and institutional money managers can acquire them.

Thanks to the growing popularity of the REIT (Real Estate Investment Trust) ownership structure, commercial real estate has morphed into just another liquid and easily tradable form of capital. Every day, billions of dollars worth of commercial properties are passed between buyers and sellers on the floors of the world’s stock exchanges—just like stocks. REITs shrink vast acreages of commercial real estate into something that can be quickly and easily bought and sold. The main difference between REITs and stocks, however, lies in the nature of the underlying asset. In the case of a stock, an investor buys a business entity, which, in turn, exposes that investor to the risks and rewards of owning a company. When an investor buys a REIT, however, instead of owning a fractional interest in a company’s current and future profits, an income producing roster of commercial properties is purchased instead. When you buy one share of a REIT, you get your fair share of the rents that business tenants pay to occupy it and, of course, a team of qualified professionals who’re responsible for managing the whole kit-n-caboodle. All of this is readily available to any investor with a few bucks and a brokerage account. Not only do REIT shareholders receive ongoing cash distributions from operational activities and rent paying tenants, it so happens that capital gains are occasionally reaped from the strategic sale of commercial properties that are held in a REIT portfolio.

Encouragingly, the REIT ownership structure is spreading to other parts of the world. China has been in the news lately because of its growing economic clout. To put China’s largeness and future economic growth potential in proper perspective, Ted Fishman, author of China, Inc., estimates that it has anywhere from 100 to 160 cities with a population of at least one million people; the U.S., meanwhile, has only 9 while Eastern and Western Europe combined have 36. Does the prospect of owning commercial real estate in China’s most vibrant metropolitan markets sound like a feasible long-term wealth building strategy? Since China recently joined the World Trade Organization and its economy is rapidly modernizing and opening to the West, owning commercial real estate in this and other up-and-coming developing countries through international REITs may be a smart way to capitalize on this and other emerging market’s luminous future growth prospects.

Last time I checked, the Standard & Poor’s 500 Index (a well-known index dominated by large U.S. companies) sported a skimpy dividend yield of 1.6%. In other words, for every hundred dollars an investor plows into the S&P 500, they’d get $1.60 a year in income. REITs, however, offer a heftier annual payout–typically on the order of 4% to 7% of a REIT’s share price. Higher REIT yields stem from the fact that commercial properties regularly generate huge cash-flows from business tenants who pay big money for the facilities they occupy to manufacture goods and serve their customers. To qualify as a REIT, which exempts management from having to pay corporate taxes, REITs must, by law, derive at least 75% of its revenues from rents and distribute at least 90% of its operating profits (also known as its funds from operations) directly to its shareholders. Unlike qualified dividends (which are subject to a skimpy 15% tax rate), REIT shareholders must pay regular income tax on whatever “income” they receive from commercial real estate holdings. And, much like stocks, REIT financials are carefully scrutinized and audited by large and respected accounting firms. The 10% of REIT income that shareholders don’t receive goes to management to support ongoing business operations, pay administrative overhead and cover essential maintenance expenses. It’s worth noting, however, that REITs offer an additional benefit as well: “pass-through” depreciation. In other words, the tax breaks that REIT properties generate is automatically factored into the payouts that REIT shareholders receive. Another worthwhile advantage of REIT income is that it’s widely considered to be a safer form of investment income. And this is because REIT cash flows are advantageously placed on the economic totem pole since, by law, corporations must pay operating expenses like rent before they can dig into their pockets to pay interest to bond holders or dividends to stockholders. Consequently, should business tenants abruptly fall on hard economic times, REIT shareholders are first-in-line to be paid.

Considering the diversification benefits that REITs offer; the fact that qualified professionals are tasked with managing the properties in question; the considerable tax benefits that commercial properties generate; the likelihood of future appreciation in the underlying value of REIT shares; and the fact that all of these benefits can be enjoyed passively—and at a much lower incremental cost than buying real estate directly—I’d say that REITs are a better way to cash in on real estate. By all means, those who insist on singing the praises of real-estate should continue humming along; only, they’d do well to include the word “REIT” in the lyrical high-notes.

