When you think of investing, stocks and bonds likely come to mind first. But if you're looking to branch out a bit, you may want to consider adding real estate to your portfolio.
Why invest in real estate? Owning property aside from the one you live in has advantages. For example, you may be interested in generating side income, diversifying your assets or building generational wealth. Real estate investing can take a variety of forms. Here are some of the more common options and the pros and cons of each.
What is real estate investing?
Real estate investing is the acquisition of property, either directly or indirectly, with the goal of gaining income or benefiting from long-term appreciation. Most commonly, that involves purchasing housing or commercial properties you intend to rent out to tenants. That could be anything from an apartment building with two units to a strip mall with several business tenants.
When you're able to generate rental income each month in excess of your costs, your profit represents a new income stream. That passive income either can supplement your primary source of earnings, provide additional resources to donate to charity or set aside for your family, or, if your profits are substantial enough, even replace the need for outside income.
Meanwhile, if it's appreciation you're after, you're betting the property or collection of properties you buy may increase in value. You then can sell the property at a later date and collect the difference between the sale price and any mortgages you owe.
It's common to try to achieve both aims at the same time. For instance, you may choose to buy an apartment building with the goal of both generating rental income and building equity in the property. If the dwelling's market value goes up relative to the amount you owe on your mortgage, you have the option to sell it and receive a profit.
However, you don't need to buy property to take advantage of potential income from real estate. For example, you can buy shares in a real estate trust that owns or manages a collection of properties. Alternatively, real estate focused mutual funds or ETFs provide professional management and diversification. Or you can purchase the stock of a home builder or other company with strong ties to the real estate market.
What are the advantages of investing in real estate?
While more traditional assets like
Additional cash flow
Buying rental properties, for example, may enable you to generate income on top of your normal paycheck. You can use this income to meet your goals, like saving more for retirement, building your child's college fund or donating to your favorite charities. While managing rental properties comes with its share of labor, it may be a more passive option than working a second job.
Historically, real estate as an asset class has a relatively
A hedge against inflation
The cost of housing is one of the largest components of the Consumer Price Index. In other words,
Investment properties provide tax benefits that can increase your net return. For example, you often can
What are the potential challenges of investing in real estate?
Despite these potential upsides, owning real estate isn't without drawbacks.
Risk of losing money
Holdings can lose value. As with most assets, the potential for a large return usually entails taking on more risk. Say you're financing a new development project that's building homes before you've secured buyers for them. If the demand ends up being lower than you predicted, you might not recoup your money.
Even if your purchase ends up being a great long-term investment, be prepared for short-term swings. If you're a landlord, for instance, you may go through a stretch where rents in your city decline for a couple of years. Or you could have trouble finding a tenant to replace the one that just left, temporarily leaving you without income to help cover your mortgage on the property. The fewer units you own, the more risk you're exposed to from turnover.
Getting involved in real estate also can be a time-consuming endeavor. That's particularly true if you decide to acquire rental properties and manage them yourself. Did the air conditioning suddenly stop working? Is there a dispute between two tenants living down the hall from each other? Ultimately, it's your responsibility to handle any of the issues that may arise while you're renting out a property—or hire a property manager who tackles those problems on your behalf. On top of that, you have to advertise vacancies, interview potential tenants and run background checks.
And then there's the challenge of getting the financing you may need. While you can invest in a real estate trust with a modest sum of money, direct investment in properties is usually expensive. You need to show the lender you have a solid credit history and realistic plans for turning a profit on your project. Be ready to hand over research that supports your expected return on investment (ROI) after taking into account loan payments and other operating expenses. Typically, you also need enough cash to cover a down payment of 15% or more and any other closing costs.
How can you get involved in real estate investment?
Investing in real estate can take many different forms, each with its own advantages and potential pitfalls. If you're thinking about adding this sector to your portfolio, understand what you're getting into. Here are some of the more common paths you may want to consider.
Perhaps the most straightforward way to invest in real estate is by purchasing a house or apartment building and renting it out. This can be a compelling route if you can find properties where your ROI is favorable compared to other uses of your money, like buying stocks or bonds.
Often, the biggest challenge is realistically predicting your revenue stream and expenses—especially when you have a small number of properties. For example, look at the quality of the tenants you can expect to attract to your property. If you're renting a unit in a neighborhood with high unemployment, for instance, you usually can expect more turnover. And that can translate into periods of lost revenue, which you need to factor into your calculations.
