Alternative Real Estate Investments

Most people invest in real estate by buying rental properties, but many people would like to invest in real estate without dealing with tenants or property management. Many investors want to diversify their holdings into real estate, but they either do not have the expertise of investing in real estate or they do not want to bother with the active management of such investments. There are a number of such real estate investments. The primary passive real estate investment is real estate investment trusts, usually shortened to REITs. REITs generally yield high dividends, since they can maintain tax efficiency by distributing at least 90% of their income. Other passive investments in real estate's include tax liens and deeds, tenants in common, triple net leases, notes and trust deeds, and limited partnerships.

Real Estate Investment Trusts

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Real estate investment trusts (REITs) are funds that invest in various types of properties, such as residential units, office buildings, warehouses, shopping centers, hotels, student housing, medical facilities, self-storage, and even cell towers. REITs that own property are known as equity REITs. Mortgage rates are another form of REIT, which profit either by lending directly for mortgages, or indirectly by buying securitized mortgages such as mortgage-backed securities.

There are also public and private REITs. Public REITs trade like stock on exchanges, thus providing a liquid investment. Public REITs also have a Board of Directors, most of whom must be independent of management and, like corporations, they are elected by the shareholders. Public REITs must also file comprehensive financial reports, just like public companies. Private REITs are restricted to sophisticated investors, since they are not regulated like public REITs, with the result that they are riskier investments. There are also public non-listed REITs that do not trade on an exchange. Such REITs should be avoided, since investors generally pay high fees, including sales commissions of 10% or greater when buying into the investment.

REITs that are not publicly traded, including private REITs, are generally formed to enrich the sponsors or the managers of the REITs. Therefore, it would behoove any investor to study this perspective of any REITs being considered.

During the past, REITs have generally performed at least as well as stocks, but with less volatility. Additionally, they pay substantial dividends, allowing investors to weather downturns in the market. However, the dividends that are paid by REITs are fully taxable, since they are not qualified dividends that receive favorable tax treatment. Therefore, many investors hold REITs in retirement accounts.

Although REITs are corporations, their dividends are not subject to double taxation, since the company does not have to pay any taxes on its income if at least 95% of it is distributed to shareholders.

There are several ways to invest in REITs. REITs can be individually purchased, just like stocks in particular companies. However, a safer and less volatile investment can be obtained by investing in mutual funds or exchange traded funds that hold REITs. REITs, including mutual fund REITs and exchange-traded funds, can also be bought on margin, which can increase returns, but also increases potential losses.

Tax Liens and Deeds

Investing in tax liens or tax deeds, depending on the state, can be very profitable at low risk. Half the states use the tax lien system and the other half uses tax deeds, giving the local governments a legal interest in the tax delinquent property. Some states allow the sale of both tax liens and tax deeds. Most tax liens and deeds are sold in auctions; unsold inventory is sold over-the-counter.

Tax Liens

The government assesses the tax lien on unpaid taxes on property, which after a certain amount of time becomes a tax certificate that can be sold to investors. A tax lien gives the holder an interest in the property but not ownership. The lienholder earns profits from interest accrued on the tax lien.

A tax lien prevents real estate from being sold, mortgaged, transferred, or refinanced until it is paid in full. Title searches will reveal the presence of the recorded lien so any buyer of the property cannot obtain good title until the lien is paid, including interest and penalties. The county tax assessor or treasurer will still collect the past due taxes on the property, but the money is then sent to the owner of the tax certificate.

The maximum amount of time for the investment to pay off is determined by the statutory redemption period, which varies according to state or locality, from a few months to a few years. Interest rates on the amounts are determined by state law or local statutes, generally ranging from 6 to 24% or higher, depending on the state and locality.

If the tax lien is not paid, then the lien holder can foreclose on the property. Since tax liens have a higher priority than any other type of lien, including a mortgage lien, the lien holder can foreclose on the property.

Tax Deeds

Tax deeds can be more profitable, but only with more research and due diligence. Additionally, there are fewer tax deeds than tax liens.

In tax deed states, the county forecloses on the property and actually owns it. Thus, buying a tax deed is actually buying the property, requiring more money and incurring greater risk than buying tax liens. The deed that is usually obtained from the county is a quitclaim deed, or in some jurisdictions, a sheriff's deed.

With quitclaim deeds and other types of deeds that do not guarantee clear title, the buyer would have to initiate a legal action, known as a quiet title action, where the buyer of the property would go to court to certify that the buyer has title over all others.

The redemption period allows the former owner to pay the taxes to regain ownership of the property, even after the tax deed is sold. The former owner would have to pay back taxes, penalties, and interest to the county treasurer. The property cannot be entered, accessed, or used by the tax deed holder in any way during the redemption period. The owner still owns the property and has all the rights that emanate from that during the redemption period.