What’s in a REIT?

Years ago, during real-estate’s glorious heyday, I was drawn into a spirited debate about the economic logic of “investing” in a home versus stocks. To put this conversation in its proper historical context, it occurred at a time of stubbornly buoyant real estate prices. An overly frothy housing market that, for ten years, bubbled nowhere but up had produced speculative frenzy and a bumper-crop of ardent real-estate fans. With financing readily available to all, it seemed like everyone was eager to buy a first, second or third home. So, it may come as something of a surprise that I spent the better part of an hour trying to explain why (if past is prologue) a home isn’t the best place to look for outsized investment returns.

Don’t get me wrong, a house can be a great investment. Particularly if it has vaulted ceilings, a modern state-of-the-art kitchen, and is situated in an upscale neighborhood that oozes suburban charm. A home’s prospects for outsized future appreciation is further enhanced if it’s close to a diverse and economically vibrant metropolitan area that’s supported by a highly educated workforce and a diverse employment base. It’s equally helpful if the zip code you’re home-shopping in boasts higher than average median incomes and has plenty of distinguished schools. Lest we forget, the appeal of home ownership is further enhanced by cozy intangibles: the comforting home and hearth amenities that a home affords. Ultimately, though these and other selection criterion may significantly boost one’s odds of turning a prospective home purchase into a lucrative real-estate investment, just because a home can be a great wealth-building tool doesn’t mean that it always is.

Why the ambiguity? To answer this question, let’s look at the financial advantages of home ownership. For starters, homeowners can deduct their property taxes and the interest (up to a million dollar mortgage limit) paid on money that’s borrowed to buy a home. This results in a sizable tax break every April 15th. But wait, there’s more… Homeowners are the economic beneficiaries of a strong historical precedent of rising home values. Thanks to this trend, people who’ve owned their homes for 20 to 30 years can usually sell them for far more than they paid for them. Additionally, a mortgage is like a forced savings account in that, over time, as monthly payments are made and the balance owed is gradually paid off, homeowners accumulate growing wealth in the form of an ever-thickening cushion of equity. This is the difference in value between what a home is worth minus whatever debt is owed against it. Should unforeseen events force a homeowner to vacate a property for an extended period, it can be converted into an income producing rental. Finally, there’s the copious availability of taxpayer subsidized mortgage debt. Thanks to this and other powerful economic incentives, real estate can be purchased and/or encumbered for mere pennies on the dollar. In light of this exhaustive list of potential financial and psychic benefits, why did I not join my friends in toasting real estate as the king of all investments? There are many reasons.

For starters, home equity has a fuzzy money quality to it. Though it’s easy to confuse a dollar of equity for a hundred pennies in the bank, this can be a costly miscalculation. To understand why, let’s explore a bit of real estate history. Before the Internet era, back when rotary dial telephones were commonplace, just about the only way that a homeowner could turn their home equity into cash was to put their house on the market, wait for it to sell, and use the proceeds to pay off their mortgage balance. After deducting real estate agent commissions, capital gains taxes and other miscellaneous expenses incurred in a property’s sale, whatever cash is left can be pocketed or spent. Collectively, these expenditures aren’t chump change; they can easily amount to thousands of dollars and consume anywhere from five-to-ten percent of a home’s sale price. So, that hypothetical dollar of home equity isn’t really worth 100 pennies, but rather, something like 92.5 cents. Fact is, this reduced figure is somewhat understated because it doesn’t reflect the transactional expenses that are incurred in the purchase of a home. Nowadays, ingenious financial innovations like HELOCs (Home Equity Lines of Credit) enable people to treat their homes as gargantuan ATM machines. Although these complex instruments do indeed liberate homeowners from the traditional hassle of having to sell their homes in order to access the equity they contain, their use is neither hassle nor cost-free. Homeowners looking to avail themselves of such options must complete reams of paperwork, deal with stuffy bankers and sign lots of intimidating legal documents that aren’t easily read or understood. Any way you slice or dice it, whether you sell a home yourself or rely on other less conventional methods, extracting money from a home is a costly and time intensive endeavor. The bottom line: unlike pure-play financial assets like stocks, bonds and REITs (which can be quickly and inexpensively sold), the added difficulty and expense of extracting equity from a home makes real-estate a comparatively less desirable investment.

