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How to Invest in Real Estate Bonds

Mortgage REITs are one way to invest in real estate bonds.(GETTY IMAGES)

 

WITH THE EXCITING performance of the stock market in 2019, it’s easy to overlook the real estate bond market. But real estate is a solid asset class that offers diversification to an investment portfolio.

 

Many understand the opportunity to invest in real estate, through actual ownership of rental properties or real estate investment trusts. Real estate bonds marry real estate investing with fixed income and offer investors the opportunity for passive income and capital growth.

 

The properties of real estate bonds apply to real estate debt investing. Real estate bonds are fixed-income investments or loans, backed by real property. That means investors in housing bonds and other types of real estate bonds can expect cash flow from underlying mortgage repayments. These passive income opportunities come in many varieties with varying degrees of creditworthiness.

 

The multiple ways to invest in real estate debt include mutual funds, real estate investment trusts or REITs, exchange-traded funds and real estate crowdfunding platforms. Additionally, real estate bonds might be secured by home mortgages, commercial mortgages or other real property debt.

 

Here are four ways to invest with these types of bonds:

 

  • Government real estate bonds.
  • Commercial real estate debt funds.
  • Mortgage REITs.
  • Crowdfunding real estate bonds.

 

Government Real Estate Bonds

The safest real estate bonds are agency residential mortgage-backed securities, says Mayra Rodriguez Valladares, a managing partner at MRV Associates in New York. These real estate bonds are backed by Freddie Mac and Fannie Mae.

 

Freddie Mac and Fannie Mae buy prime mortgage loans from banks and pool them into a security or a bond.

“Because these government-sponsored enterprises back the bonds, they are the safest securitizations for investors,” Rodriguez says.

 

Investors can purchase these government bonds through mutual funds or ETFs such as the Vanguard GNMA Fund (ticker: VFIIX). The fund offers a 2.8% yield, has a 10-year annual return of 3.2% and charges a 0.21% management fee.

 

Commercial Real Estate Debt Funds

For investors seeking equity-like returns with bond-like volatility, senior secured commercial real estate debt funds are an alternative.

 

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Evan Gentry, founder and CEO of M360 Advisors in Ladera Ranch, California, says that commercial real estate debt funds can serve as defensive investments, with attractive returns during the current market environment. The yield and regular distributions offer cash flow for income-seeking investors.

 

Commercial mortgage-backed securities may originate from such diverse sources as hotels, apartments, warehouses, agricultural facilities, shopping malls and casinos. These loans are grouped according to the risk level of the underlying securities.

 

Credit rating agencies assign grades from AAA to unrated, Rodriguez says. Accordingly, lower-rated real estate bond funds will offer higher returns, albeit with a greater risk of default.

 

The iShares CMBS ETF (CMBS) tracks an index of investment-grade commercial mortgage-backed securities, with an expected life of at least one year. The debt is backed by income-producing property such as shopping centers and hotels. The five-year average return is 3.1% and currently yields 2.6%. The ETF charges a reasonable 0.25% expense ratio.

 

Gentry encourages investors in commercial real estate debt funds to vet the managers to ensure the fund’s management is experienced in handling various market conditions and in overseeing these types of investments.

 

Mortgage REITs

Mortgage REITs, or mREITs, fund income-producing real estate by purchasing or originating mortgages. Investors earn interest and principal on these investments.

 

These real estate bond investments provide important cash for the real estate market and invest in residential and commercial mortgages as well as residential mortgage-backed securities and commercial mortgage-backed securities.

 

Mortgage REITs might concentrate on either residential or commercial mortgages and, occasionally, both. Investors will find mortgage REIT investment opportunities in both mutual funds and ETFs.

 

New Residential Investment Corp. (NRZ) is a REIT that focuses on investing in and managing residential mortgage-related assets. NRZ’s investments include real estate securities, residential mortgage loans, consumer loans, including unsecured and homeowner loans. NRZ and offers roughly a 13% yield. The shares are volatile with a 52-week trading range of $13.63 to $17.47. The 13% yield and wide share price trading range suggests that investors in NRZ should be prepared for stock price volatility, which will impact the investment’s total return.

 

Crowdfunding Real Estate Bonds

Real estate crowdfunding is on fire since the passage of the Jumpstart Our Business Startups Act in 2012. This legislation loosens the Securities and Exchange Commission’s regulations on small businesses and provides greater access to crowdfunding.

 

Real estate crowdfunding pools an individual’s money with others to invest in either real estate debt or equity.

 

Many real estate crowdfunding companies have sprung up, offering both equity and debt funding investment opportunities. Others offer just one or the other.

 

For the most part, investors of all income levels can participate in the real estate bond markets. But some firms are only open to accredited investors.

 

The difference between REITs and real estate crowdfunding is that with crowdfunding, investors can choose the specific projects in which to invest. REITs are also more liquid than crowdfunded real estate bonds, which can tie up the investor’s money for years.

 

PeerStreet is a real estate debt crowdfunding site for accredited investors. The company allows investors to create their own portfolio of real estate investments or provides an automated investment option.

 

For nonaccredited investors, Fundrise offers eREITs, which doesn’t trade on the stock exchanges like typical REITs. Fundrise’s investment opportunities include real estate bonds or debt financing.

 

Louis Wolkenstein, managing principal at The Investment Advisor in Pittsburgh, says investors should be aware that investing in mortgage-backed securities may involve early returns of principal to the bondholder since the underlying mortgage debt is refinanced at a lower interest rate and when loans are paid off early.

 

He adds that this might reduce the principal amount invested as part of the money is returned to the investor before maturity. In a declining interest rate environment, this reduces the total returns on the housing bond investment.

 

As with any investment, investors should understand the credit ratings of the underlying debt and make sure that the risk level of the investment is in line with their own.

 

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