California and Texas both allow redemption of property even after a tax deed sale. However, some states, such as Texas, do allow the tax deed holder to collect rents, leases, or any other types of revenue from the property during the redemption period, even if it is later redeemed.

Net Leases

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A net lease is a lease whereby the tenant pays not only the rent, but also some or all of the operating expenses, such as insurance, taxes, maintenance, and repairs. It is referred to as a net lease, because the landlord receives the rent, net of some of or all of the expenses. In some cases, the tenant may also pay for capital improvements. If the tenant pays for all operating expenses, then the lease is often referred to as a triple-net lease (aka net net net lease, NNN lease). Generally, the landlord pays for any repairs to the structural components of the building, such as the foundation, roof or walls, and may repair equipment for heating and air-conditioning, plumbing, electrical, and roadways and parking areas. Net leases are also sometimes referred to as bond leases, because investors of net leases receive income without expenses, just like bonds.

Many net leases are the result of a sale/leaseback arrangement, where the tenant sells a building that it previously owned for additional capital to expand their business or to pay down debt. Triple net leases are frequently for retail locations, such as fast food restaurants.

Hence, a major drawback to investing in net leases is that the value of the investment will be determined by the terms of the lease, which potential investors would have to scrutinize. Investors who are unfamiliar with net leases should consult with an attorney or even have a lease abstract prepared, which summarizes important provisions. The lease should clearly delineate the responsibilities of the landlord and the tenant, since much litigation has arisen from omissions and ambiguities in the lease contract.

Net leases are also subject to significant inflation risk since lease terms can be as long as 50 years with lease rates that are rarely adjusted for inflation. An investor should also consider whether the property could be used as-is for another tenant or whether it can be economically converted to another use to appeal to another tenant, if the current tenant goes bankrupt or becomes insolvent.

Much of the risk of net leases and the due diligence required to lower that risk can be avoided by purchasing REITs that hold triple net properties.

Discounted Paper

To promote property sales, some sellers finance the purchase for the buyer. However, sometimes the seller wants to convert the note to cash, so he will sell the note, sometimes referred to as paper, at a discount to an investor. The seller assigns the mortgage or contract-for-deed to the investor. Offers of discounted paper can be found in classified ads and on the Internet.

Generally, the note investor will pay less than the full amount of the debt. How much less depends on current interest rates. The amount paid for the note is determined by the present value of the cash flows of the mortgage payments, discounted by the interest rate that the note investor is seeking. If interest rates drop, then the note investor can sell the note for a higher price, in the same way that bonds can fetch a higher price when rates drop.

There is also a market for delinquent loans that would allow a note investor to ask for a deed in lieu of foreclosure or to foreclose on the property. Many investors accept a deed in lieu of foreclosure, and allow the original homeowners to remain in the house, paying a lease. If the property does go to foreclosure, then the noteholder can bid on the property to assure that a minimum price is paid. If the noteholder wins the bid, then he can take the property. If a higher bid wins, then a higher profit is earned. In some states, the noteholder can also seek a deficiency judgment, if the amount received at a foreclosure sale was less than the note, plus interest in legal fees.

Due diligence is necessary to profit from discounted paper. The property should be worth more than the note since there is some risk in buying the note. Additionally, potential investors would have to investigate what liens are on the property, especially senior liens, such as for mortgages, property taxes, federal income taxes, and homeowner's association assessments. Additionally, an investor would have to ascertain whether the contracts comply with state and federal laws and determine if the seller disclosed required information.

If the buyer does default, then the noteholder would have to follow the procedures to foreclose on the property, so it would behoove any potential investor to determine the time and cost of foreclosing on the property to ensure that the investment is a good one.

Tenants in Common

Real estate may be owned as a tenancy in common, where multiple owners own and undivided, fractionalized interest in the property. Although tenants in common (TIC) are usually related individuals who have inherited the property, the tenancy in common has also been extended as a type of investment, sold mostly as a private placement investment to high net worth individuals. The investors hold a title deed for an undivided fractional share in a large commercial property, such as regional shopping malls, luxury apartments, and high-rise office buildings.

TIC investments are formed by sponsors as private placement offerings. The minimum investment is usually hundreds of thousands of dollars, though some may offer investments as low as $50,000. TIC properties are managed either by the sponsor or by a property manager selected by the sponsor.

Many syndicators of TIC's buy the property before selling the TIC units, allowing them to sell the total property for more than what the property would fetch at a single price. Sales commissions ranging from 3% to 10% are charged for their sale. Additionally, the TIC sponsor keeps a spread to pay for administration and marketing costs. To entice investors, they may offer a guaranteed distribution rate for the 1st couple of years. Often times, the distribution rate is too high to be sustained by the property, so it declines.

TIC's must follow SEC and tax rules. As a private placement, the number of investors cannot exceed 35, though married couples count as a single investor; each investor shares profits and pays for losses proportional to their investment interest — the TIC sponsor cannot cover any expenses. Additionally, IRS rules require that each tenant in common have voting rights proportionate to their ownership share.

