We’ve covered alternatives to REITs funds: dropping them, subbing in SC Value or Utilities ETFs, and choosing individual REITs instead. But what if we think outside of equities to replace REITs? A new generation of fin-tech intermediaries show some promise. How might these work in a RP portfolio?
My initial decision to invest in REITs, back in those days where I was just figuring out what investing was, came about when I jumped at the mention of “real estate.” As I learned more, I saw REITs as a way to gain access to this differently behaving (yet still lucrative) asset class while maintaining the liquidity and convenience of mutual funds, and then ETFs. We hear lots about the need for different asset streams, and we know that the housing market has its own logic and rhythm, so surely REITs must be good, right?
As we have looked at in the first installment, though, the connection between REITs and real estate is more complicated than it would seem. Yes, REITs are connected to actual properties, but what we mean by that is extremely varied. VNQ has some companies that seem perfect fits, and others that could just as easily be in another sector (AMT manages cell phone towers, for example, so why is it real estate and not communications?). It also leaves off a lot of companies that would seem to be perfect fits, like homebuilders, and the real distinction regards the tax treatment that the businesses want to have. Real Estate is a wide field; REITs are just one element of it, united by a particular tax law.
If you’re looking at REITs to gain access to the broad real estate field, then, REITs are an option, but other investment vehicles have an even great claim on the asset class. In this post, I’ll review some of those. Again, these aren’t necessarily for everybody, and I don’t mean that REITs are a negative asset or a blight in your portfolio - I’m just trying to get at the bottom of better portfolio construction, and there are no sacred cows on this quest.
The amount of control and oversight the investor has is a good way to divide up the world of real estate investing. Direct real estate investing is when you have maximum control but also maximum time requirement - you buy an investment property, collect the rents, fix the plumbing, the whole shebang. “Mostly direct” is what I call it when you hire a property manager to do the day-to-day work of renting it out. On the other side of the spectrum is indirect, in the form of REITs or real estate-related equities in which you buy shares, collect dividends, and sell on an exchange. Less control, but also way less oversight needed.
Then right in the middle you have semi-direct, offering you a little of both extremes. You can pick your property, but at the same time, management is baked in, making these pretty hands-off once you get them. Broadly speaking, semi-direct real estate investing includes syndication deals, “hard money” private lending, and a new genre of tech-based financial companies that are making the process more convenient and accessible to DIY investors.
Speaking as a group, the main risk to these is illiquidity - the fact that you just can’t get your money out when you need it. This affects direct real estate, as well, but at least with that, you generally can sell a property at some price, no matter how low or how inconvenient. In some cases of semi-direct real estate, there is a lock-up period where you literally CANNOT access your funds for one, two, or maybe even five years. In other cases, you are making loans that may have a scheduled maturity date, but there is little you can do before then or in the case that the borrower is late on their payments. As you think about alternatives to REITs, this illiquidity is a major thing to consider, and if it is a deal breaker, perhaps you’d be better off with REIT alternative #1 or #2.
Another consideration is that these semi-direct real estate investments rest a bit upon an illusion. If you have them in a portfolio, they will certainly seem non-correlated in the sense that the ups and downs of the stock, bond, or commodities markets will have little impact on the money coming into your bank account. But that’s really more of how they are perceived by the investor, since we don’t really know how volatile or how correlated they actually are. The trick is that their prices are not marked to market - you don’t get a sense of how they are doing on a daily, monthly, or maybe even annual basis (while I disagree with a lot in this article, here is a good explanation of why we shouldn’t confuse illiquidity with stability or non-correlation).
Here, then, are some ways to invest semi-directly in real estate:
(full disclosure: this is a referral link. If you sign-up and then fund an account, you’ll get a $50 credit and I’ll get a $50 credit. Please read the disclaimer at the end for more info).
I can speak to this directly, as I started an account earlier this year and have been monitoring it closely (strictly small stakes, for the record). Groundfloor is a fin-tech take on private lending, or “hard money” loans, made to individual real estate investors who either can’t or don’t want to seek out traditional mortgage funding. These loans can be for a variety of things: new construction, cash-out refinancing, rehabs, and especially, “purchase and renovation,” or flipping. The property markets are all over the US, but focused in the Southeast. They are secured loans, meaning Groundfloor takes a lien on the property (and will take ownership and sell if the borrower doesn’t pay it back).
On the plus side, the website is easy to use and provides details on individual properties and borrowers if you want to take a fine-grained look. The entities you invest in are called LROs, or “limited recourse obligations.” There is also an A through F grading system that gives you a quick assessment of the quality of the borrower and the loan based on loan-to-value, location, borrower’s history and a few other factors. Grade A loans are deemed the safest, and typically return 5.5 or 6%. Grade F loans are riskiest and can pay back around 15%, though honestly, I rarely see these on offer (maybe because people snap them up immediately?). Minimum amounts per loan are very low, just $10, which is handy for increasing the variety of your lending portfolio (notice I didn’t say diversification!) since you can fund dozens of LROs at once if you wish.
