Real estate investment trusts (“REIT’s”) are vehicles through which an investor can invest in real assets. Real assets can include real estate such as commercial and residential rental properties and hospitals, as well as other income producing real property such as timber land. REIT’s can also hold real estate related debt instruments such as mortgage backed securities.
Similar to other trusts, distributions of income, dividends and capital gains from a REIT are passed through to the investor and are not taxable to the trust entity provided that certain requirements are met.
REIT’s can be publicly traded, similar to a stock, or be closely held by a small group of investors.
REIT’s which are not publicly traded oftentimes do not have much liquidity and can be difficult for an investor to dispose of in certain cases. Such REIT’s oftentimes have higher yields which compensate investors for taking on the additional liquidity risk.
Publicly traded REIT’s, on the other hand, tend to be liquid and be relatively easy to buy and sell on an exchange. The result of this is a “liquidity premium” where an investor will typically receive a lower yield from a publicly traded REIT than from a non publicly traded REIT in exchange for the REIT having greater liquidity.
In today’s low interest rate environment, whether or not to pay off a mortgage early is a question which is often asked and debated. Oftentimes one could benefit more by paying off a loan over a longer time frame, as inflation will tend to degrade the real value of the loan principal over time. In the current low interest rate environment the carrying costs of the debt are minimal. Because a mortgage is a long term obligation, the additional funds can instead be invested in a diversified portfolio of equities and bonds, preferably in a ROTH IRA or ROTH 401k.
Many of the arguments for early mortgage payoff were valid in prior decades, when interest rates were much higher. Take, as an example, the 1990’s when the 30 year rate hovered between 7% and 10%. In these years, it was usually advisable to pay off a loan early, as significant savings could be realized by doing so. As an example, consider a $500,000 30 year mortgage at an 8% rate, which was a typical situation in the 1990’s. By paying off such a mortgage 10 years early, savings of over $300,000, or 60% of the loan principal, could be realized.
Contrast this with a $500,000 30 year loan at a 3% rate, which is more typical in today’s environment. Paying off this mortgage 10 years ahead of schedule would result in savings of less than $100,000, or about 20% of the loan principal. An argument could be made to pay off such a mortgage later rather than sooner, as one could more easily afford to carry the principal and invest the additional funds elsewhere. Meanwhile, inflation will tend to reduce the real value of the loan principal over the 30 year period.
Owners of real estate, including home owners, are able to access the equity in their property in several ways, including reverse mortgages, liquidation of the underlying real asset, and using the property as collateral for a loan. A home equity line of credit or loan is a way to use the equity in a piece of real estate as collateral for a loan or line of credit. The loan or line of credit places a lien on the real estate that is used as collateral, which has the effect of reducing the amount of equity in the real property. Here we will discuss the situation where a homeowner uses their primary residence as the collateral for this credit. In this scenario, the interest on the loan or line of credit is typically tax deductible.
Home equity loan versus line of credit
A home equity line of credit (frequently known as “HELOC”) is a facility which can be accessed or drawn upon by the borrower. Funds can be drawn during the draw period, and the payment amount during the draw period is usually based upon the amount drawn and the interest rate on the loan. Oftentimes it is only required to make interest payments during this period, and in some situations no payment is required. The length and terms of the draw period vary. Once the draw period ends, the repayment period usually begins, and the required payments during the repayment period are typically higher than during the draw period. In some cases, a single lump sum payment, known as a “balloon payment”, is due at the end of the draw period, which can expose the borrower to significant risk. Interest rates on a HELOC are usually variable.
A home equity loan is a lump sum loan amount, secured by the equity in the home, which must be paid according to a fixed term or schedule. Unlike with a HELOC, which usually has a variable interest rate, the interest rate on a home equity loan is typically fixed.
Any home equity loan or line of credit contract or agreement should be understood carefully and in detail before executing or signing. Careful attention should be paid to interest rates and repayment periods and terms. Keep in mind that you typically have the right to cancel any home equity loan or line of credit contract within three days of signing.
Assets held overseas or denominated in a foreign currency can expose your investment portfolio and assets to currency risk. Here we will discuss the risks associated with holding stocks, bonds, real assets and cash denominated in a foreign currency, and options for mitigating this risk via hedging. Overall we believe that hedging as an investment strategy is an expense which will have the net effect of reducing the return of the portfolio over time.
Currency risk of stocks and bonds
The effect which exchange rate risk has on overseas assets such as stocks and bonds is a very complex subject. The performance of the foreign business issuing the securities is effected by currency risk due to its inventory, receivables, and other assets being denominated in the country’s currency. When stocks or bonds are issued and denominated in a foreign currency, they typically pay interest or dividends in that currency. The investor is therefore exposed to currency risk in a variety of ways.
A portion of these currency risks can be hedged using currency futures, however keep in mind that there are inherent costs associated with hedging. Additionally, there may be an underlying need to own assets denominated in the currency of another country, as discussed more below.
Currency risk of real assets
There may be an underlying need to hold assets in a foreign country, and real assets held overseas, such as real estate and commodities, can serve as both a currency hedge and an inflation hedge. An instance of this is where real property is held in a country to which the holder of the asset intends to return to at a future date, for example to retire.
Rental real estate can be an excellent investment. Real property offers a significant opportunity to obtain income and capital appreciation for an investor. It also has many advantages to an investor from a tax perspective. These advantages include the ability to exchange property on a tax deferred basis, as well as the ability to write off numerous expenses associated with the property, including depreciation and depletion of the underlying assets.
