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Real estate investing with REITs, MLPs and mutual funds

A way of investing in lands and buildings without getting your hands too dirty.

Other articles from this series

Real estate, an ancient expression that means "actual property", is basically everything consisting of lands or buildings. Wikipedia has the proper definition, which comes from the Oxford Dictionary online. Let me quote it:

Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature.

So investing in real estate means, among other things buying, selling or renting lands, buildings, structures or resources. For example if you own a house or a tomato field, you are a real estate investor!

Now, let's say I want to invest in the real estate market because I think it will be profitable in the near future. One option would be to own the physical building, say a flat, and rent it or sell it once it has gained value over time. However in this article I don't want to talk about that way. I want to focus on three main financial instruments that act as a intermediate layer between me and the underlying physical assets: real estate investment trusts (REIT), MLPs and real estate mutual funds.

Note that I definitely don't reject the physical possession as a feasible option to invest in real estate market. Buying, selling or renting a house is a formative experience but it requires a good amount of knowledge, money and free time in your backpack. If you buy a property, you've made a big commitment. On the other hand there are many financial instruments that should lower the barrier to entry in the real estate investment business.

REITs

A Real Estate Investment Trust (REIT) is a company, namely a bunch of people, that invest in various forms of real estate. A trust is, indeed, an array of assets managed together by a group of investors. The available options include houses, commercial buildings, hospitals, hotels and so on, but also real estate related assets such as mortgages. They provide a way for investors to get broad exposure in a real estate market without going to buy a bunch of properties themselves. They also provide diversification: REITs will often have more properties than an individual could get, or very large properties that would be too expensive for a single investor.

You can buy them like stocks, since they trade on a stock exchange. In fact REITs are to real estate properties as mutual funds are to stocks. Let me pick a random REIT from the web, for example the Acadia Realty Trust (ticker symbol: AKR): it's traded on the New York Stock Exchange and you can easily find more information about it on Google Finance or Yahoo Finance.

Three types of REITs

Nowadays there are three main types of REITs:

  • equity REITs — this is the most common type of real estate investment trust: they invest in real estate assets (office buildings, apartments, shopping malls, ...) and make money by charging rents;

  • mortgage REITs — they invest in residential and commercial mortgages, and generally lend money to real estate buyers. Mortgage REITs generate income from the interest earned on the loans;

  • hybrid REITs — a mixture of the two styles above.

REITs' inner workings

REITs are a U.S. creation, designed back in 1960 by the U.S. Congress. Today many countries have their own REITs defined by specific standards. In the United States for a company to qualify as a real estate investment trust it must:

  • invest at least 75% of its total cash in real estate;
  • retrieve at least 75% of its gross income from real estate investments;
  • pay 90% of its taxable income to its shareholders each year.

The rules above have been defined by the SEC, so they may vary for other countries. For example in Italy there is something called SIIQ (società di investimento immobiliare quotate), where the percentages outlined above shift to 80%, 80% and 85% respectively.

MLPs

MLP stands for Master limited partnership, which in turn is a type of limited partnership; let me break it down. A limited partnership is a form of collaboration where two or more guys, called limited partners unite to do business together. The term limited comes from the fact that the risk is somewhat confined: they are liable only to the extent of the amount of money they have invested, for example in case of a debt.

An MLP then is just a limited partnership that is publicly traded, which means you can buy it like stocks on a stock exchange. Don't ask my why the master part in the MLP acronym means "tradable". A couple of random MLPs are, for example, AllianceBernstein Holding L.P. (AB) or 8point3 Energy Partners LP (CAFD). I just don't know a thing about those companies, but as you may see they present all the gritty details of traditional stocks. Plus, the trailing "L.P." in the names should suggest their limited partnership nature.

Initially, MLPs and REITs might seem to be the very same thing, from a practical perspective. MLPs do share some similarities with REITs, but actually an MLP differs in its fundamentals. Let's see how.

MLPs' inner workings

First of all for a partnership to be legally classified as an MLP it must derive most of its cash flows from three sectors: energy, natural resources/commodities or real estate. So MLPs are less restrictive than REITs for what concerns their scope.

In an MLP (and in an LP too, of course) there are two types of partners. The limited partner is the guy that puts money into the MLP. It then receives dividends from the MLP's cash flow. The general partner is the other guy that is responsible for managing the assets. It gets paid for the MLP's performances. When you buy a share of an MLP you become an actual partner in the company, namely the limited partner, with limited liability. This is an alternative form of ownership to being a shareholder.

Well, where is the difference between REITs and MLPs, from a practical point of view? Here it goes: taxation. Partnerships, at least in the U.S. (but I guess the formula applies to other countries as well) do not pay taxes. Instead their income and costs are passed to the individual partners, who must then include it on their personal returns. You then, being a limited partner, are required to taking into account the MLP income as well, when you fill up your individual income tax return.

Real estate mutual funds

The last kind of financial instrument I want to take care of is the real estate mutual fund. I have already written a lot about mutual funds, so I won't dwell on that here. To put it simply, real estate mutual funds are funds that invest mainly in real estate companies, businesses supplying services to the real estate market and, of course REITs.

Playing with real estate mutual funds follows all the rules and investment schemes I have described in my previous articles: they are plain old mutual funds, after all. However, this way you are actually stacking up an additional layer between you and the real property, which is the fund itself with its fund manager. Will it work for you? That depends as always on your preferences and your investment style.

Sources

Wikipedia - Real Estate (link)
Money-zine - Real Estate Mutual Funds (link)
Money-zine - Real Estate Investment Trust (REIT) (link)
Money-zine - Real Estate Investments (link)
Investopedia - REITS versus Real Estate Mutual Funds (ESRT, TRREX) (link)
Investopedia - What is the difference between a REIT and a real estate fund? (link)
Investopedia - Real Estate Investment Trust - REIT (link)
Wikipedia - Real estate investment trust (link)
Energy Manager Today - Follow the Money: REITs, MLPs and Yieldcos (link)
StackExchange - Money - What are the differences between a REIT and an MLP? (link)
Online Etymology Dictionary - Real Estate (link)
Il Sole 24 Ore - SIIQ (link)
StackExchange - Money - Owning REIT vs owning real estate - which has a better hypothetical ROI? (link)
Investopedia - Limited Partnership - LP (link)

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