Real estate investment trusts

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.


Small cap stocks

Small cap stocks are publicly traded equity interests in smaller companies, typically companies with $1 – $5 billion in market capitalization and less.  Unlike most large cap stocks, which include household names such as IBM, Apple and Google, small cap stocks tend to be less well known to the public.  As an asset class, they tend to have more risk and be more volatile than large cap stocks.  This is mostly due to the fact that smaller firms have less access to capital and are less diversified in their operations than larger firms.

Historically small cap stocks have, generally speaking, outperformed their larger capitalization counterparts over the long run.  This is due to the fact that small firms oftentimes have a smaller market share, and therefore have more room for growth than larger firms, who may have already captured a large share of the market in which they operate.  As a result, smaller firms are oftentimes able to grow and expand their market share, revenues and earnings at a higher rate than larger firms.

Due to their relatively high volatility and risk, small cap stocks are best suited for investors with longer time horizons and higher risk tolerances.  For the right investor, small cap stocks can play an important and valuable role in his or her overall asset allocation.  By combining them with other asset classes such as domestic large cap stocks, international stocks and fixed income instruments, the portfolio can be tailored to the risk tolerance and time horizon of the investor.

Closed end funds

Closed end funds are, as discussed previously, mutual fund shares which trade on an exchange much like a stock.  Like open end funds, they are registered as investment companies under the Investment Company Act of 1940 and are highly regulated.  Unlike open end funds, which are priced at the end of the day and valued based upon the holdings in the fund, the market price of a closed end fund is determined by supply and demand for the fund on an exchange.

This results in a closed end fund having a market price which can at times vary significantly from its net asset value.  As discussed previously, this discrepancy can create an opportunity for an investor to buy fund shares at a discount to net asset value and sell fund shares at a premium to net asset value.

Closed end fund shares are issued once during an initial public offering, after which point shares can only be obtained by purchasing them from other shareholders.  This is on contrast to an open end fund, whose operators have the ability to create and redeem shares in reaction to capital flowing in and out of the fund.

Closed end funds tend to be capitalized in the $100 million to $1 billion range, which is much smaller than the typical open end fund, which oftentimes has a market capitalization exceeding $10 billion.  Closed end funds oftentimes employ leverage to boost returns, and frequently pay dividends and interest exceeding 6% per annum.



Large cap stocks

Large cap stocks represent publicly traded equity interest in the largest corporations in the economy, typically in the $10’s of billions and higher.  They tend to be well known companies and are usually household names.  Large cap stocks tend to be less volatile and risky than small cap stocks but typically offer less opportunity for growth and appreciation.

The shares of large cap companies tend to trade frequently and be more liquid than shares of small cap companies, which oftentimes do not trade as frequently and can be less liquid.

Large cap companies tend to be very established in their line(s) of business and highly diversified in their operations. Many large companies are known as “blue chip” companies due to their high level of quality.  The advantage which such companies have is that they tend to be less risky and more stable than smaller companies due to their breadth, size, and access to capital. The main disadvantage which these companies have is that they are unable to grow their revenues and earnings as rapidly as small companies.

As an investor, having a portfolio which is diversified across many different asset classes is a good strategy to manage the risk of your portfolio.  By combining large cap stocks with other asset classes such as small cap stocks, international stocks and bonds an investor can tailor their portfolio to their needs.


Tax advantages of rental real estate

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.

Tax deferral

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.



The Intelligent Investor by Benjamin Graham

There are several excellent books in print which were written by extremely successful money managers, and “The Intelligent Investor” by Benjamin Graham is one of them (“The Alchemy of Finance” by George Soros is another one).  Graham was Warren Buffett’s teacher and mentor and ran the Graham Newman investment partnership in the first part of the 20th century.  This book outlines Graham’s philosophy of value investing.  The book is relatively easy to understand for a lay person, and outlines in detail the underlying principals behind Graham’s investment philosophy and how it can be applied to analyzing and valuing individual securities.