Welcome back! As we’re finishing up our discussion of alternative investments, it is essential to discuss real estate. When speaking of real estate as an investment, most conjure up the image of a wealthy real estate mogul purchasing many properties, both residential and commercial, and turning a large profit.
While that is certainly a possibility, there are several other ways to invest in real estate without having access to extensive wealth. Today, I will introduce you to the different means in which investors can capitalize on real estate investments.
This is the most obvious method: The investor purchases a tangible property to sell it at a profit over the span of several years. It is both costly in transactions fees (legal, mortgage, etc.) and requires a hefty investment or credit prerequisites. In addition, managing the property and the tenants can require physical effort and time.
Real Estate Investment Trusts
REITs are publicly traded funds that allow you to invest a smaller amount and to buy a fund of pooled income-producing real estate properties. The REIT company purchases, operates, and manages said properties. This is referred to as an indirect real estate investment, since you do not have physical access to the properties in which you invested. To paint a clearer picture, here is a breakdown of how a REIT would work:
• A real estate investment trust, which operates as a corporation, purchases several real estate properties, whether commercial or residential.
• They rent out those properties and generate income from said properties.
• They create shares of the corporation.
• The investors buy the shares.
MBS are investments in a pool of debt used to purchase properties. Individual investors who purchase properties tend to obtain mortgage financing from their banks. The banks generate their loans through creating mortgage-backed funds, which allow individual investors to raise funds for said loans. This creates an opportunity for investors to have access to the real estate market through indirect debt. Here is an example to demonstrate how and why MBS are created.
1. Alice needs to buy a house and decides to get a mortgage from bank XYZ.
2. The bank agrees to give Alice a mortgage after assessing her credit and home.
3. The bank creates a loan for Alice (a mortgage) and adds it to a pool of other mortgages from individuals that have a similar credit rating.
4. The bank then sells shares (MBS) of this pool to investors.
5. As Alice pays off her mortgage over the years, the payments go to this pool to pay back the investors. A small percentage of this payment goes toward the bank for administering the loan.
There are different levels of risk for MBS, and they are classified based on the default rates, the years to maturity of debt, and credit ratings of different mortgages.
Direct investments in property, REITs, and MBS are the main ways for investors to have a piece of the real estate market pie. MBS and REITs are more accessible, highly liquid, and have low transaction fees but may generate lower returns than direct investments in an income-producing property or a home.
As we now finish off our discussion of alternative instruments, this brings us to the last day of our course. Tomorrow, we’ll have a look at rules of thumb for investors and common pitfalls to avoid.
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