Securitization of Real Estate: a brief history

Real estate is a fundamental asset class in a diversified investment portfolio. The benefits it provides are capital growth and investment income. Also given that it has a correlation coefficient of 0.59 to U.S. equities it provides great diversification.  The correlation coefficient suggests it performs in-line with U.S. equities only 59% of the time. When US stocks are down real estate can pick up the slack, but it can under perform when the market is strong (ex. 1986-2000).

Let’s say you want the benefits of real estate, but not the hassles of owning and managing it yourself. That is where securitization comes in – the process of creating a security either equity or debt instrument for the purpose of owning a real and/or tangible asset. There are three primary type of securitized real estate 1) Limited Partnerships, 2) Real Estate Investment Trusts, and 3) Mortgaged Back Securities.

Limited Partnerships part 1

            In the last 60 years limited partnerships (LP’s) were the first common way to invest in real estate in a securitized manner. The benefits were passed through by means of a K-1 to the investors in either income or losses, without a corporate income tax applied to those proceeds. Investing in real estate lps in the early 1980’s was primarily for tax shelters- one made their money in the tax loss. The Tax Reform Act of 1986 closed many of those tax loopholes that allowed the tax shelter investing to be profitable. Many of these partnerships had huge amounts of leverage and were not designed to be financially viable without the tax loss, thus they blew up hurting their investors, giving real estate a black eye.

Later in the 80’s and early 90’s a new type of LP investment appeared investing low-income affordable housing. The developers were given 1% 50 year mortgages in exchange for multi-family developments that were priced along the lines of area household income. The profit came from annual tax credits that were equal to 15% of the equity for ten years (150% total). At the end of 15 years the property could be used as regular housing... These partnerships did well when managed correctly.

One other type that has done well is the all cash LP. These were designed for generating income from real estate, Buying, holding, taking the income. The managing partners used little or no leverage in acquiring their properties and raised enough money to pay for the property wholly. These lps prospered, but had one main down fall-they lacked liquidity. The secondary market for lps is very thinly traded and favors the buyer.

Real Estate Investment Trusts

            Real Estate Investment Trusts (REITs) were created by the Real Estate Investment Trust Act of 1960. The first one was formed in 1963. REITs are a pass through entity in which 95% of all net income must be sent back to the shareholders where a part is taxable subject to the amount of depreciation the real estate has that year.

These were slow to take off at first. The tax reform Act of 1986 helped spur more on by allowing management to run the properties versus having to have a third party run and maintain them.

In the early 1990’s more old-line real estate companies began to go public either for estate planning purposes or to increase their capital. This catalyst has helped the market capitalization of REITs to grow exponentially over the last decade.

REITs may invest in only two things: real estate or mortgages. There are also two types: ones traded on the exchanges and non-traded.

Mortgaged Back Securities

            A mortgage-backed security (MBS) is similar to a bond whose cash flows are backed by mortgage payments. They began in the early 70’s with Fannie Maes and Ginnie Maes. For simplicity they are a block of mortgages ($100 million lets say) that can be cut up and traded among investors. These increase liquidity in the mortgage market by letting lenders turn their money. One receives principal and interest payments simultaneously until you are paid back your principal.

Limited Partnerships part 2

           The LP’s of the 90’s slowly converted to a Limited Liability Corporation (LLC) format. By 2003 many of those converted to a non-traded REIT format. In which they added liquidity features.

            One form of the LLC still exists today – it’s in the Tenants In Common (TIC) marketplace. The TIC market primarily designed to take advantage of Internal Revenue Code part 1031 to convert real property into a securitized form. An example would be farmer selling his free and clear farm for $800,000. Using the IRC 1031 he invests into and a $6.4million office complex by using a financial intermediary. He takes possession of his 1/8 as a tenant in common and the operation of the complex is controlled by a LLC operating agreement. Later he can be bought out by a REIT or sell and buy another property as TIC. By doing this he avoided capital gains taxes and created income on that property for himself and future generations. Remember always consult your tax, legal, and financial advisors for transactions like the one above.

            In conclusion one can have the benefit of investing in real estate without actually owning the property through real estate securities. Returns might not be as great as a leveraged property one owns, but neither are the headaches of tenants calling about their air conditioner on a summer weekend holiday.