When it comes to diversifying your investment portfolio, real estate is a go-to for many people. People like owning something they can see and understand, and most forms of real estate investment allow that.
Another big advantage of real estate as an investment is the ability to use OPM--other people’s money. While buying stock on margin is considered risky, buying real estate with borrowed money is considered normal.
Let’s take a look at some ways to invest in real estate and consider the advantages and disadvantages of each.
Buy Your Primary Residence
Most people’s first (and many people’s only) real estate investment is their own home. The federal mortgage interest deduction and the state homestead exemption both give favorable tax treatment to this basic real estate investment. It can be purchased for as little as 3.5% down, with the rest financed over thirty years.
The home that stretched the newlywed’s budget can become a place to live rent-free in retirement, or something that can be sold to either upgrade or downsize as income increases or the kids leave home. Finally, it can become a major asset of your estate, or the means to pay your nursing home bill.
The main risk involved in buying a home is not being able to afford it. If homeowners are unable to keep up with the mortgage payments and are not able to sell the house before foreclosure, their credit will take a hit, and they will have to find new housing. However, affording a house doesn’t just mean affording the payments. Taxes, insurance and repairs/maintenance also have to be considered. As a renter, the dishwasher is the landlord’s problem; as a homeowner it is yours.
In most areas, decreasing real estate prices aren’t a problem--the price may drop some, but as long as you are happy in your home and able to afford it, temporary price drops don’t affect you. However, if decreasing prices and/or a poor economy in the area change the neighborhood such that you no longer want to live there, you could find it necessary to dig into savings to afford a similar house elsewhere.
Buy Rental Property
For some people, owning rental property means renting out the house they inherited, or renting out their first house when they move on to bigger and better things. Others buy property specifically intending to rent it out.
Rental property can make you money in two ways: its value can appreciate so that you can sell if for more than you paid or you can rent it out for more than it costs you to own. While neither of these scenarios are guaranteed, real estate has generally proven itself to be a steady if not spectacular investment.
The main disadvantage to owning rental property is dealing with rental property. While a property management company can take over the headaches of finding tenants, dealing with maintenance requests and evicting deadbeats, they also take over a portion of your profits.
Before purchasing property with the plan of renting it out, make sure you run the numbers. Things you need to know include:
- How much do similar properties in that neighborhood rent for?
- How much is your mortgage payment going to be?
- How much are the other regular expenses such as taxes, insurance and property management?
- How much do you plan to set aside each month for maintenance and repair? (no, this is not optional. Things will break).
- If the monthly cash flow is not strongly positive, do you have a reason to believe that will change in the near future or that the property values will increase enough to make it worth it?
Buy Shares in a REIT
A REIT is a Real Estate Investment Trust. These shareholder-owned companies own and/or operate a portfolio of real estate and/or debt instruments securing real estate purchases. Tax laws allow these companies to pay no income taxes, but in return, they are required to pass 90% of their earnings through to shareholders in the form of dividends, which, if they are not in retirement accounts, become taxable income for the shareholder. As a general rule, REIT dividend yields are higher than most stocks.
Different REITs own different types of real estate so you can pick one that does something you believe will be profitable long term or avoid one that you think will crash and burn. As public companies, much of their financial data is available to the public and should be reviewed before an investment is made.
Buy Shares in Real Estate Mutual Funds or ETFs
If you want to spread your money around the real estate sector without studying financial statements and nationwide real estate markets, investing in a mutual fund or ETF that focuses on real estate may fit the bill.
Most of the major fund families offer one or more choices in this sector, and as with other funds, there is no evidence that higher expense ratios equate to higher performance; in fact the evidence is the opposite. Here are some options:
- Vanguard Real Estate Index Fund Admiral Shares (VGSLX)
- Fidelity® Real Estate Index Fund Investor Class (FRXIX)
- First Trust S&P REIT Index Fund (FRI)
- Invesco Active U.S. Real Estate Fund (PSR)
- iShares U.S. Real Estate ETF (IYR)
All of these have low expense ratios and annual returns on the Net Asset Value (share price) of over 7% for the last five years. Dividends are extra, and generally over 3% per year.
As with any security, shares in Real Estate Funds are subject to market risk and interest rate risk, so if you need to sell, you may lose money. However, these funds are the easiest and lowest-risk way for people who know nothing about real estate to add real estate to their portfolio.
Invest Via an Online Service
The advent of the internet has made it possible to offer investments to people across the country and across the world and some companies have chosen to make real estate investing available to the masses via the internet. Investors can review projects that have applied for funds and invest in ones that interest them. As with other investments, the higher the possible return, the higher the risk of losing money. Let’s look at a couple of the choices:
- Fundrise investors are basically buying shares in portfolios assembled by the company. Anyone can invest and the minimum investment is $500. Investors select one of four portfolios, depending on whether their goal is current income or long-term appreciation or a mix of the two.
- RealtyShares only allows accredited investors (a/k/a rich people) to invest. They allow investors to select the projects they want to fund.
Adding real estate to your portfolio can provide regular income even in years when the stock market (or even real estate market) are down. Hopefully this post has shown you how you can invest in real estate.