In an investing environment that remains stunted by historically low interest rates and lackluster economic growth, investors must look for income outside the meager yields of stocks and bonds. One asset category where investors are finding predictable income and favorable risk-adjusted returns is real estate. Real estate investments come in many forms, ranging from direct ownership (private real estate and crowd funding) to equity (REITs) to fixed income (mortgage pool funds).
When compared to yields on publicly-traded REITs currently averaging around 4%, both direct real estate ownership and fixed income appear more attractive. Private real estate deals generally produce cash yields exceeding 7% and most mortgage pool funds can consistently deliver 7-10% returns.
REITs trade daily and offer more liquidity than other real estate investments. The trade-off for their higher liquidity, however, is more volatility and the risk of price declines due to short-term developments. Prices aren’t calculated on a daily basis for properties and mortgage pool funds so these investments are more likely to be valued on long-term fundamentals. In addition, predictable cash flow from interest payments, professional management of operating costs and fixed rate loans make returns from these products more stable than other alternative assets. In addition, since returns are generated from income and not reliant on capital gains, investors have greater security of returns, resulting in less stress and worry.
Because of low correlations with stocks and bonds, real estate adds diversification to a portfolio. Property owners may diversify within this asset category by holding multiple property types and markets. Real estate returns are impacted by local market conditions so there are major benefits associated with diversifying beyond the investor’s home market. Mortgage pool funds diversify by holding many loans, spread across different markets and property types. The combination of strong yields and low volatility give private real estate and mortgage pool funds a more appealing risk-return profile than some other alternative assets.
Both mortgage pool funds and private real estate have excellent track records as hedges against inflation. Inflation is modest at present, but changes in monetary policy and efforts by the Trump administration to stimulate GDP growth are likely to make inflation heat up. Real estate stays ahead of inflation due to the ability to raise rents. Although most fixed-income investment cannot keep pace with inflation, mortgage pool funds are an exception. This is due to the short durations of the loans in their portfolios. The loans that mortgage pool funds make to property rehabbers and developers tend to have very short maturities, typically ranging from one to five years. Interest rate risk associated with these loans is minimal since short maturities mean that proceeds are continually being reinvested in new loans at higher interest rates.
While offering some benefits that are similar, there are important areas where private real estate and mortgage pool funds differ. One such area is access. Historically, private real estate deals were available only to larger institutions that had the time and resources to perform due diligence on individual properties. In addition, with purchase minimums exceeding $100,000, few individual investors could afford to own more than one property. In recent years, crowdfunding has helped level the playing field somewhat by lowering investment requirements. However, crowdfunding deals often invest in riskier properties that have already been rejected by institutional investors. Another drawback of crowdfunding is the product’s lack of a multi-year track record, which makes it difficult to detect excessive management costs, poor underwriting or overpriced assets.
An important advantage of mortgage pool funds is diversification already built into their portfolios. There are hundreds of loans in the typical mortgage pool fund portfolio, diversified geographically, by size and terms, and by property type. Another area where mortgage pool funds excel is their demonstrated track record. These funds have been available to investors for nearly a decade; the funds that have thrived are those that have demonstrated superior analytical abilities and expertise in managing through downturns.
Investors in private real estate deals must be mindful of severe liquidity constraints, which can exceed five to seven years, and a lack of readily available information about the investment. Several years can transpire between the purchase and sale of a property, making it difficult to access management’s performance and the valued added to the asset. In contrast, mortgage pool funds are professionally managed and administered, offer regular performance updates, and provide investors with annual tax statements.
Access to management is also a consideration. With a crowdfunding deal, investors have no direct exposure to the deal sponsor or manager. This is not the case with mortgage pool funds, which typically have fewer than 200 subscribers. Because of the small ownership base, every subscriber is important and fund shareholders usually have ready access to the fund’s senior managers. Liquidity constraints are a major issue for property investors, but rarely a problem for mortgage pool funds due to the steady flow of new capital into the fund. Many mortgage pool funds allow investors to redeem all or a portion of their investment at a time of their choosing. Investors aren’t required to wait until the fund is liquidated to withdraw capital.
Both mortgage pool funds and direct property ownership provide investors with predictable income, attractive yields and hedges against inflation. A well-managed mortgage pool fund also provides built-in diversification benefits and the superior safety that comes with professional management and an established track record. For the average investor, a mortgage pool fund may offer a safer, simpler and more practical way to invest in real estate.