In 2008, the collapse of the overheated real estate market nearly toppled the global economy. Four years later, real estate as an asset class is rebuilding its image by providing much needed stability and diversity for investors. With low property prices, cheap financing and yields that are better than most bonds, the attractions are many, despite the inherent downsides.
"If you remember where yields were four or five years ago, you didn't have to go to real estate for a reasonable return," says Peter Boyle, principal and chief investment officer of Clifford Swan Investment Counsel in Pasadena, Calif. Like many other planners, Boyle is adding real estate to his clients' portfolios.
Most are using public REITs, mutual funds or, in some cases, mortgage-backed securities. But some are also investing directly via nonpublic REITs, limited partnerships or mortgage pools. Some advisors are also urging clients to buy properties outright. Even the structural problems of direct property ownership - illiquidity and management costs - can be outweighed by overall yields, compared with other investments. A strong rental market is providing steady "dividend" income.
"This is a very good time to be buying real estate," says Brian Parker, co-founder of EP Wealth Advisors in Torrance, Calif. "About 15% to 20% of our clients have done some sort of real estate transaction recently. In most cases, I think they have made good investment decisions."
Financial Planning spoke with planners across the country to gauge how their real estate investing strategies have changed - or not - in the past several years. We discovered a greater willingness to embrace real estate as an investment option among planners who historically had considered it outside their expertise.
There are plenty of challenges to this strategy. Planners can take a hit when their clients choose to buy real estate directly. "It's hard to figure out how to get paid," Boyle points out. "We charge a percentage of assets under management and it's hard to get a percentage of zero." Even worse, many clients have ruined themselves in this recent real estate bust.
One client who inherited $2.5 million from her grandmother's estate invested it all into a single home near the top of the real estate bubble.
"I tried to explain to her that she would pay $200,000 in fees and commissions," says the woman's planner. "I was shocked that she wanted to do it."
The woman, the planner presumes, probably lost heavily in the dramatic slide of home values. He doesn't know for sure because, with none of her assets remaining for him to manage after the purchase, he lost her as a client before the bust.
Yesterday's trials and changing global markets have helped to lay fertile ground for real estate investors in the post-bust era. The allure of real estate's noncorrelated returns to the stock market have inspired some planners to look hard for unique opportunities.
INVESTING AND HELPING
Last year, John Bailey, founder and CEO of Spruce Private Investors in Stamford, Conn., took 15 clients and prospective clients on a trip to view real estate in Brazil. The group, which included heads of large families and a few foundations, surveyed several residential apartment developments in Sao Paolo and Rio de Janeiro that were valued at up to $100 million. Units in the properties, marketed to Brazil's emerging middle class, were expected to sell for as much as $100,000.
The group explored the local political and cultural landscape. They visited Vik Muniz, one of Brazil's most famous artists who sources materials from one of the world's largest landfills. Proceeds from his art sales are distributed to residents of the landfill who survive by combing through trash, looking for sellable recyclables.
"There were people in tears," Bailey says, referring to the trip attendees. "It put a face to the challenges of poverty that many people in Brazil are facing. We don't [travel] just to see good investments. We want people to have life experiences. We don't want them to think of their investments as black lines on a document. We did [the trip] because we wanted people to understand the variety of aspects of the culture, as well as the risk."
Bailey is betting that the Brazilian real estate investments will generate hefty returns while fueling social progress. As Brazil's leaders try to integrate the residents of the favelas, or slums, into the civic fabric, affordable housing will be a vital part of the solution, he says. "Many of our clients feel good that they are contributing to the build-out of the middle class in Brazil," Bailey says.
Investing in private equity partnerships with direct on-site research into properties is a cornerstone of Spruce's approach to real estate. The firm doesn't use REITs because, Bailey says, he regards them as real estate-related equities, making them overly correlated to stock market swings.
As the global economy continues its recovery, Bailey sees plenty of opportunities to invest in distressed properties in the U.S. and Europe. "We think that between spin-off situations, between asset sales and between collateralized mortgages, you will be able to buy very attractive assets at attractive valuations," he says. "The trick is to come into these assets with unencumbered capital."