Is a home a financial asset? To answer this question, and build a framework for discussion, let’s define two relevant economic concepts. What is a financial asset and how does it differ from a liability? To keep things simple, let’s agree that an asset is something that puts cash in your pocket whereas a liability does just the opposite, it takes money away. Sounds simple, right?

The most perplexing thing about real estate is that, as investments go, its status as an asset or liability is somewhat elusive and hard to pin down. Fact is, a home isn’t permanently categorizeable as an asset or a liability; many factors go into making this determination. No matter how the economics of home ownership are analyzed, buying a property initially qualifies as a liability because it means parting company with a huge pile of cash in the form of a down payment. This sizable outlay, which amounts to anywhere from 5% to 20% of a home’s asking price, will be followed by a very long series of follow-up payments as the principal and interest components of a mortgage are paid off in monthly installments over twenty to thirty years. And while it’s certainly true that a home’s potential for long-term price appreciation is indeed substantial, this shimmering pot of gold at the end of the debt service rainbow often takes decades to materialize. Meanwhile, the outflows associated with a monthly mortgage payment will suck plenty of cash from a homeowner’s wallet. But that’s not all, there are other costs for a would-be homeowner to consider. Property ownership is an arrangement that, once entered into, carries with it additional financial obligations that must be satisfied. And the failure to do so sets in motion a strange circuitous legal process that eventually results in a homeowner being forcibly relieved of his or her property. Essentially, there are two ways for a homeowner to go seriously wrong. Failure to pay a mortgage is one because it prompts foreclosure by a lender. Refusing to pay one’s property taxes is another because it causes a home to be relinquished to its default owner: Uncle Sam. Our government is in the business of renting land to its citizenry; short of a successful foreign invasion, no other entity will threaten to and eventually reclaim your property in event that these taxes aren’t paid. A close reading of the tax code relating to a homeowner’s patriotic responsibilities in this regard should dispel any confusion on this topic. Sadly, the economic burdens of home ownership don’t end there. In addition to these expenses, there’s also the cost of property insurance and ongoing maintenance expenses to consider. After totaling all of these costs, and taking a thoughtful moment to contemplate the lifestyle implications of having to satisfy them for several decades, it should be readily apparent that a home purchase is a tremendous financial liability. Basically, a newly acquired home with little-to-no equity is just a rental garnished with a heap of debt and a few other financial obligations.

But here’s the part where real estate fans will reach for their sparklers and break out their party hats, if a home is held long enough, it morphs into an asset. But how can this be? How can a home start out as an economic liability, and then, poof, become an asset? At some point in the long tedious process of paying off a mortgage, the amount of equity that’s accumulated in a property will equal the amount of debt that’s owed against it. Let’s call this eagerly anticipated and widely celebrated moment in a homeowner’s life the economic tipping point. At this stage of the game, monthly mortgage payments enrich the homeowner’s bottom line more than the mortgage originator’s. Once this delicate economic point is reached, assuming the value of the home in question doesn’t decline, then and only then can a home become a financial asset. It‘s worth noting, however, that it usually takes decades of faithful debt-service for real estate to shift from the liability column of a homeowner’s balance sheet to the asset column.

