Dividend-paying stocks and interest-bearing bonds aren’t the only ways to generate potential investment income. Real estate has the potential to meet that objective as well.
In fact, income generation is a key reason why many people diversify their investment portfolios to include different types of real estate assets, be they commercial, net lease, self-storage, medical or multifamily. Many real estate investments are predictable and durable in their ability to generate monthly income—although rental income is never guaranteed since real estate is a living, breathing asset.
During the pandemic some assets are performing particularly well, such as leased properties occupied by essential businesses, including drugstores, medical services and industrial distribution facilities that deliver products purchased through e-commerce.
Diversification is another reason to consider investment real estate, because the performance of privately-owned real estate assets typically does not correlate with the market for publicly-traded stocks and bonds. In other words, investment real estate is a potential hedge against the volatility of the equities market, a goal that we have found many investors are keenly interested in. It is important to note that diversification does not guarantee profits or protect against losses. However, it is considered by many to be a prudent tool when constructing an investment strategy.
There are many ways to participate in the investment real estate market in pursuit of income, appreciation and diversification. Here’s a look at four ways.
Real Estate Investment Trusts (REITs)
The market for publicly-traded REITs is well-established, and many people access the market through their retirement plans and stock brokerage accounts. REITs are typically companies that own and operate real estate, so you’re investing in the company, not just the underlying real estate. REITs pay out their income in the form of dividends, which are taxable.
The biggest downside to REIT investments (aside from their high correlation to the overall stock market and the volatility it ensues) is the absence of the ability to take advantage of a 1031 exchange—and thus defer taxation—on any capital gains from the sale of shares.
Direct ownership of triple-net leased property
Triple-net leased properties are typically retail, medical or industrial facilities occupied by a single tenant. With a property of this type, the tenant—not the owner—is responsible for the majority, if not all, of the maintenance, taxes and insurance expenses related to the property. While these benefits can be potentially attractive, direct ownership of such properties comes with distinct downsides, starting with concentration risk if an investor places a large portion of their net worth into a single property with one single tenant.
Other risks are potential exposure to a black swan event, such as COVID-19, if the tenant turns out to be hard hit (think restaurants and non-essential business retailers) and management risk. I have owned dozens of triple-net properties over my career and they are anything but passive and hands-free—they require intensive asset management to properly operate them in a prudent way.
Delaware Statutory Trusts (DSTs)
A DST is an entity used to hold title to investments such as income-producing investment real estate. Most types of real estate can be owned in a DST, including industrial, multifamily, self-storage, medical and retail properties. Often, the properties are institutional quality, similar to those owned by an insurance company or pension fund, such as a 500-unit class-A apartment community or a 50,000-sq.-ft. industrial distribution facility subject to a long-term net lease with an investment grade rated Fortune 500 logistics and shipping company. The asset manager (the DST sponsor company) takes care of the property day-to- day and handles all investor reporting and monthly distributions.
DST investments are used by those investors seeking a cash investment with a typical minimum of $25,000, as well as those seeking a turnkey 1031 tax-deferred exchange solution.
Tenants-in-Common properties (TICs)
A TIC structure is another way to co-invest in investment real estate. With a TIC, you own a fractional interest in the property and receive a pro rata portion of the potential income and appreciation of the real estate. As a TIC investor you will typically be given the opportunity to vote on major issues at the property, such as whether to sign a new lease, refinance the mortgage and sell the property.
Although TIC investments and DSTs have their nuances and differences, they often will hold title to the same types of investment properties. While the DST is generally considered the more passive investment vehicle, there are some circumstances in which a TIC is desirable, including if the investors wish to utilize a cash-out refinance after owning the TIC investment for a few years in order to potentially receive a large portion of their invested equity back, which can be invested in other assets. Both DSTs and TICs can qualify for 1031 exchange tax treatment (via Revenue Ruling 2004-86 and Revenue Procedure 2002-22), which allows capital gains tax to be deferred if the gains are reinvested in other investment properties. And both structures are used by direct cash investors seeking diversification out of the stock market into passive real estate investments.
Bottom line, dividend-paying stocks and bond investments aren’t the only path to achieve potential yield in the yield-starved environment we find ourselves in at the beginning of 2021. Real estate offers the potential for income, as well as appreciation and diversification, plus some welcome tax advantages to shelter rental income and defer capital gains taxes.
Dwight Kay is founder and CEO of Kay Properties and Investments, LLC, which operates a 1031 exchange property and real estate investment marketplace online.