When you think of real estate investing, your home is probably the first thing that comes to mind. Of course, real estate investors have many other options when it comes to choosing an investment, and not just physical real estate.
Real estate has become a popular investment vehicle over the past 50 years. Here are some of the best options for retail investors, and reasons to invest.
Central thesis
- Real estate is considered an asset class in itself and should at least be part of a diversified portfolio.
- One of the main ways an investor makes money in real estate is by becoming the owner of a rental property.
- Pinball players try to buy undervalued real estate, restore it and sell it for a profit.
- Real estate investment trusts (REITs) provide indirect real estate exposure without the need to own, operate or finance real estate.
Historical price
Real estate has long been considered a solid investment, and for good reason. Prior to 2007, historical real estate data suggested that prices could continue to rise indefinitely. With few exceptions, the average selling price of a home in the U.S. rose every year between 1963 and 2007—the start of the Great Depression. Real estate prices fell slightly at the start of the COVID-19 pandemic in spring 2020. However, as a vaccine rolls out and pandemic fears ease, house prices have accelerated, hitting record highs by 2022.
This chart from the Federal Reserve Bank of St. Louis shows average selling prices between 1963 and the first quarter of 2022 (latest data available). The light gray shaded area indicates a U.S. recession.
Rental property
When you invest in rental property, you become a landlord – so you need to consider your suitability for that role. As a landlord, you are responsible for things like paying your mortgage, property taxes and insurance, maintaining your property, finding tenants, and solving problems.
Unless you hire a property manager to handle the details, a landlord is a practical investment. Depending on your situation, looking after the property and tenants can be a 24/7 job – and it’s not always pleasant. However, by choosing your property and tenants carefully, you can reduce the risk of major problems.
One way landlords make money is by collecting rent. How much rent you can charge depends on where the rent is located. Still, determining the best rent can be difficult because if you charge too much, you’ll drive the tenant away, and if you charge too little, you’ll leave money on the table. A common strategy is to charge enough rent to cover expenses until the mortgage is paid, at which point most of the rent turns into profit.
Another major way landlords make money is through appreciation. If your property appreciates in value, you can sell it for a profit (when the time is right) or borrow equity for your next investment. While real estate tends to appreciate in value, there are no guarantees.
This is especially true during periods of extreme housing market volatility, most recently during the COVID-19 pandemic. From February 2020 to March 2022, the average home price in the U.S. rose a staggering 38%. With the sharp increase, many wondered if the price was due to the crash.
Flip the house
Like day traders who are miles away from buy-and-hold investors, real estate speculators are a very different breed from buy-and-rent landlords. Pinball players buy real estate to hold it for a short period of time — usually no more than three to four months — and sell it quickly for a profit.
There are two main methods of mirroring properties:
- Fixes and updates. With this method, you can buy a property that you think will appreciate in value after some repairs and updates. Ideally, you’ll get the job done as quickly as possible and then sell for more than your total investment (including renovations).
- Hold and resell. This type of mirroring works differently. Instead of buying and repairing a property, buy in a fast-rising market, hold it for a few months, and sell it for a profit.
With either type of mirroring, you run the risk of not being able to unload assets at a profitable rate. This can be a challenge because Fins often don’t have enough cash on hand to pay real estate mortgages in the long run. Still, when done right, flipping can be a lucrative way to invest in real estate.
REIT
A real estate investment trust (REIT) is formed when a company (or trust) is formed to use investor funds to buy, operate, and sell income-producing real estate. REITs are traded on major stock exchanges, just like stocks and exchange-traded funds (ETFs).
To qualify as a REIT, a company must return 90% of its taxable profits to shareholders in the form of dividends. In this way, REITs avoid paying corporate income tax, while ordinary corporations are taxed on their profits, depleting the returns they can return to shareholders.
Similar to regular dividend stocks, REITs are suitable for investors who want regular income, although they also offer opportunities for appreciation. REITs invest in a variety of real estate, such as shopping malls (about a quarter of REITs specialize in these industries), healthcare facilities, mortgages and office buildings. Compared to other types of real estate investments, REITs have the advantage of being highly liquid. 5
Real estate investment group
A real estate investment group (REIG) is similar to a small rental investment fund. If you want to own a rental property but don’t want the hassle of a landlord, a real estate investment group may be the solution for you.
A company buys or builds a series of buildings, usually apartments, and then allows investors to join the group by buying them through the company. A single investor may own one or more individual housing units. But the company that runs the investment group manages all the units and is responsible for maintenance, advertising and finding tenants. In exchange for this management, the company charges a percentage of the monthly rent. 6
There are several versions of investment groups. In the standard version, the lease is in the investor’s name and all units share a portion of the rent to avoid temporary vacancy. This means that even if your house is vacant, you have enough money to pay the mortgage.
The quality of an investment group depends entirely on the company that provides it. In theory, it’s a safe way to get into real estate investing, but groups can charge the kind of steep fees that plague the mutual fund industry. As with all investments, research is key.