There are several disadvantages of TIC investments. Profits and losses are subject to passive activity rules. Investments are highly illiquid, since they are not publicly traded and must be sold to accredited investors. Even if the TIC investor can find another investor to buy his shares, it will usually involve selling at a steep discount; likewise, if the sponsor buys back the ownership. High operating costs and sales commissions reduce potential returns for a given investment. Many TIC investments have become heavily involved in litigation because of the dissatisfaction of many investors. To sell or borrow against the property, IRS rules require the consent of all owners.

Many TIC holders are using the TIC as a tax-deferred exchange, or a 1031 exchange, to sell or exchange into a larger property. However, such exchanges must be done within narrow time limits to qualify for the tax deferral. Indeed, many investors of TIC's had real estate in which they wanted to make a tax-deferred exchange, but could not find suitable property within the strict time limits, so the TIC was an available solution.

However, to qualify for tax deferral, the property must be exchanged for like-kind property; likewise, the form of ownership must be the same. So if the investor owned real estate directly, then some TIC property may not qualify because they may serve as a security or as a partnership interest in real estate, disqualifying it for the tax deferral. To qualify for the tax deferral, the replacement property must be identified within 45 days after the close of the property being sold; the transaction for the replacement property must be completed within 180 days. TIC sponsors target these groups of investors since they are willing to pay more for the tax deferral.

Investors who perform due diligence for a TIC property should consider the following: who is receiving commissions and how much; how much did the TIC sponsors pay for the property; what are the lease terms of the current tenant occupying the property; does the tenant have an out clause that would allow it to break the lease unilaterally with little or no financial penalty; does the TIC have an advisory firm that supervises the property management company, and does the TIC sponsor have any relationship to the property management company, since having an advisory firm and owning the property management company will result in higher fees. Since this is a passive investment, the TIC investor would have virtually no say in how the property was managed nor would the investor be able to reduce fees.

Notes and Trust Deeds

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Investors can also buy notes and limited partnerships in trust deeds that are secured by real estate. A trust deed is a deed held in trust for the benefit of the lender until the loan is paid off. Banks in many states use trust deeds instead of mortgages. A servicing agent collects the payments from the borrowers and pays the holders of the notes or of the limited partnership units minus a servicing fee. Generally, the borrowers have poor credit, which is why they are not using a bank. Consequently, potential returns are higher, often 10 to 15% + loan fees of 3 to 5 points, which is prepaid interest. Because of the default risk, a conservative loan-to-value ratio is used to determine the maximum loan amount.

An investor can buy a single note or a fractionalized note. The single noteholder receives the monthly loan payments from the servicing agent minus the servicing fees. A fractionalized note represents an undivided interest in a portion of a note that is typically held by 2 to 10 investors; each investor receives a pro rata share of the monthly loan payments.

Investments can also be made in units of a limited partnership holding a pool of trust deeds, lowering risks through diversification over holding notes or fractionalized notes. Income is paid monthly or quarterly by the servicing agent collecting the mortgage payments.

Risks include not only borrower default, but also latent defects with the property or unrecorded tax liens. To reduce risk, the investor should fully investigate the value of the property to ensure that the collateral is sufficient. Also, the investor should select properties that they would be willing to own if the borrower defaults.

Real Estate Syndication

Real estate syndication finances real estate projects by pooling money from many investors. The syndicator or sponsor forms the business entity for the syndication, which can be a corporation, limited liability company, or limited partnership. The syndicator actively manages the business, searching for properties to acquire, performing due diligence, managing the property, and possibly renovating the property. The real estate syndicate generally buys property, acquires a stake in a large project, or provides commercial mortgages. The syndicator receives an equity stake plus a percentage of the net income from the property. The syndicator pays for insurance, taxes, maintenance, and repairs. The other investors, usually limited partners, typically receive 8% to 12% over the life of the syndication plus a certain percentage of the remaining cash flow after the interest that has been paid, yielding a cash-on-cash return greater than the preferred interest rate if the investment is successful.

Cash-On-Cash Return Formula
Cash-On-Cash Return=Net Operating Income – Debt Payments
Equity

The syndicator charges an acquisition fee of 1% to 5% or a flat fee for the purchase of properties and an asset management fee of 1% of gross revenue that covers management of the properties and the syndicate partnership.

As with any other type of pooled fund, investors should perform due diligence on the people who operate the fund or syndicate, including their track record and their equity stake in the fund. Because investment success will depend crucially on the terms of the contract, potential investors should have the contract reviewed by an attorney specializing in real estate. Although real estate syndications are regulated by state and federal laws, there is still a great potential for fraud or mismanagement, as evidenced by the many failures in the past, especially during and after the 2007 - 2009 downturn in the real estate market.