The benefits of adding real estate to your investment portfolio are well-documented. Adding real estate to a portfolio dominated by stocks and bonds improves diversification and reduces risk. Diversification is the result of real estate’s low correlation with stocks and bonds. This was apparent in 2015 when S&P 500 stocks declined 0.73% for the year and bonds returns were a meager 0.3%. Contrast this with commercial real estate, which returned 12.7% in 2015 according to the National Association of Real Estate Investment Fiduciaries (NCREIF). Real estate also provides reliable monthly income from rents or interest payments and an effective hedge against inflation since rents typically rise when interest rates climb. In addition, as a bricks and mortar asset, real estate retains a tangible value regardless of economic cycles.
Investors may gain exposure to real estate by purchasing properties, real estate equities such as REITs or fixed income instruments such as mortgage pool funds. For the average investor, property ownership is usually not the optimal investment. This is due to the fact that real estate transaction costs are high and property management fees can be significant. Buying or selling properties often require input from appraisers, attorneys and tax accountants and deals can take months to close. Rental properties are also costly to operate and require ongoing maintenance.
Unless you plan to care for the property yourself, a property manager must be hired. Management fees can range from 4% to 10% of monthly gross property income. If you decide to manage the property yourself, there are costs associated with your time and efforts.
Due to high purchase costs, most investors can only afford to own a few properties, which concentrate the risk of the investment. A factory closing near your property or a natural disaster such as a flood could destroy your entire investment if the property portfolio isn’t sufficiently diversified.
Real estate markets also tend to be cyclical so there may be long periods when properties produce sub-par returns. High vacancies rates in the area may reduce rents to levels barely above breakeven. Similarly too few potential home buyers may cause home prices to plummet, leaving investors paying a mortgage on a property that is underwater.
By investing in a mortgage pool fund, investors avoid most of the risks associated with property ownership while adding diversification and high risk-adjusted returns to their portfolio. A mortgage pool fund is a group of real estate loans owned collectively by the fund’s investors. In recent years, most mortgage pool funds have delivered 8-10% annual returns for their investors. Compared to property ownership, mortgage pool funds offer the following advantages:
- Superior diversification: Mortgage pool funds own portfolios of real estate loans diversified geographically and by size of the loan and property type, so the risk associated with any one loan is minimal. Most mortgage pool funds have hundreds of mortgage loans or trust deeds in their portfolio. A trust deed is similar to a mortgage, but offered the added benefit to the lender of being able to foreclose on the property without going through the judicial process. There are also other protections inherent to mortgage pool funds that further reduce risk. For example, many mortgage pools restrict their holdings to first lien trust deeds, which have priority over all other claims on the property. Top priority ensures that the first lien holder gets paid first, regardless of other mortgages or liens on the property.
- Professional risk management: Mortgage pool fund managers are experts in asset-based lending. Most managers use a conservative loan-to-value ratio as part of their underwriting criteria to further reduce risk. This ratio measures the loan as a percentage of the property’s resale value. A low loan-to-value ratio provides a safety cushion for investors if the borrower defaults and the property must be foreclosed and sold to pay off the loan. If the value of the property exceeds the loan amount by a significant sum, investors shouldn’t lose money even in the event of a foreclosure. Most mortgage pool funds limit loan-to-value ratios to below 75%. This is much more conservative than many commercial banks, which were lending at loan-to-value ratios as high as 90% prior to the housing market collapse.
- Better liquidity: One of the drawbacks to real estate is that it is an illiquid asset. Selling a property can be an arduous, time-consuming process. Because of a constant flow of capital into the pool, most mortgage pool funds are able to offer better liquidity to their investors. Fund start-ups sometimes have lock-out periods, but established mortgage pool funds generally allow investors to redeem all or a portion of their investment when they choose, rather than forcing them to wait until the pool is liquidated.
- Reliable monthly or quarterly income: Rental properties can sit vacant for months not generating income, but most mortgage pool funds are structured to deliver reliable quarterly or monthly distributions to investors. At present, annualized shareholder returns from the monthly distributions paid by the Socotra Fund exceed 9%. Most mortgage pool funds also give investors the choice to take cash dividends or reinvest dividends back in the pool to grow the investment.
- Demonstrated track record: Property ownership has many risks and uncertainties. With an established mortgage pool fund, investors can eliminate some uncertainty by assessing past financial performance. A $100,000 investment in the Socotra Fund at the fund’s inception in mid-2011 would have been worth $153,748 at year-end 2015. However, investors should note that past results don’t guarantee future performance. One of the reasons that the Socotra Fund is able to generate consistent returns is that the fund is extremely efficient at deploying investor capital. At any given time, 97% or more of investor capital is earning interest.
Property ownerships may appeal to some individuals, but for most investors a mortgage pool fund offers a safer, simpler and more practical way to gain exposure to real estate and collect attractive risk-adjusted returns.