In the last fifty years or so, real estate has become a common investment vehicle. Here are some of the most popular options for individual investors, along with the benefits of investing.
• Real estate is regarded as a distinct asset class and should form at least a portion of a diversified portfolio.
• Real estate investment trusts (REITs) offer indirect real estate exposure without the need to own, operate, or finance properties.
• Flippers attempt to buy undervalued real estate, fix it up, and sell it for a profit.
Historical Prices
Real estate has been regarded as a wise investment for decades, and for good reason. Prior to 2007, historical housing data suggested that prices would continue to rise indefinitely. With few exceptions, the average home sale price in the United States rose every year between 1963 and 2007, the beginning of the Great Recession. At the onset of the COVID-19 pandemic in the spring of 2020, home prices did experience a slight decrease. Nonetheless, as vaccines were introduced and pandemic fears subsided, home prices accelerated to record highs by 2022.
Rental Properties
If you invest in rental properties, you will become a landlord; therefore, you must consider whether you will be comfortable in this role. As a landlord, you will be responsible for paying the mortgage, property taxes, and insurance, maintaining the property, finding tenants, and resolving any issues that arise.
Being a landlord is a hands-on investment unless you employ a property manager to handle the details. Depending on the circumstances, taking care of the property as well as the tenants can be a 24-hour-a-day, often unpleasant job. However, if you choose your properties and tenants with care, you can reduce the likelihood of experiencing major issues.
Rent collection is a source of income for landlords. The amount of rent you can charge depends on the location of the rental. Still, it can be difficult to determine the optimal rent, as charging too much will drive away tenants, while charging too little will leave money on the table. A common strategy is to charge sufficient rent to cover expenses until the mortgage is paid off, at which point the majority of the rent becomes profit.
The other major source of profit for landlords is appreciation. If your property appreciates in value, you may be able to sell it for a profit (when the time is right) or use the equity as collateral for your next investment. Although real estate tends to increase in value, there are no guarantees.
This is especially true during periods of extreme volatility in the real estate market, such as the duration of the recent COVID-19 pandemic. From February 2020 to March 2022, the median home price in the United States increased by an astounding 38%. Many are speculating that the prices are about to crash as a result of the astronomical growth.
Flipping Houses
As day traders are leagues apart from buy-and-hold investors, real estate flippers and buy-and-rent landlords are an entirely different species. Flippers acquire properties with the intent of quickly selling them for a profit, typically within three or four months.
There are two principal ways to flip a property:
Repair and update
Repair and modernize with this strategy, you purchase a property that you believe will appreciate after undergoing certain repairs and updates. Ideally, you would complete the project as quickly as possible and then sell it for more than you initially invested (including the renovations).
Hold and resell
This flipping method operates differently. Rather than purchasing a property and renovating it, you purchase in a rapidly appreciating market, hold for a few months, and then sell for a profit.
With either type of flipping, you run the risk of not being able to sell the property at a profit-generating price. This can be problematic because flippers typically do not have sufficient cash on hand to pay long-term mortgages. Nonetheless, if done correctly, flipping can be a lucrative way to invest in real estate.
REITs
A real estate investment trust (REIT) is formed when a corporation (or trust) is formed to purchase, operate, and sell income-producing properties using investor funds. Similar to stocks and ETFs, real estate investment trusts are traded on major exchanges (ETFs).
To qualify as a REIT, the entity must distribute 90% of its taxable profits to shareholders as dividends. By doing so, REITs are exempt from paying corporate income tax, whereas a regular company would've been taxed on its profits, reducing the returns it could distribute to its shareholders.
Similar to dividend-paying stocks, REITs are suitable for investors seeking regular income, though they also offer appreciation potential. Malls (about a quarter of all REITs specialize in these), healthcare facilities, mortgages, and office buildings are among the properties in which REITs invest. REITs have the advantage of being highly liquid in comparison to other types of real estate investments.
Real Estate Investment Groups
Real estate investment groups (REIGs) are comparable to small rental property mutual funds. A real estate investment group may be the solution for you if you want to own rental property but don't want the hassle of being a landlord.
A company will purchase or construct a group of buildings, typically apartments, and then permit investors to purchase them through the company, thereby joining the group. A single investor may own one or multiple self-contained residential units. However, the company that operates the investment group is responsible for maintenance, advertising, and tenant recruitment. In exchange for management services, the company receives a portion of the monthly rent.
There are a variety of investment groups available. In the standard version, the lease is in the name of the investor, and all units pool a portion of the rent to protect against vacancy. This means that you will be able to pay the mortgage even if the unit is vacant.
The quality of an investment group is entirely dependent on the organization that provides it. Theoretically, it is a safe way to invest in real estate, but groups may charge fees comparable to those in the mutual fund industry. Like all investments, research is essential.
Real Estate Limited Partnerships
Similar to a real estate investment group (REIG) is a real estate limited partnership (RELP). It is a legal entity created to acquire and hold a portfolio of properties, or sometimes just one. However, RELPs only exist for a limited time.
