John Corretti loves investing in real estate but buying locally doesn’t make much sense.
“It’s very expensive and not very landlord-friendly, plus I don’t have several hundred thousand dollars and the rents aren’t very high,” says the project manager of a New York software company. . That leaves investing in real estate in other US cities, but Corretti admits he doesn’t have the time or expertise to research those markets.
Even so, Corretti owns six properties: two in Cleveland and one in Pittsburgh; Columbia, South Carolina; Atlanta; and Birmingham, Alabama. He bought them through HomeUnion and Roofstock, two online companies that convert real estate from an active investment to a passive investment.
“They do the research, crunch the numbers, and connect you with a property manager,” says Corretti. “All I do is pay the money. It’s like buying real estate on Amazon.
And for Austin, Texas-based software developer Kevin Kaplan, New York is an attractive real estate option.
“Owning an apartment in New York would be great, but it’s a lot of capital, plus I would need to hire a property manager,” he says.
Instead, Kaplan bought slices of ownership through Compound, a New York-based company that launched in January and sells stocks in real estate in New York, Miami, Nashville and Austin, Texas. He has also invested in properties through RealtyMogul, Fundrise, Sharestates and YieldStreet.
“I’m a fractional investor in commercial and residential real estate,” he says.
Raising a red flag for some advisers, however, neither Kaplan (which held now-expired Series 6, Series 63, and Series 65 licenses) nor Corretti used financial planners to weigh the pros and cons of these investments.
“These aren’t terrible investments,” says Gregory Young, a planner in North Kingston, Rhode Island. “But without strategy and discipline, plus maybe a little help from an objective professional, it’s no longer investing. It’s speculation.
Nonetheless, Jennie Stewart, partner and tax attorney at Kutak Rock LLP in Little Rock, Arkansas, says interest in online passive real estate companies is high, so planners should be aware that their clients may be interested in fractional real estate ownership.
Very specific bets
Fractional ownership allows customers to place a very specific bet on a city, neighborhood and property, even when they don’t know enough about a city to make an informed call.
“These services provide easy access to the rental property economy, without having to spend time researching properties or performing normal landlord duties,” says Andy Panko, CFP in Iselin, New Jersey.
However, he says, investors pay a premium for access and convenience, and those additional costs can hurt the bottom line.
The other major downside, says Panko, is the lack of cash. “Stocks, bonds and mutual fund shares can be sold in days, but it takes weeks to months to complete a real estate transaction.”
Additionally, he says, there is an established market for the sale of homes and commercial properties. There is no established market for a fractional condominium, although most condominium corporations say they hope to create one.
Nashville planner Shaun Melby adds that investors who want passive exposure to real estate might be better off with a traditional, publicly traded REIT, which diversifies by investing in hundreds or thousands of properties, rather than in a specific property.
Compound, the company used by Kaplan to buy real estate shares, chooses the property, acts as a sales broker and manages the property management. The company exclusively buys middle-market, single-family and residential properties in good condition, it says.
“It’s not affordable or ultra-luxury housing, and we don’t buy from repairers,” says Janine Yorio, CEO of Compound. “We buy new or almost new condos in good condition and rent them with 12-month leases.
Each condo is owned by a single-purpose REIT, and a client can purchase part or all of a particular property, with a minimum investment of $50. Shareholders receive semi-annual dividends on rental income and their share of the appreciation of the property when it is sold. Business models vary from company to company. The goal may be to lease the property, in which case the start-up finds a tenant before investors get involved. Or perhaps the company’s goal is to renovate and transform the structure, paying investors when the house or business is resold.
The client never paints a wall, does a credit check, shampoos a carpet, argues with a contractor, or pulls Legos out of a tenant’s plumbing.
Either way, though, the client never paints a wall, does a credit check, shampoos a rug, argues with a contractor, or pulls Lego out of a tenant’s plumbing. The real estate company takes care of everything.
Ownership is usually stock in a stock REIT or a Delaware statutory trust. Investments are not liquid until the property is sold. Investors bear the market risk and pay dividend and capital gains taxes when a property sells.
1031 exchange benefits
Depending on the legal structure, however, a co-ownership investment can do something that a REIT cannot: meet the needs of investors who want a 1031 exchange.
To qualify as a 1031 exchange, fractional real estate investments must be shares of a Delaware statutory trust (some online real estate companies, including Roofstock, use this model). REITs and SDRs differ in their tax treatment. A DST is a working interest in real estate, and is therefore eligible for the 1031 exchange rules and tax deferral. REIT stocks are not.
DST shares also benefit from the tax advantages of direct real estate investments: taxable income generated by DST shares can be amortized through interest and depreciation deductions. REIT shares are not eligible for this treatment.
Michael Whitman, a planner in Chapel Hill, North Carolina, has two clients who use the 1031 and 1033 real estate exchanges to invest in DSTs. The first client owned a beach house on the Jersey Shore that she rented out to vacationers all summer long.
“She was tired of dealing with tenants and tired of marketing the property, even though she loved the revenue,” Whitman says.
So Whitman and his client looked at alternative real estate investments and settled on private placement DSTs for accredited investors. His client, says Whitman, will get what she primarily wants: passive real estate income. She will also benefit from some diversification – as she plans to choose a trust that owns multiple properties – tax deferral and some depreciation. The client’s estate will benefit from an increase in its base upon her death.
One of Whitman’s client families is suing the less common 1033 exchange. The clients own a farm in Tennessee and the government wants to build a road on the land where the farm currently stands.
Since the land was transferred by donation over time, there was no increase in the base over the years. “Three hundred years is a lot of capital appreciation, so they’re looking at millions of dollars in capital gain,” says Whitman.
Under eminent domain rules, these clients have three years to reinvest the money in real estate or pay capital gains tax. A natural disaster, the other circumstance that creates an opportunity for a 1033 exchange, gives owners two years.
The farm was used as business income, so the family cannot use the money to buy new homes for themselves.
“Clients have the option of becoming direct owners or completely offloading purchasing and management,” says Whitman.
Direct ownership would let the family control everything: choice of tenant, date of purchase, date of sale, insurance company. But they would also have the headache of managing these many complexities. With a DST, the family would give up control — and the headaches — while retaining passive income, depreciation, and a future 1031 option.
Cash flow option
As for individual investors, Kaplan says it’s too early to measure returns, while Corretti likes what he sees. From a cash flow perspective, he is simply paying off his mortgages. Counting cash flow, equity and appreciation, however, Corretti estimates he’s earning 19.22% a year – not a bad return, he says, on a property he won’t see. never in person.
Young admits that, with professional guidance, co-ownership could add diversity to an established investment plan. Even with that caveat, however, he says he wouldn’t recommend such an addition to a beginner customer’s portfolio.
“I don’t think a young client new to planning or investing would go down this avenue,” says Young. “Maybe I would explore it as a viable source of income planning and income diversity for more established clients – maybe.”