Investment property can qualify for a “like kind exchange” which is known as a section 1031 exchange. Under a section 1031 exchange, the investor can defer gains on the property as long as the proceeds from the real estate sale are re-invested in another property. Certain requirements must be met, including the identification of a replacement property and subsequent closing on that property within certain time frames, as well as the use of a qualified intermediary to transfer the funds from one property to another. It is important that such an exchange be done in consultation with the appropriate advisers as the rules are complex.
Deduction of investment expenses
In addition to expenses associated with operating the real property including contractor and employee expenses, real estate taxes, utilities, repair costs, and travel related to running and managing the property, real estate investors can also deduct depreciation of the property and of many of the fixtures inside the property. There are certain IRS conventions which are used to depreciate property, including the accelerated cost recovery system (“ACRS”) as well as the modified cost recovery system (“MACRS”). Under these systems the depreciation is calculated based upon the current basis in the property as well as the number of years remaining in the cost recovery period. A unique feature of deducting depreciation expenses is that the cash flow of the property is not affected. In certain situations an investor can operate a property which has positive cash flow but which shows a loss on the income statement, resulting in a tax advantage.
Owning versus renting: which is better? We will provide a basic comparison between owning and renting a home. Oftentimes a home is thought of as an investment, however we believe that it is more of a consumption item than an investment item, with the added benefit of serving as an inflation hedge for the owner.
As an example of this, consider a 30 year fixed mortgage note which is paid exactly as agreed. Over this 30 year period, rents and wages will rise, however the mortgage payment will remain constant. There may be times when housing prices rise at a substantial rate however research has shown that in the long run housing has merely kept pace with inflation since 1890.
A large part of this is due to the large transaction costs incurred during purchase and sale of real estate. These costs are much higher for a typical consumer purchasing a home than they are for typical professional real estate investors, who purchase real estate regularly and thus enjoy an economy of scale due to their expertise and the volume of transactions which they engage in. Owning a home also results in additional time which must be spent by the homeowner in maintaining the home, while renting will typically require less time and expense on maintenance.
For many individuals and families the purchase of a home is the largest purchase they will make in their lifetime, and determining how much to spend is therefore very important. How much of a house you can afford will depend on the amount of your income as well as the stability of your income. The lender or originator of the mortgage will be happy to tell you how much home you can afford according to their standards, but these standards are designed to manage their risk, not yours. Although oftentimes your interests happen to be aligned, it is important to do your own careful analysis of your financial situation before purchasing a home. In this article we will discuss ways to determine how much home you can purchase using an analysis of your income, cash flow, assets and liabilities, and financial objectives and goals.
Bank/lender underwriting standards
The bank, lender or originator of the mortgage has certain guidelines which they use to determine whether or not you meet their criteria. The two most important metrics which they use are the “front end ratio”, which is designed to measure the house payment in relation to your gross income, and the “back-end ratio”, which is designed to measure your total long term liabilities in relation to your gross income. Other factors are used as well, but these two metrics are the ones which are most easily quantifiable. A standard which is frequently used for a good credit score is a 28% front-end ratio and a 38% back-end ratio. In other words, if your gross monthly income is $10,000 your principal, interest, taxes and insurance can not exceed $2,800 per month. Similarly, your principal, interest, taxes, insurance, installment loan payments, credit card payments, and student loan payments combined can not exceed $3,800 per month. Note that loans which are scheduled to be paid off within the next 12 months are considered a current, not long term liability and are thus not included when calculating the back-end ratio.
A self directed IRA allows an investor to invest in real estate in an IRA account. The IRS code restricts investments in IRA accounts, and certain investments are prohibited (such as art, antiques, S-corp stock, life insurance, and collectibles). Investment real estate is allowed, however, as long as the participant is not benefiting from the real estate in any way. In order to qualify under IRS rules the participant may not use the property in any manner, or receive rental income from the property outside of the IRA.
To invest in real estate, typically the IRA participant must designate a financial institution, in the majority of cases a trust company, as the trustee and custodian of the self directed IRA account. The IRA participant can then direct the trustee to purchase real estate for the IRA. All real estate expenses must be paid from the IRA account, and all income from the real estate must be paid directly back into the IRA account.
As long as the self directed IRA is set up correctly and is compliant with IRS rules, the IRA participant is able to enjoy the tax advantages of the IRA. This includes tax deferral of both the income received from the property as well as capital gains received when the property is sold. In the case of a ROTH IRA, the participant is also entitles to receive tax free withdrawals, assuming that the normal requirements are met.
Selling your home will not necessarily have an adverse impact as relates to taxes. When you sell real estate, you are usually subject to capital gains taxes unless you perform a “like kind exchange”, or section 1031 exchange, or reinvestment of the proceeds into another piece of real property. A 1031 exchange is limited to investment property, however, for which a primary residence typically does not qualify.
There is, however an exception, or exclusion, in the case where you sell your primary residence (up to $250,000 if you are filing single or head of household or $500,000 if married filing jointly). In order to qualify for this exclusion, you must meet certain criteria. Firstly, you must have owned the home and used it as your primary residence in 2 of the 5 years prior to sale. Secondly, you must not have acquired the home through a like kind, or section 1031, exchange during the five years prior to the sale. Thirdly, you must not have excluded the sale of a home during the 2 years prior to the sale of the home which you now want to exclude. If these three criteria are met you can exclude $250,000 in figuring the capital gains taxon the home ($500,000 if married filing jointly).