The general partner is a good experienced property manager or real estate development firm. Then, outside investors are solicited to provide financing for the real estate project in exchange for a limited partnership stake. Partners may receive periodic proportions from income generated by the RELP's properties, but the real payoff occurs when the properties are sold, with any luck, for a substantial yield and the RELP is dissolved in the future.
Real Estate Mutual Funds
Mutual funds that invest in real estate primarily invest in REITs and real estate operating companies. They allow investors to diversify their real estate exposure with a relatively small amount of capital. Depending on their strategy and diversification objectives, they offer investors a much broader selection of assets than can be obtained by purchasing individual REITs.
Similar to REITs, these funds are relatively liquid. The analytical and research information provided by the fund is another significant benefit for retail investors. This may include information on acquired assets and management's perspective on the viability and performance of particular real estate investments and the asset class as a whole. Speculative investors can invest in a family of real estate mutual funds that strategically overweight particular property types or regions to maximise return.
Why Invest in Real Estate?
Real estate can improve a portfolio's risk-and-return profile by providing competitive risk-adjusted returns. In general, the real estate market is relatively stable, especially when compared to equity and bond markets.
When compared to more conventional sources of income return, real estate is also advantageous. This asset class typically comes at a yield premium to U.S. Treasuries and is particularly attractive in a low-rate environment.
Diversification and Protection
Another advantage of real estate investment is its diversification potential. Real estate has a low correlation, and in some cases a negative correlation, with other major asset classes. This means that when stocks decline, real estate typically appreciates. This indicates that the addition of real estate to a portfolio can reduce volatility and increase return per unit of risk. The hedge is more effective the more direct the investment in real estate. Less direct publicly traded vehicles, such as REITs, will reflect the performance of the overall stock market.
Direct real estate carries less principal-agent conflict, or the extent to which the investor's interest depends on the integrity and competence of managers and debtors, because it is backed by physical assets. Even indirect forms of investment carry some level of security. REITs, for instance, are required to distribute a minimum proportion of profits as dividends (90%).
Some analysts believe that the correlation between REITs and the stock market will increase now that REIT stocks are included in the S&P 500.
Inflation Hedging
The inflation-hedging capacity of real estate is a result of the positive correlation between the growth of the gross domestic product (GDP) and the demand for real estate. As economies grow, increased demand for real estate drives up rents, which in turn increases capital values. Therefore, real estate tends to preserve the purchasing power of capital by passing on a portion of inflationary pressure to tenants and by incorporating a portion of inflationary pressure through capital appreciation.
The Power of Leverage
With the exception of REITs, investing in real estate provides leverage, which is unavailable to investors in the stock market. Leverage is when you use debt to finance a larger purchase than you have cash on hand. Unless you are purchasing on margin, you must pay the full value of the stock when placing a buy order. Even then, the percentage you can borrow is significantly less than with real estate, owing to the mortgage's magical financing method.
Most conventional mortgages require a 20% down payment. However, depending on your location, you may be able to find a mortgage with a 5% down payment. This implies that you can control the entire property and its equity for a fraction of its total value. Obviously, the size of your mortgage will affect how much ownership you actually have in the property, but from the moment the papers are signed, you have complete control.
This encourages both real estate flippers and landlords. They are able to obtain a second mortgage on their homes and make down payments on two or three additional properties. Whether they rent them out so that tenants pay the mortgage or wait for an opportunity to sell them for a profit, they retain ownership of these assets despite having paid a small fraction of their total value.
How Can I Add Real Estate in My Portfolio?
Why real estate considered as a hedge against inflation?
Inflation and home prices tend to rise in tandem. Inflation increases the costs of homebuilders, which must be passed on to buyers of new homes. Existing homes, however, also increase with inflation. If you have a fixed-rate mortgage got from the bank or lender your fixed monthly payments become more affordable as inflation rises. In addition, if you are a landlord, you can raise the rent to account for inflation.
Why Are Home Prices Impacted by Interest Rates?
Because real estate is such a large and expensive asset, loans are frequently required to finance its acquisition. Consequently, interest rate increases make mortgage payments for new loans more expensive (or on existing adjustable-rate loans like ARMs). This can deter buyers, who must consider the monthly cost of carrying the property.
The Bottom Line
Real estate can be a wise investment with the potential to generate a steady income and increase wealth. The relative difficulty of converting an asset into cash and cash into another asset is a disadvantage of investing in real estate.
A real estate transaction can take months to close, as opposed to the seconds required to complete a stock or bond transaction. Even with the assistance of a broker, finding the ideal counter party can take several weeks. Obviously, REITs and real estate mutual funds offer superior liquidity and pricing in the market. However, they are more volatile and provide fewer diversification benefits than direct real estate investments due to their greater correlation with the overall stock market.
As with any investment, maintain reasonable expectations and conduct thorough research prior to making any decisions.
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