You also want to look at the condition of any building you intend to purchase and lease out, just as you would when purchasing your own home. In general, older properties need more upkeep and require you to set aside more money into a maintenance fund if, say, the roof starts leaking or windows need to be replaced.
Residential units aren't the only opportunity to acquire rental income. If you're interested in an investment opportunity that comes with a higher potential for returns, you may consider purchasing a commercial space, whether it's for office, retail or industrial use.
Buying and leasing commercial real estate aren't for the faint of heart, however. For one, you generally need a larger upfront investment to acquire these properties. Your operating expenses may be higher as well. For instance, you need insurance sufficient to cover potential on-site injuries or property damage. Real estate taxes and maintenance fees associated with these properties are often considerably higher as well.
And as a landlord, you have to make sure the property complies with federal, state and local laws. Depending on the nature of the building and where you buy, that might include having everything from accessible entryways and working smoke detectors to disclosing potential contaminants like mold and lead paint.
As with residential rentals, investing in a commercial property may not result in a profit. But if your research suggests the potential for a strong ROI and you're willing to do some extra legwork, investing in the commercial end of the real estate market can provide some substantial returns.
Buying real estate you intend to list as a short-term rental—for example, on Airbnb or Vrbo—is similar to investing in long-term housing. You generally need to put down 20% or more for a down payment, plus enough to cover closing costs that can range from 2% to 5% of the property's value. You also need a good-to-excellent credit score, which shows lenders you're a reliable borrower.
This segment of the market has certain challenges of its own, however. For starters, you need to know which areas allow short-term rentals; some jurisdictions prohibit them. You also have to research the revenue potential. Some areas have fairly steady year-round demand, while others attract the majority of their guests in the summer or winter months.
Because of the frequent turnover between guests, managing short-term rentals can be more time-consuming than leasing other residential units. You need to be in regular communication with potential customers and step in to clean linens and wipe down the kitchen when they leave. If you hire a property manager or cleaning crew to do the legwork for you, you have to factor those costs into your analysis.
On the other hand, the additional attention short-term rentals require come with additional dividends, and you may earn a higher (if less consistent) monthly average—provided you have a sufficiently popular vacation destination.
House flipping is another opportunity with potential upsides. Here, you're buying properties that need some work—whether it's sprucing up the kitchen, adding a fresh coat of paint to certain areas or installing new carpeting—with the hope of selling them quickly for more than you put into them.
Being a successful flipper involves understanding the local real estate market, which often means buying homes near where you live. Without a clear sense of what the home could fetch once you've made your improvements, you leave the outcome of your project up to chance. It also helps if you're handy enough to do much of the labor yourself, which substantially reduces renovation costs and increases your potential ROI.
The idea of doing repairs for a few weeks and selling the home for a quick profit can sound enticing. But along with the possibility of a big payday comes a considerable amount of risk. This is an avenue you should probably only explore if you have cash you can afford to lose if things don't go quite as planned.
Real estate investment trusts (REITs)
Perhaps you don't have the money to buy a rental property or simply don't want the hassle of managing it. If you'd still like some exposure to the real estate market, investing in an indirect way may be more your speed. One of the most popular ways to do that is by purchasing shares of a real estate investment trust, or REIT.
REITs come in two basic varieties. An equity REIT is a company that owns or manages a collection of income-producing real estate properties. A mortgage REIT, on the other hand, provides financing for real estate acquisitions or invests in mortgage-backed securities.
Some of these companies are listed on a stock exchange while others are sold privately. The former companies are easier to buy and sell because there's an active market for them. They also provide more flexibility—in addition to buying shares of listed REITs directly, you also can purchase mutual funds or exchange-traded funds that own shares of multiple trusts.
REITs can help
Before adding these securities to your portfolio, understand that REITs, like stocks, can experience volatility, especially in the short term. And even when they're performing well, be prepared for the potential tax repercussion. By law, these companies have to distribute at least 90% of their taxable earnings to shareholders in the form of dividends, which the government taxes at your ordinary income tax rate. To avoid an immediate tax hit when the REIT makes a distribution, you may consider investing through a tax-deferred account, like a 401(k) or individual retirement account.
Is investing in real estate worth it?
Adding real estate to your investment mix can provide valuable diversification and increase your potential return. But before getting started, understand the risk as well. If you're buying a property directly, research the local market and perform a thorough analysis to estimate your total operating expenses.
Before moving into a new asset class for the first time, consider talking to a financial advisor who can guide you in the right direction. A