Now that we’ve explored the asset-liability duality of home ownership, let’s examine the opportunity cost of buying a home. When we crunch these numbers, you’ll see that it’s enormous. What is opportunity cost? Economists define it as the highest foregone alternative. In other words, whenever you spend money you forfeit the right to invest that money elsewhere. By making an economic decision you’re passing up alternative choices for how you might have spent your money. Makes sense, right? Now, when weighing the pros and cons of buying a home, it’s worth noting that any economic decision carries with it a series of potential costs and benefits. Though marrying a mortgage might seem like a can’t-miss wealth building strategy, there’s a minor (and frequently overlooked) fine point to consider first. If the primary purpose of buying a home is to transform a hefty down payment and a staggering amount of debt into an even greater sum of money somewhere down the calendar, it’s worth considering the time value of money and thinking about how rapidly the cash that’s invested in a home might appreciate if it were allocated elsewhere instead. Suppose the financial capital that’s put into a home were to instead appreciate at a rate equal to the S&P 500’s long-term historical returns? When we run these numbers, and compare the side-by-side returns of investing in a home vs. stocks, the economic logic of buying a home is downright questionable.

To illustrate this point, we’ll pit $500,000 invested in a home against $500,00 allocated to the S&P 500 stock market index (with dividends reinvested) and examine the comparative returns of both investments over three different holding periods: five, ten, and twenty years starting from July 2006. According to research conducted by Edward Jones, half a million bucks invested in a home over a five year period would’ve amounted to $730K, easily trouncing the S&P 500’s returns by $155,000. Over a ten year period, however, real estate’s luster dims noticeably; $500K invested in the S&P 500 appreciates to $1.2 million whereas $500K invested in a home is worth $937K, a $263K difference in the stock market’s favor. When we compare the price performance of real estate vs. stocks over a twenty year period, the disparity in returns widens even more aggressively; $500K invested in the stock market amounts to $4.83 million whereas $500K invested in a home becomes $1.5 million—a staggering $3.33 million difference in the stock market’s favor. Clearly, though real estate has proven it can outperform stocks over a five year period, it hasn’t demonstrated an ability to do so over the long-haul.

Another frequently overlooked risk of home ownership is that it concentrates a high percentage of one’s net-worth in a single investment. The fact that our government chooses to subsidize interest on real estate debt distorts incentives and encourages people to take on bigger mortgages than they might otherwise afford. The tax code is one reason why consumers over-concentrate their wealth in housing. From a risk management standpoint, this can be costly. Disruptive events of natural and economic origins have, throughout history, adversely affected real estate values. The San Francisco Bay Area’s 1987 earthquake gave property values a nasty shake. Home values in New Orleans were similarly devastated by levee failures caused by hurricane Katrina. These and other disruptive events show how violently real estate values respond to natural disasters. Major economic events, which tend to have a less visible and dramatic impact on housing values, can be equally traumatic and damaging. Consider the market-wide adjustment in property values owing to deteriorating economic condition in hard-pressed areas like Detroit, a once vibrant and thriving metropolitan hub that was once home to a dominant and seemingly unstoppable U.S. automotive industry. More recently, during the 1990s, the loss of defense contracting jobs in southern California had a chilling effect on real estate values in that part of the country for years. The economic aftermath of the 1980s Savings and Loan fiasco exerted downward pressure on numerous hard-hit real estate markets. Clearly, economic and natural disasters both pose significant (but frequently overlooked) risks to housing wealth. Those who’ve been adversely affected by these and other calamitous events realize—perhaps more keenly than most—the folly of concentrating so much of their personal net-worth in their homes.

Having examined the pros-and-cons of home ownership, I think it’s fair to say that a home (though it doesn’t offer the best long-term returns—those bragging rights go to stocks) can be a powerful wealth-building tool. When it comes to cashing in on real estate, however, it turns out that there’s an easier way to go about it than to shackle oneself to a mortgage. As investments go, real estate is dandy. Luckily, for people who don’t have oodles of spare cash lying around or are unwilling to assume an astronomical amount of debt, there’s a much easier way to cash-in on real estate. Which brings us to Real Estate Investment Trusts (REITs). These financial instruments put the American dream of real-estate ownership within easy reach for ordinary folks by enabling people of modest means to acquire professionally managed income producing commercial properties. Moreover, with REITs, the underlying asset is owned free and clear. Moreover, it generates income from the get-go without the subsequent hassle of having to pay a mortgage or fork over additional money for taxes, maintenance expenses and property insurance. Insofar as real estate investing is concerned, REITs are terrific and will be discussed in greater detail next.