Eric Bruck, principal of Silver Oak Wealth Advisors in Los Angeles, doesn't claim to be a real estate expert. Yet he agrees with Bailey that distressed debt has merit. "It's somebody else's problem that we see as something to capitalize on," he adds.
Bruck has invested his clients in two real estate investment companies. One, he says, has run a nontraded REIT that produced roughly a 7.5% return, fully sheltered from taxes, since last year. Recently, it went public and provided an additional bump in valuation. Bruck says now he is investing in the same company's next nonpublic REIT, which focuses on the health care sector. His second real estate investment is a mortgage pool Bruck discovered in 2003. He remained invested in it - before, during and after the real estate bubble burst.
"It's a private bridge loan mortgage pool," Bruck says, which provides close to zero correlation to the stock market. "These are first position, 12- to 18-month loans, with most durations typically a lot less than 18 months. They are what I call a soft-hard moneylender. The credit requirements are higher so their rates are lower and their positioning is much more disciplined. They won't take anything but a first position. If there is a first in place, then they will get it to move to second position and guarantee the debt service on the first in order to make the loan."
Unlike REITs, the mortgage pool is taxable, so Bruck uses it mainly in his clients' retirement plans. "Although in some cases, because the yield right now at 8% is higher than in taxable bonds, it can make sense to use it in taxable portfolios," he says.
Silver Oak's path to the mortgage pool began with a client who wanted to invest. "My knee jerk reaction was, 'That's the kiss of death; don't go near it,'" Bruck recalls thinking at the time. But after investigating on the client's behalf, Bruck and his partner decided to invest with other clients' money. Because the pool is based near Silver Oak's offices, Bruck says, they've had breakfast together with the pool principals each quarter for nine years.
"They've been very smart,'' Bruck says. "No single loan is more than 1% to 1.5% of their entire pool, so the diversification has been excellent. Whatever defaults they have has been made up out of their cash flow.'' Those benefits are "the kind of thing we are looking for in this environment."
Of the $120 million in assets Silver Oak manages, up to 15% is in the pool at any one time. Initially comprised of commercial real estate, the pool began to move into residential real estate as well after the crash, he says. These days, it is adding distressed properties. Returns have ranged from 6.5% at the low point to more than 9% in the early 2000s. While there were defaults from 2007 to 2009, the losses have never exceeded the managers' ability to use cash flow to cover them, Bruck says. "They've managed to keep it whole and strong," he says.
Although there are risks to investing directly in mortgage pools and non-public REITs, Bruck says, he prefers that strategy to trusting assets to some of the huge public REITs. "The lessons of the 1980s were these huge public programs that sold through B-Ds," he says. "They were black boxes. The general partners had all the control. The fees were high. If it's not simple enough for me to understand, for a client to understand I'm not going to go near it."
By contrast, the due diligence in his mortgage pool "ran circles around what the banks were doing," he says. "And some of these borrowers could not get qualified with the banks."
THE BANE OF BAD LOANS
Some clients found themselves on the wrong side of the real estate crash. Parker, the advisor in Torrance, Calif., says some of his clients bought California vacation homes near Mammoth Lakes or in the desert near Palm Springs. Joe Graziano, a partner at FFP Wealth Management in Bayonne, N.J., says up to 10% of his clients bought second homes in Florida at the market's peak.
"Granted there are tax advantages to doing this,'' he says, "but, in essence, they are throwing more money into these investments." With losses mounting as high as $300,000 on the Florida homes, clients continue to pay up to $60,000 a year to cover the loans, he says. Out of a sense of obligation - and out of fear of ruining their credit - not one of them has handed keys to the bank or sought a short sale, Graziano says.
Parker sees the same determination. "I've actually been surprised how many clients regard it as a moral obligation,'' he says. "They say, 'It's not in my makeup to do anything other than pay back what I've borrowed.'"
Some underwater clients have found ways to breathe. Graziano says that one client bought a property for $220,000 at the top of the market, before the value dropped to $120,000. With a 7.5% interest-only loan and a balance of $168,000, the client was paying $1,800 a month on the loan, more than he could afford, Graziano says.