Limited partnership in real estate
A real estate limited partnership (RELP) is similar to a real estate investment group. It is a company established to buy and hold a portfolio of properties and sometimes just properties. However, RELPs have a limited lifespan.
Experienced real estate managers or real estate development companies as general partners. Outside investors are then sought to fund real estate projects in exchange for a share of the property as a limited partner. Affiliates may receive periodic distributions from the proceeds of the RELP property, but the actual payment occurs when the property is sold – for a substantial profit if you are lucky – and the RELP is dissolved.
The quality of an investment group depends entirely on the company that provides it. In theory, it’s a safe way to get into real estate investing, but groups can charge the kind of steep fees that plague the mutual fund industry. As with all investments, research is key.
Real estate fund
Real estate funds invest primarily in REITs and real estate companies. They offer the opportunity to obtain diversified real estate investments with relatively little capital. Depending on their strategy and diversification goals, they offer investors a wider range of investment options than buying individual REITs.
Like REITs, these funds are fairly liquid. Another important benefit for retail investors is the analytical and research information provided by the fund. This may include details of the assets purchased and management’s views on the profitability and performance of specific real estate investments and as an asset class. More speculative investors can invest in a family of real estate mutual funds and tactically overweight certain real estate types or regions to maximize returns.
Why invest in real estate?
Real estate can enhance the risk/return profile of an investor’s portfolio and provide competitive risk-adjusted returns. Overall, the real estate market exhibits low volatility, especially when compared to stocks and bonds.
Real estate is also attractive compared to more traditional sources of income. The asset class typically trades at a yield premium relative to U.S. Treasuries and is particularly attractive in an environment of low Treasury rates.
Diversity and Protection
Another benefit of investing in real estate is its diversification potential. Real estate has a low, and in some cases negative, correlation with other major asset classes – meaning that real estate typically rises when stocks fall. This means that adding real estate to a portfolio can reduce its volatility and provide a higher return per unit of risk. The more direct the real estate investment, the better the hedging: Direct publicly traded vehicles like REITs reflect the overall performance of the stock market.
Because they have physical backing, direct real estate also has few principal-agent conflicts, or the extent to which the investor’s interests depend on the integrity and competence of managers and debtors. More indirect forms of investment also offer a degree of protection. For example, REITs require a minimum percentage of earnings (90%) to be paid out as dividends.
Inflation hedge
The inflation-hedging ability of real estate stems from the positive correlation between gross domestic product (GDP) growth and real estate demand. As the economy expands, demand for real estate drives up rents, which in turn leads to higher capital values. As a result, real estate tends to maintain the purchasing power of capital by passing on some of the inflationary pressure to tenants and absorbing some of the inflationary pressure in the form of capital appreciation.
The power of leverage
In addition to REITs, investing in real estate provides investors with a tool that stock market investors cannot: leverage. Leverage means using debt to fund larger purchases than the cash you have. Unless you are buying on margin, if you want to buy a stock, you must pay the full value of the stock when you place the purchase order. Even so, the percentage you can borrow is still far less than real estate, thanks to a magical form of financing called a mortgage.
Most traditional mortgages require a 20% down payment. 9 However, depending on where you live, you may be able to find a mortgage for as little as 5%. This means that you pay a fraction of the total value and you control the entire property and the equity in it. Of course, the amount of your mortgage will affect the amount of ownership you actually have in the property, but once the document is signed, you can control it.
This encourages real estate flippers and landlords. They can take out a second mortgage on their home and put down a down payment on two or three other properties. Whether they rent out these assets to make tenants pay their mortgages, or wait for an opportunity to sell them for a profit, they control the assets, even if they pay only a fraction of the total value.
How do I add a property to my portfolio?
In addition to buying real estate outright, ordinary investors can also buy REITs or funds that invest in REITs. REITs are collective investments that own and/or manage real estate or own mortgages.
Why is real estate seen as an inflation hedge?
Real estate prices tend to rise with inflation. That’s because inflation increases costs for home builders, which must be passed on to buyers of new homes. 10 Existing properties also increase with inflation. Holding a fixed-rate mortgage effectively makes your fixed monthly payments more affordable as inflation rises. Also, as a landlord, you can increase your rent to keep up with inflation.
Why are real estate prices affected by interest rates?
Because real estate is such a large and expensive asset, borrowing is often required to finance its purchase. Because of this, rate hikes make mortgage payments on new loans (or existing adjustable rate loans like ARMs) more expensive. This could deter buyers who must consider the monthly cost of moving the property.
Final result
Real estate can be a solid investment with the potential to generate steady income and build wealth. However, one disadvantage of investing in real estate is illiquidity: the relative difficulty of converting assets into cash and cash into assets.
Unlike a stock or bond transaction that can be completed in seconds, a real estate transaction can take months to complete. Finding the right counterparty can take weeks, even with the help of a broker. Of course, REITs and real estate mutual funds offer better liquidity and better market prices. However, they come at the cost of higher volatility and lower diversification benefits, as they are much more correlated with the overall stock market than direct real estate investing.
As with any investment, you should keep your expectations realistic and do your homework and research before making any decisions.
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