Real Estate Bets in Shaky Times

Most analysts are down on real estate investments, but investors can still benefit in some ways from exposure to the market

The slump in the U.S. housing market has convinced many investors to stay away from real estate investments for the foreseeable future, with analysts unable to call a market bottom. That's weighing not only on hard assets such as homes and condos, but on stocks like real estate investment trusts, whose prices have dropped since the beginning of the year.

Year-to-date through July 6, most of the REIT indexes have dropped by about 3%, to 6.5%, while the Standard & Poor's 1500 Composite index gained 8.5%, according to Standard & Poor's Equity Research (see, 7/10/07, "A Rundown on REITs").

REIT investors look for attractive cash flows in the form of quarterly distribution income and capital appreciation over time. In terms of cash flow, publicly traded REITs—with yields of 3% to 4%—aren't attractive, compared with the higher yields on risk-free Treasury bonds, according to Milton Balbuena, chief investment strategist at Contango Capital Advisors, the wealth management arm of Zions Bancorporation.

With yields as weak as they are, investors are betting on the prospect of properties appreciating in value over time, which also is a bigger risk than it used to be, Balbuena says. In fact, with yields coming down, he's advising people to steer away from real estate altogether.

But real estate is still a key component of any investment portfolio for the diversification it provides and the low correlation to stock and bond markets, say other financial advisors. This week, Five for the Money looks at some ways that investors can still benefit from real estate exposure.

1. International REITs

Stay away from U.S. REITs, which account for roughly 55% of the global REIT market and are suffering from the housing slump, advises Jay Hutchins, president of Comprehensive Planning Associates in Lebanon, N.H. He steers clients toward mutual funds that focus on international REITs or on a mixture of international and domestic ones. He also prefers equity REITs, which invest in actual properties and make money on capital appreciation, to mortgage REITs, which offer income based on interest rates.

An easy way for people who don't have large portfolios to diversify is through the Morgan Stanley Global Real Estate Fund (MRLAX), which currently has 60% of its assets in foreign real estate. The distribution income is similar to a Standard & Poor's 500-stock index fund, and the expense ratio is reasonable—a little higher than 0.95%.

He also recommends the Alpine International Real Estate Fund (EGLRX), which has a strong track record and is up 15.5% year-to-date. It targets areas that are doing very well and is getting into emerging markets such as Brazil. Its expense ratio is 1.17%, which isn't cheap but may be warranted given its five-year rate of return of 31%, vs. 22.5% for the average REIT.

2. Private REITs

The primary advantage of REITs that aren't publicly traded is more stable cash flows and net asset valuations (NAV), as they aren't buffeted by stock market fluctuations. For one, their NAV is priced once every quarter, as opposed to public REITs that are priced daily and therefore are more volatile, says Michael Kuziw, vice-president for asset management at Lenox Advisors in New York.

Unfortunately, they're only available to retail investors through separately managed accounts, which are typically affordable only to people with cavernous pockets. To get what he thinks is a decent level of diversification in an SMA, the portfolio size should be at least $1 million.

Advocating a more global approach to real estate investment allocation, Kuziw says, "Clients probably miss out on a lot of opportunities by not looking at exposure in Europe, Western Europe, and industrial Asia that are probably in earlier stages of real estate expansion." While the values of some foreign properties are under pressure, they're still a smart component of a portfolio for their low correlation to macroeconomic forces, he says.

For risk takers and wealthy clients, Lenox prefers exposure to core real estate holdings such as office buildings, retail properties, and apartment houses. He selects properties with a view to each client's appetite for risk, sticking to cash-only purchases for the more conservative and using leverage for the more adventurous. To own larger properties with the greater potential for capital appreciation, investors need to be comfortable with using a combination of cash and debt to buy them, Kuziw says.

He looks for fairly a stable NAV and a quarterly distribution of between 5% and 6.5%. And, depending on how they're managed, every two to three years they might offer an extra dividend if they sold a property that had appreciated and reinvested the profit in another property. "We look at them almost like a private equity play, [where you're] raising a certain amount of money and then investing in properties like office buildings, looking for capital appreciation," he says.

3. Use Your IRA

There's also money to be saved if you buy real estate as part of your IRA portfolio, which can be either tax-deferred or have its taxes prepaid like a Roth IRA. Keep in mind, though, that the properties aren't shielded from the slowdown in the real estate market.

