Have you ever felt the rush of excitement when a friend mentions she recently purchased an investment property? You immediately start dreaming of passive income pouring in on a monthly basis (aka, someone else paying your mortgage) and soon you’re calling your friend’s real estate agent.
Investing in real estate is one of those topics of conversation that can make a person seem like a sophisticated investor but whether or not it’s a prudent part of one’s portfolio, depends entirely on your specific financial profile. Much like the stock market, it’s easy to fall for the rush of “getting in while it’s hot” but there is no way to perfectly time your investment and you should be ready to commit as a long-term investor. There’s no doubt that real estate can be a beneficial part of a diversified portfolio but it’s its own animal and there are many risks to consider alongside the potential opportunities.
Real estate should be considered an investment whether it’s your primary home, an apartment building or commercial office space. When considering real estate as part of your total investment portfolio, it is traditionally categorized as an alternative investment. One of the many benefits it provides is diversification because it has the potential to behave differently than other asset classes during various periods of the economic cycle. Outside of your primary residence, real estate also typically provides income to the owners through direct rent payments or dividends. Real estate is also a strong inflation hedge because the value of real property rises along with inflation. What’s more, it provides the opportunity to leverage your investment by borrowing against the property.
Most people’s first investment in real estate is their primary home. Whether it’s a desire to make the place your own or you’re tired of paying someone else’s mortgage, it can make good sense to invest in a home. However, no matter where you live or how affordable it might seem, buying a home should always be considered a long-term investment with many associated risks. Here are some questions to consider before buying a home:
- Do you have enough money for the down payment without digging into your emergency fund? If not, it might be best to wait and save.
- How long do you plan to live in the home? If the timing is uncertain, it may be better to wait. Transaction costs and market fluctuations might turn a prudent, long-term investment into a high risk, short-term one.
- Does your income fluctuate? Be sure your expected income and savings are sufficient to cover your mortgage, tax, insurance and maintenance payments.
After considering these questions, it may make sense to consider buying rather than renting. The primary benefit of owning vs. renting is that you create value over time through the principal portion of your payments. In addition, rent can go up over time with inflation, while a mortgage payment is typically locked in at a set rate at the time of purchase (variable rate mortgages are also an option).
For owners of a primary residence, what does owning additional property look like? To begin, there are a number of different ways to invest in real estate, depending on your personal time horizon, risk tolerance, capacity to manage the investment and the size and diversity of your total portfolio. You can purchase individual properties such as rental homes or commercial buildings. You may also invest in properties through partnerships and private pools that allow for smaller investments or more diversity. Lastly, publically traded Real Estate Investment Trusts (REITs) are the most liquid form of real estate investing and can be purchased in small quantities through diversified exchange traded funds (ETFs). We’ll outline some of the benefits and drawbacks of each investment vehicle.
Purchasing a physical rental home or a commercial property is a major investment decision. Before making this purchase, you want to ensure you have ample liquid assets and income to cover the down payment and costs associated with owning and maintaining an additional property. Assuming this is the case, the investment decision will include a cash flow and return analysis. The return will need to justify the significant risks associated with the purchase of a single property because owning a single property adds concentration risk. What will happen in a down cycle if you can’t lease the property? How will you cover the loan payments? Do you have the liquidity to cover expected and unexpected maintenance costs? It is important to factor all costs into the return and cash flow analysis, including transaction, funding and maintenance expenses and even the potential for unforeseen costs.
Another important aspect to consider when purchasing an investment property is how much time you have. Will you maintain and manage the property yourself or hire someone? If you plan to hire someone, you’ll need to factor this into the return analysis. Even if you end up subcontracting these efforts, remember that you’ll spend time managing the contractors. The benefit of owning a property outright is that you have full control over the decisions but this can be daunting at the same time.
In many cases, purchasing an individual property will present too many risks or involve too much work on the part of the owner to justify the investment. An alternative is to invest in an LLC or partnership that allows multiple parties to invest together to buy or build a property. The investors share proportionately in the income and investment returns. In many cases, there will be a general partner and a group of limited partners. The general partner is responsible for managing the project while the limited partners contribute capital. The benefit of this structure for limited partners is that they typically don’t have an investment of time. The drawback is sharing returns with the general partner without having full control over the decisions.
Another option for investors with limited capital or time who don’t want to take on the liquidity and concentration risk of a direct investment, publicly traded REITs may be the answer. While the upside potential may be more limited than with direct investment or partnership, they allow for minimal investment amounts, ample liquidity and increased diversity. For additional diversity amongst property types, investors may want to consider a REIT exchange traded fund.
There’s no doubt that investing in real estate can be additive to a diversified portfolio. Yet, each opportunity is unique and every investor’s situation should be carefully analyzed before making a significant investment decision.