I generally use their grading system to target Grade B or C loans, which can range from 8 to 12%. Loans are also differentiated by their term, with 3 months or so being the near end and about 18 months being the far end. Here is an example:
So far, my experience has been good, and I have enjoyed receiving my small interest payments regardless of what market news I read or hear. For all their LROs (as of their May 2022 analysis), Groundfloor reported that:
I haven’t experienced any loss, though I have experienced delays, which is when borrowers extend the length of their loan beyond the original term. Interest is still being charged and added to the balloon payment borrowers make at the end, but are these extensions a sign that the loans won’t be paid back in full? That hasn’t happened yet, but yes, extensions could be a sign of trouble. Another element giving me pause is that during Groundfloor’s existence, the American real estate market has been quite strong and mortgage rates quite low, except for a stretch in Q1 and Q2 of 2022. It remains to be seen what the effect of a large-scale downturn might be, though I suspect this would mean more that loan opportunities would dry up, but defaults are always a possibility that should not be ignored.
(once again, a referral link that you would benefit from, if you were going to sign up anyway. We’d both get $50 credits. See my disclaimer below).
I just signed up for this in the past week, after thinking about doing so for months. This is a crowdfunding real estate site that allows non-accredited investors to essentially take part essentially in syndication deals - you invest some of the funds towards purchase of rental or commercial properties, and then receive a pro rata share of income generated through management of the property or the sale. Available properties are pretty diverse, everything from stand alone single-family rentals to apartment complexes to mini-malls to warehouses. Here are some examples:
Those individual properties are accessible to the investor once they get to the “core account level” by investing $5,000. At lower levels of investment, Fundrise is…well… a private REIT! It’s the Fundrise Flagship Real Estate Fund and currently holds 60 Fundrise properties within it. Its benefits and demerits would be those of REITs, though if there’s one small thing I like, it's that it is currently not generating much dividend income, just 1.11%. I’m still at the lower level, but will work up to core level and report back on how it does.
Since it is so early, I don’t have a great sense of the site or how it actually performs as an investment beyond the advertising.of how it is supposed to work and its reporting on returns. I did find a handy chart comparing Fundrise investing accounts with public REITs and with the S&P 500. Fundrise’s return has sometimes exceeded those, and sometimes lagged, but the noticeable thing is how divergent they are. Again, that’s not really non-correlation, though it may seem like it:
- For non-accredited investors, these types of semi-direct real estate investments are often lumped together as “crowdfunding” real estate. Some others in this genre are DiversyFund and PeerStreet. Here is a good article exploring some of these.
- I took a look at Landa, which promises a way to invest in small shares of individual properties, but it seems a little too small to get off the ground.
- In a sense, though, these are just the tech-enabled iterations of real estate investments that have been around for a long time. Groundfloor is just a new type of “hard money” or private lending, and you can find out more by Googling those terms (or else bridge loans), and since these are often limited geographically, the state you live in. Fundwise is a new version of syndication, and again, it’s a good idea to put a place where you’re interested in in order to make your search easier.
- If you’re an accredited investor, the universe of possibilities is even larger. I’m intrigued by Acretrader, which connects investors to agricultural properties such as fruit orchards, soybean farms, and timberland. Acretrader claims an average return of 11% for the farms it lists, and it certainly would seem logical that those returns are uncorrelated with other elements of your portfolio. Cadre seems similar, though with commercial properties. Again, only for accredited investors, but this one allows the investor to choose a fund or focus on individual holdings.
- Finally, RoofStock is a way to buy “turn-key” investment properties. You buy an investment property with a property manager (and often a tenant) already in place. This is probably the closest thing to direct real estate investing that you can do over the internet.
To wrap-up, I’m not necessarily saying these are better for a RP portfolio than REITs would be. They all have their individual risks, and as high dividend payers, they would certainly not be very tax-efficient. I, for one, don’t need the income right now, so I’d only be looking at these as possibilities for a later life stage. All of these here are illiquid investments, as well, so I don’t think I’d ever make my allocation to them too large.
But, if you’ve been in REITs because you wanted exposure to the real estate market, I would argue that these actually do that, whereas with REITs the connection is fuzzy. Groundfloor and Fundrise offer returns that have outpaced VNQ recently (can’t say if this will continue), and as long as you can be patient, have provided steady returns to supplement the mark-to-market “volatility” of ETFs. Finally, if you’re investing in REITs solely for the dividend income (and are willing to commit your funds for the long term), these could be superior to publicly traded REITs, as well.
My next post will be the last in this series on REITs, and I’ll endeavor to answer the big question: Do REITs belong in your RP portfolio?
No spoilers, but I’m sure you can guess by now!