While most IRA custodians tend to focus on stocks and bonds, Entrust Northeast, in Verona, N.J., which administers self-directed retirement accounts, allows for a wider range of investments, including first and second mortgages. "People usually come to us having some idea of what they're interested in investing in before they get here," says Jaime Raskulinecz, chief executive of Entrust Northeast, one of 30 franchises nationwide of Entrust Group, which doesn't recommend or sell anything.

It costs clients $50 to open a new account and, as long as someone makes a deposit in cash, there are no fees until the client directs Entrust to make an investment on behalf of the account. Each transaction costs $95 and clients pay either $250 per asset per year or a certain percentage of their account value, starting at 0.0085%.

For example, when a client opts to buy a condominium, Entrust serves as the conduit for the transaction. Rather than the client owning the property, it's owned by and gets deeded to the IRA, much the way stocks are held in an account. As with traditional IRAs, all gains on sales in that account are tax-deferred as long as the owner is at least 59 and a half years old when making a withdrawal. Properties held in Roth IRAs, where taxes are prepaid, can be sold with no minimum time limit as long as the IRA has been open and funded for at least five years.

4. Vacation Homes

The most obvious real estate investment is a vacation home, although people may not think of them that way. For retirees who are seeking or open to a change in lifestyle, relatively inexpensive opportunities exist outside the U.S., particularly in parts of South and Central America.

Panama has gained in popularity, mainly because well-known U.S. real estate developers such as Donald Trump are building sophisticated luxury high-rises there, says Brent Lipschultz, a principal in the Personal Wealth Advisor Practice of Eisner. "A lot of investors see these big players coming in there and feel more comfortable with their own investment," he says.

Costa Rica also has a growing population of U.S. retirees, mainly because of the economic environment and its attraction for tourists. The stable political environment in Panama and Costa Rica is a key reason for investors' interest.

Whether someone is buying a property for a primary residence, a vacation home, or a rental property determines how ownership should be structured legally, according to Lipschultz. One disadvantage: Certain U.S. banks won't lend for offshore real estate, probably due to concerns about it not being protected under U.S. laws.

Buying a property for a primary residence gives the same tax breaks you'd get by owning personal property in the U.S. But if a property is put into a structure like a limited liability company, you could forfeit the right to a home-exclusion benefit when it's sold, he warns. If you're renting property and the local jurisdiction recognizes limited liability companies, then using an LLC would provide adequate liability protection from renter lawsuits.

For example, if a home is being held for investment purposes and there's interest or debt incurred, that debt might be considered investor interest expense and there would be limitations on the size of the tax deduction, he explains.

5. Fractional Home Ownership

For those who dream of owning a vacation home but find the prices too expensive in light of the small amount of time their families will actually be able to spend there, fractional home ownership has become an attractive option. Until recently, it's been reserved for the very wealthy—those who can afford the typical Ritz Carlton cost of $250,000 for a share of an actual property on a world-class golf course, plus $75,000 in annual fees for golf club membership and home maintenance.

That's now within reach of folks in much more moderate income brackets, thanks to Private Quarters Club, which is owned by real estate developer Devcon Development in Jupiter, Fla. The company offers shares in three-bedroom luxury villas in Fernandina Beach, Fla., and Lake Geneva, Wis., for $79,900, plus an all-inclusive annual fee of $4,000. That buys you 21 days a year at any of the six villas that have been built on the Amelia National Golf & Country Club in Fernandina Beach or the 20 villas now available at the Geneva National Golf Club. Owners can book their stays with a full-time concierge up to a year in advance.

Owners are using the villas mainly as vacation homes, but they make sense as investments as well. Not only are they a tangible investment for family use and fun, but they're also a hedge against inflation because people can expect to pay the same price 10 years from now as they pay today, says Joe DeSilva, chief operating officer of Private Quarters Club.

Because owners have fee-simple deeds on their shares, they can bequeath them as part of an estate to family members. In addition to having them for personal use, business owners can use them as perks for trading partners who want a place to play golf for a week or for internal company use as incentives for their most productive salespeople, DeSilva suggests. "If they do it right, they could find themselves with a tax write-off."

However, fractional owners should be aware that they won't be able to sell their shares at a profit until all 17 shares of each villa are sold out. Within two to three years, Private Quarters plans to have a total of 20 villas on the Amelia golf course and 40 villas in Lake Geneva.

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