How to navigate the pros and cons of various real estate investment vehicles.
Real estate has been a reliable builder of wealth for generations. The first thing people consider when thinking about buying and owning real estate is their home. Buying physical property is not just about home ownership, however. It has become a popular investment for many people who want to diversify their portfolio.
Various investment vehicles for real estate exist. Investors must carefully consider the opportunities and the pitfalls of each.
Owning Rental Property
Rental properties have been around since the nation’s founding and have been used not only as a source of income but also as a wealth generation tool.
With a rental property, the owner and landlord are responsible for paying the mortgage, taxes, insurance and maintenance costs for the property. Typically, a landlord buys a rental property with the hope that the amount of rent received will cover most, if not all, the costs associated with owning it.
This strategy requires patience, as there may not be enough rental income to provide much profit until after the mortgage is paid off. Once the mortgage is paid off, however, most of the rent collected becomes profit and the property is considered a “cash-flowing” property.
Appreciation is another benefit to owning rental property. As long as you own the property, you receive all the value that comes with the property’s appreciation in value. On top of cash flow, it is the most significant benefit of owning a rental property. Based on the location of the property, appreciation rates may vary, but the value of the property can increase by double digits over a relatively short period.
Investors must take into account the location of the rental property they are considering—proximity to schools, work areas and transportation hubs—and the rent that can be demanded for the neighborhood.
The neighborhood where the property is located will influence both the type of tenants you will attract and the vacancy rate. By choosing the right neighborhood, you reduce the risk associated with high tenant turnover rates. Choose the wrong area, and you may be saddled with bad tenants, lower rent and damage to your property.
A rental property will often need exterior and interior work after it is purchased. The difference between being a landlord and participating in other types of real estate investments is the amount of time you must spend renovating and maintaining the property. You could hire a professional management company, but then, of course, you would have to deduct that expense from any potential profits from the property.
The “fix-and-flip” strategy is the opposite of buy and hold. It works like trading stocks, in that an investor identifies an asset that could potentially make a profit, purchases the asset and “flips” it for a profit.
Most investors who employ this technique buy homes with the intention of holding them for only a few months and then reselling. The strategy can be challenging because the investor needs to identify properties that are significantly undervalued for their neighborhood while ensuring that the cost of renovation will not eat up too much of the potential profit.
Another challenge is that the improvements to the property must be appealing enough to compel prospective buyers to accept the market price; however, there is a risk. An investor who is unable to sell the property has to carry the expenses associated with the property, namely, the mortgage and maintenance.
The costs associated with this type of investment are high. Many times, flippers need to take out a short-term loan, typically with a much higher interest rate than a traditional mortgage, to outbid competitors. If the property doesn’t sell or they run into problems with the renovation, the investor may get stuck making those high mortgage payments for many months, or be forced to dump the property for a loss.
Real Estate Investment Groups
Real estate investment groups are a type of investment vehicle, similar to a mutual fund, that invest into rental properties in specific markets. This strategy is a good investment for those who like the idea of owning rental properties but don’t want the headache associated with collecting rents, maintaining the property and filling vacancies.
Under this scenario, a management group builds or buys rental properties, typically apartment buildings and multifamily dwellings, and holds them in a rental portfolio. Individual investors are then asked to join the group with one or more properties that they own, but the management company takes care of the duties related to operating all the properties in the group. In exchange for overseeing the group of properties, the management company receives a percentage of the total rents collected.
Typically, the investor still holds the lease for his or her property, while contributing a portion of the rent into a fund each month to cover the management fees and other shared group expenses. There are several variants of this type of real estate investing group depending on the type of property you own, the area where the property is located and the kind of returns your property generates.
Real Estate Limited Partnerships
Like an investment group, a real estate limited partnership (RELP) holds and maintains a rental property or a portfolio of rental properties; however, a RELP holds these properties for only a specific number of years.
An experienced real estate property management company typically acts as the general partner. Individual investors are invited to provide financing for the venture in exchange for an ownership share of the limited partnership.
The partners in the venture typically receive periodic income distribution based on the rental income the group of properties generates. At a later date specified by the terms of the partnership, the properties are sold for a profit, the partners split the proceeds and the RELP is dissolved.
This investment strategy allows investors to participate in the real estate market without having any previous real estate investing or management experience. The downside is that since the properties are held for a specific period, the money you invest may be tied up for quite some time.
Real Estate Investment Trusts
A real estate investment trust (REIT) is similar to a RELP, except the properties form a holding trust. The trust is converted to certificates, similar to a stock, which are then sold off to individual investors.
In a REIT, a corporation acquires a group of income-generating properties that it holds and manages. These properties may include medical buildings, office buildings, malls or other high-capacity rental properties. The money raised from the certificate sales is used to finance the purchase of additional revenue-producing properties to be held by the trust.
The revenue generated from mortgages or rents on the REIT’s properties is distributed to the certificate holders on a regular basis. It is a good strategy for real estate investors who want a steady rental income without the hassles of being intimately involved in the buying and management of physical properties.
Real Estate Mutual Funds
Real estate mutual funds invest in REITs and other real estate-related companies. This strategy allows individual investors to dabble in real estate without risking much capital. Mutual funds invest in a diversified group of real estate assets, therefore reducing the investor’s risk and exposure. They allow individuals to participate in a broader range of real estate investments than provided by REITs.
The advantage is that novice investors can get involved in real estate after making an educated and informed decision. Mutual funds have a wealth of analytics and other data that can provide investors with all the tools they need to diversify their investment into sectors of the industry that make the most sense for their investment goals.
Why Real Estate is a Great Investment
Real estate has proven to be a great wealth-generating tool over the past several decades. Even after you factor in the housing crisis of 2008, private commercial real estate investing returned 8.4 percent annually over the decade of 2000–2010.
Real estate investing is also a great way to diversify a portfolio of stocks and bonds. Historically, real estate has low volatility compared to the stock market. While stocks can lose nearly all their value, it is improbable the same will occur with physical real estate that you own.
Diversification of Your Asset Portfolio
With real estate, an investor can hedge against a market downside by owning tangible assets, with low risk of severe devaluation.
Real estate has a negative correlation to the stock market, meaning that when the stock market drops, real estate-related investment products are usually up. Although the Great Recession was somewhat of an anomaly, residential real estate prices continued to rise after 14 of the last 15 recessions.
During expanding economic conditions like we are experiencing now, demand for housing rises. When demand rises, rents and values rise along with it. In this respect, the correlation between gross domestic product (GDP) growth and real estate passes some of the inflationary pressure onto tenants, while generally retaining the purchasing power of the investor’s capital.
Real estate investing makes good sense to balance out an investor’s portfolio of stocks and bonds, mutual funds and physical commodities. Although real estate investing is generally accepted as an “alternative investment,” it can help investors hedge against wild stock market swings, provide appreciation and a steady income stream, and improve balance to an investment portfolio of securities and other physical assets. ∞