Say the word “investing” and most people immediately think of stocks and bonds. But real estate investing can also be a part of a diversified portfolio. There are two primary ways to invest in real estate: indirectly through an ownership stake in real estate securities — the Wall Street route — or the Main Street approach by owning property directly.
What is real estate investing?
Real estate investing involves buying, selling or renting property to earn a profit. For most, a single-family home is what comes to mind when discussing real estate. This is an investment, as it is an asset that typically appreciates in value over time. For many families, owning a home has been a path to building long-term wealth.
But there are actually a wide range of real estate investing categories outside of home ownership available to investors: multi-family residential properties, office buildings, warehouses, retail facilities and hotels, to name a few.
Investing in real estate you don’t live in
Many financial planners believe real estate investments aside from one’s primary residence have a place in investment portfolios. The creation of investment vehicles that combine elements of Wall Street and Main Street now provide access to average investors who wish to invest in a wide array of real estate with broad diversification. Here are a few options.
Real estate investment trusts
The primary vehicle for real estate investors who don’t want to own and manage properties directly is the real estate investment trust, or REIT. Most REITs own property, collect rent and distribute their income to shareholders as dividends.
The shares of many REITs are publicly held and traded on a stock exchange like other equities, making them liquid investments that investors can buy, sell or hold as they see fit.
A REIT is required to invest at least 75 percent of company assets in real estate, cash or U.S. Treasuries and derive at least 75 percent of its gross income from rent, real estate sales or interest on mortgages that finance real property.
A REIT must also pay a minimum of 90 percent of its taxable income in the form of shareholder dividends each year, so “passing through” a property’s income is what makes them a favored real estate investing vehicle. It allows a property’s income to be taxed only once, instead of twice, which would be the case if the REIT had to pay tax on the income itself and then distribute the after-tax remainder to its shareholders, who would then pay tax on the distribution.
Real estate investment groups
While REITs pool investor capital in exchange-listed investment vehicles, many real estate investments continue to be funded through private pools of capital managed by a general partner in which limited-partners own interests.
Partnerships collect enough capital to buy large properties, such as office buildings or shopping malls. Partnerships are also “pass-through” entities, meaning that each partner may deduct their share of the partnership’s expenses, such as mortgage interest, and report as income their share of what the partnership nets. Capital gains or losses once the property is sold are also passed through to the partners.
Real estate investment platforms
A recent development in private real estate investing involves crowdfunding platforms. These are online businesses that serve as a marketplace for investors and real estate owners/developers seeking capital.
Some platforms permit investments as low as $500. In addition to the low entry cost, the platforms sometimes offer shares in private REITs, which are like the public variety, except their shares don’t trade on an exchange, making them less liquid.
Some crowdfunding platforms also require investors to be accredited, thereby meeting a requirement of the Securities and Exchange Commission intended to protect less-affluent investors from what could be risky investments.
An accredited investor is one who has income of at least $200,000 over the last two years (or $300,000 together with a spouse) or assets exceeding $1 million, excluding one’s home.
For investors who prefer to be active real estate investors, meaning to own and manage a property themselves instead of through an intermediary, there are other alternatives.
Some people choose to buy a single-family home and rent it out. Others may buy a vacation home and rent it to tenants either part-time or year-round. Still others buy and manage a small multi-family building, an office building or a store.
While owning and managing such assets usually involves more work and personal involvement than passive real estate investing, the properties owned can constitute a significant share of the owner’s total investment portfolio and should be considered in any comprehensive financial plan.
Another approach to real estate investing is “flipping,” which involves buying a property, usually a house that is dated or in need of repairs, renovating it to increase its appeal, and then selling it. The goal is a quick profit.
Flipping has been glamorized in television shows, but it can be risky. Renovations often take longer and are more costly than anticipated, financing can be tricky and market conditions may change over the course of the renovation.
Pros and cons of real estate investing
Nearly all financial experts agree that real estate should be considered as part of a broad, diversified investment program. The performance of real estate investments is generally not correlated to the performance of equity or fixed-income markets, which means that real estate often does well when stocks and bonds don’t. The uncorrelated nature of real estate returns, the potential for capital gains and the tax benefits that may accrue from real estate ownership are key appeals.
However, each approach has plusses and minuses. Owning real estate directly eliminates intermediary costs, can be done on a small scale, and offers tax, income and wealth-building advantages.
The negatives include the time and effort necessary to manage properties, the illiquid nature of real estate compared to financial assets, concentration risk (for example, owning just one house that goes unrented for several months) and the unlimited liability of ownership (someone slips on your property’s sidewalk, and you get sued).
Real estate ownership through passive entities — REITs and limited-partnership interests — keeps many of the positives of direct ownership and eliminates many negatives, although limited-partnership stakes also tend to be illiquid and usually cannot be readily bought or sold in the way exchange-listed shares can.
Who should invest in real estate?
Any investor seeking a broadly diversified portfolio should probably consider real estate for some portion of it. What form that investment takes depends on an investor’s individual circumstances and preferences.
For someone who’s handy and has free time, a direct investment in a rental property may be perfect. For someone busy raising a family and pursuing a career, the best choice might be a diversified REIT. Working with a financial advisor who can best assess one’s unique circumstances, needs and risk tolerance — as well as appropriate investment opportunities — is probably the best place to start.
No investment strategy can guarantee a profit or protect against loss. Specific sector investing such as real estate can be subject to different and greater risks than more diversified investments. Equity REITs may be affected by changes in the value of the underlying property owned by the trust. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.