Help arrived in the mail. Although the client had unsuccessfully sought a loan modification once, Chase, which holds the property note, suddenly offered a 15-year, fully amortized loan at 4.65%. The client's new monthly payment dropped to $1,300, below the amount of the rental income, Graziano says. "He's still underwater for what he owes," Graziano says, "but at least if the market goes up and there's a crossover, there's an exit."
Obviously, his client is delighted. A Chase spokeswoman says the modification probably came through the federal Home Affordable Mortgage Program. The spokeswoman says the bank may solicit prospective participants for the program or a borrower can request it. She did not respond to questions asking why the bank initially turned the client away when he requested a modified loan. Graziano say he plans to tell other clients about the program.
Real estate appeals because of its bondlike income stream from rents and its stocklike appreciation over time. The original idea behind REITs was to help more Main Street investors access these qualities, plus liquidity, via large-scale, institutional real estate investments, says Rick Romano, a principal and REITs portfolio manager at Prudential Real Estate Investors. Prudential sells three REIT mutual funds. "You have some of the biggest trophy buildings across the globe owned by REITs," Romano says.
The maturation of the REIT market during the past 40 years has brought down returns, says Tim Courtney, chief investment officer for Exencial Wealth Advisors in Oklahoma City. "When the REIT market was still in its infancy," Courtney says, "there were no REIT indexes that you could go by, which is why there were some outsize returns."
A decade ago, it was difficult to invest in buckets of commodities, he says, and that lack of access drove up yields. In the 2000s, he says, REITs as a class produced a 12% annualized return, whereas the S&P 500 produced up to 2%.
He says he doesn't envision those returns in the near future. "We think that, going forward, it's unlikely there will be the kind of low, double-digit returns that we had with REITs because there's a lot of liquidity in the market," Courtney explains. "We would guess that REITs would probably generate returns somewhere between stocks and bonds. We feel that's where they should be risk/return-wise. It's a logical place for them to land, in terms of expected returns."
For now, Courtney believes that domestic REITs look fairly valued, a view that is largely shared by Romano, who adds that public REITs are trading near net asset value. "You are getting what you are paying for," Courtney says. "They are probably yielding a little less than 3.5% to 4% in rent pass-through as dividend and trading at about two times their book value. Those are probably fair prices. I wouldn't say they are really cheap or really expensive." REITs are required to distribute or "pass-through" 90% of their rents as dividend payments to be classified as REITs.
By contrast, Courtney thinks that international REITs may offer a better deal, with pass-through yields as much as 6%. The international real estate market has higher risks that can drive higher returns. "They look very attractive relative to the pricing," he says.
For his firm's clients, Courtney relies on index funds that buy pieces of all the approximately 200 REITs in the global market. He uses Dimensional Fund Advisors, an Austin, Texas-based firm started by University of Chicago academics.
Dimensional employs a passive approach, although the firm adjusts for momentum. If an investment starts to underperform or outperform, it may continue to do so for a few quarters. "The saying is, 'You don't want to catch a falling knife,'" Courtney says. The company charges 17 basis points for its U.S. funds and 40 to 50 basis points for its international funds.
Given the drop in overall REIT performance, Courtney says, his firm is slightly underweighted to REITs with about 5% of clients' assets invested. Not surprisingly, Romano sees economic trends that he believes will boost the performance of REITs overall.
"If you look at commercial real estate in particular, not a lot has been built," Romano says. "One of the benefits of the credit crisis is that supply is at historically low levels. ... If that continues, we'll see demand [for real estate and REITs] pick up."
He points to the marked increase in rental prices as evidence. "If you look at their access and cost to capital," Romano notes, "the equity market is open to them and that capital can be deployed by buying new assets on an accretive basis. We think the potential to grow is pretty visible and pretty strong right now."
Time will tell if he's right. "What does the future look like?" Boyle asks. "I argue that it can't possibly have the run it's just had but, given my youth, perhaps I will be surprised."