Including real estate as an asset class in your investment portfolio adds diversity to reduce your overall investment risk. There are many real estate investment strategies to achieve this. Some options, such as real estate investment trusts (REITs), are as passive as dividend-paying stocks. Others, such as buying and holding rental properties to generate cash flow and capital appreciation, require active participation and considerable knowledge to be successful.
I have personally found that active real estate investing results far more than more passive strategies. And let's face it, owning real estate and profiting from it is much more exciting than owning stocks on paper.
Like any investment, having real estate in your investment portfolio has its pros and cons.
The Pros of Real Estate Investment
1. Real Estate Appreciates Over Time
Properly selected real estate appreciates over time, usually at a rate well in excess of annual inflation. Yes, there are occasional market corrections and people can buy real estate at the wrong time. But I discovered that there is always an opportunity to buy a quality property at a discount, make improvements to increase the equity, and finally sell for a profit. It's the real estate equivalent of the stock market mantra of “buy low, sell high.” And real estate always has intrinsic value. The stock may drop to zero, but property is a tangible asset that will always have value derived from both the raw material and the “improvements” (building structures attached to the land).
2. Real Estate Has Unique Tax Benefits
The unique tax benefits of real estate allow investors to build wealth over time. Rental income is not subject to self-employment tax, and the government offers tax breaks to real estate investors. These include depreciation and significantly lower long-term capital gains tax rates. And depending on your income level and classification as an investor or real estate professional, there's a good chance that your rental property will give you excess tax deductions that you can use against your other income. Rental real estate is a business, which means that many expenses, such as travel expenses to inspect your property, are tax-deductible expenses for running your business.
3. Real Estate Provides a Steady Cash Flow
A rental property can provide a steady stream of monthly income, called “cash flow.” This is the extra money left over after paying all the bills. Once your property is established, cash flow provides ongoing monthly income that is mostly passive, allowing you to spend your time building a business, spending time with family, or reinvesting in more real estate.
If you're looking to buy a rental property and need help navigating the market, you can use a free service like HomeLight to find a real estate agent in your area to help you find the best deal for you.
4. Real Estate Lets You Use Leverage
You can use the power of leverage to quickly grow your real estate holdings and accelerate your wealth building results. Leverage is the use of borrowed capital to purchase and/or increase the potential return on an investment. Leverage, when used wisely to minimize risk, is a powerful asset in real estate investing. With a conditional loan, you can purchase an investment property with a 20% down payment. So, for example, with an initial investment of $30,000, you have the opportunity to control and reap all the benefits of owning an asset worth $150,000. If done with proper due diligence, you can grow your wealth using leverage, especially in the low interest rate market we are currently enjoying.
5. Real Estate Builds Equity
When you use leverage wisely, your tenants basically buy the property for you. The rental income pays off your loan each month and builds equity for you. When you buy a rental property with a mortgage, it is your tenant who pays the mortgage payment, adding to your net worth each month. Think of it as a savings account that grows automatically without you having to deposit any money each month.
Today you may owe $200,000 on a rental property, but next year you may owe only $195,000 because the tenant is paying for you, making you $5,000 richer. After thirty years (or whatever your loan term is), it pays down to $0. You have an important asset that you can sell or continue to rent out because your tenant is paying the mortgage.
6. Real Estate Gives You Control
You have much more control over the success of your overall real estate investment than you do with other types of investments. You cannot sit in a boardroom and direct management decisions that affect the value of the stocks you own. With real estate investing, you are in the driver's seat of many decisions. You can reduce risk and grow your portfolio at a much faster rate by investing in real estate. As a real estate investor, I control my own success or failure. When I want to find deals, I can hurry. In a competitive rental market, I employ strategies to ensure my properties attract the best tenants. I can make strategic improvements to increase rental income.
7. Real Estate Provides a Hedge Against Inflation
Inflation is an economic reality in which prices rise over time due to the decline in the value of money. Annual inflation fluctuates. In the 12 months ending in June 2019, US inflation was 1.6%. Inflation was 3.2% in 2011.
Inflation erodes the value of many investments. If your stock portfolio returned 5.5% annually last year, your real return was only 3.9%, and the purchasing power of your money has declined at the rate of inflation.
Real estate investments keep pace with inflation. As the price of bread rises, so do rents and property values. The only thing that doesn't go up is the monthly cost of a fixed rate mortgage. Therefore, as your annual rental income increases, the value of your property does not. As inflation increases the cost of living, your cash flow increases. And inflation itself increases the value of the property. In 10 years, when I want to sell, my property will be worth much more than it is now.
The Cons of Real Estate Investment
Investing in real estate also has some drawbacks that should be carefully considered before taking the plunge.
1. Real Estate Requires Money
You need money to make money. Forget the gurus who promise. “You can get rich buying real estate with OPM (other people's money). While you can buy stocks with minimal cash outlay, investing in real estate takes money. You'll need a down payment to get started, plus closing costs and money to renovate and update the property to maximize rental income. And once you own the property, there will be ongoing costs such as property taxes, insurance, mortgage payments, and property maintenance.
2. Real Estate Takes a Lot of Time
You should spend time learning and managing your real estate investments. There is a learning curve and you can lose a lot of money in real estate if you don't know what you are doing. Additionally, actively managing your rental property can be time-consuming.
However, some services can be “heavy lifting” when it comes to managing your rental property. Roofstock is an online investment platform that allows you to buy turnkey rental properties. That means you don't have to lift a finger if you choose. The service's certified property managers can do all the work for you. Additionally, properties listed on Roofstock are pre-screened and already cash flow positive.
3. Real Estate Is a Long-term Investment
Real estate should always be bought with a longer-term strategy in mind. You're buying a tangible asset that you can't quickly liquidate with cash if you need funds urgently. Selling property takes time and transaction costs are higher than selling shares.
4. Real Estate Can Be Problematic
Tenants can cause problems and cost you money and valuable time in court. If you own a rental property, your cash flow can be significantly affected if you rent to a tenant who doesn't pay, leaves the property in a very poor condition when you leave, or both.
In Maryland, where I invest, the law is very “rental” requiring a non-paying tenant to be taken to court three times before they can claim ownership. And when you're evicted, you'll probably have to spend money to repair the damage your disgruntled tenant did to your property.
5. Real Estate Benefits Don't Always Apply
At certain income levels, some of the tax breaks no longer apply. Before assuming that you qualify for any exemption, you should consult with an experienced real estate tax professional.
6. Real Estate Investing Has Unique Risks
The risks must be understood and mitigated as much as possible. Some of the important risks of investing in real estate are:
- Buying the wrong property at the wrong time
- Increased liability for accidents that may occur on your property
- Sticking with a “tenant professional” who knows how to navigate the legal system at your expense
- Overleveraging This is a temptation that brings down many real estate investors. You need to be able to make your monthly debt payments despite market downturns, tenant issues, vacant
- properties, unexpected repairs, maintenance costs, and other expenses that are part of the business of investing in real estate.
Real estate crowdfunding services like Fundrise and RealtyMogul can answer many of the questions raised above. We recommend that you review them first.
The main reasons why people invest in real estate are:
- diversify your investment portfolio through an asset class that is not directly linked to the stock market;
- generate monthly income from rental cash flow, and
- benefit from long-term capital appreciation.
Active real estate investing is not for everyone, as there are unique barriers and risks.
Buying and owning rental real estate is not going to build wealth right away. Real estate can be an incredibly powerful wealth building strategy, but only if you do it right. You need to learn how to find, evaluate and buy good real estate deals. You need to build a team of contractors, lenders, property managers and other professionals who provide competent services at affordable prices.
As you build your rental portfolio, you can put systems in place that limit the need for their active participation. Your wealth then grows steadily through passive income, equity growth through debt repayments from your tenants, and long-term capital appreciation. This works for me!