January 21, 2023
When thinking about whether to invest in real estate, the factors you should consider depend on what kind of purchase you’re considering and the reason you’re buying it. Real estate can help diversify an investment portfolio and serve as a hedge against inflation, but there are many ways to do that. Your reasons for buying will affect how you choose to invest in real estate. In turn, the form that your real estate investment takes will affect the factors you should consider in your purchase.
The key takeaways of this blog are:
Do you want to be an active or passive investor?
Investing in real estate can be as active or passive as you choose. Buying rental property and managing it yourself will involve time and effort unless you hire someone to manage it for you. If you’ve never been a landlord, be sure to talk with other landlords to get a sense of the potential rewards and pitfalls. Other real estate investments, such as real estate investment trusts (REITS), exchange-traded funds, mutual funds, real estate limited partnerships, or raw land, demand less day-to-day involvement. If you’re investing simply to diversify an investment portfolio, those may satisfy your needs without the challenges of owning property.
However, bear in mind that the same factors that can influence the value of a direct real estate investment–the negative impact of a drop in real estate values generally, economic downturns, rising interest rates that affect the cost of obtaining a mortgage, changes in property taxes or zoning laws, demographic changes, natural disasters, and many other factors–can also have a significant negative effect on REITs, mutual funds and ETFs.
Are you investing for income, capital appreciation, personal use, or a combination?
Real estate investments can offer potential for all three, but there is often a tradeoff among them. For example, raw land may have development potential, but it likely will not provide any return until that potential is realized. You may be able to earn income from rental property that has the potential to increase in value over time, but your ability to use it yourself will be limited if you want to enjoy a rental’s tax benefits. Ranking your priorities can be useful.
Are you looking for a quick return or long-term investment?
Real estate speculators have been known to earn high profits from buying distressed property, fixing it up, and reselling it at a profit, especially in a buyer’s market. However, the real estate market is notoriously cyclical. If you’re speculating, hoping for a quick return on your capital, the liquidity of a real estate investment will be important to you; so will making sure you don’t overpay to begin with. If you have a longer time frame, you may have a wider range of investing options.
Is real estate going to be a full-time business for you or a sideline?
Some real estate investors find that what they intended as a hobby or retirement diversion quickly becomes more than they can handle. Think about just how much time and capital you’re prepared to devote to your real estate investments, and how much of a cushion you have in case things don’t work out as you expected.
Are you investing for tax considerations?
Operating expenses for rental property can be tax-deductible if you don’t use the property yourself or use it only minimally, and you may also benefit from deductions for depreciation. Also, any profit from the sale of real estate generally is taxed not as ordinary income but at the lower rates for capital gains, and you may be able to use capital losses to offset capital gains. Other forms of real estate investment, such as REITs and ETFs, may have only limited value as tax shelters. Also, remember that tax laws can change. If tax considerations are your primary focus, be sure to consult your financial professional to see whether real estate is the most effective means of addressing your tax concerns and which type or types might be most appropriate.
Residential real estate/vacation property
If you are considering investing in a single-family dwelling, multi-unit property, or vacation property for rental or as a second home, you should analyze market value, as well as potential income and operating costs.
To determine a property’s market value, it is important to understand the local economy and real estate market conditions. A period of low interest rates and high supply may indicate a good time to invest. The location of the particular property you are considering is also important, as is the condition of the property. Be sure to have the property inspected and appraised by professionals. To make sure the asking price is reasonable, compare it to several similar properties in the area. Research whether there are current building plans that will change the neighborhood (e.g., a large department store or strip mall). And finally, talk to neighbors about any problems that might exist in the neighborhood (e.g., noise, crime).
Caution: The assessed value of the property for property tax purposes may not be an indication of the property’s real value.
To analyze potential income and operating costs, you should review the property’s operating figures for the past three years, if they are available. Compare the percentage of occupancy to similar properties in the area. If occupancy is relatively high, rental rates may be too low (or vice versa). Obtain the rental rates charged in comparable properties in the area. To evaluate the property’s potential for future increases in rental rates, estimate the local population’s median income. Once realistic potential income is determined and costs are estimated (don’t forget to include tax liabilities and financing costs), prepare a cash flow statement. If the property offers a positive cash flow–in other words, if the potential rental would more than cover the mortgage payments and expenses–the property may make sense as an investment.
Timeshares represent ownership of a share of a piece of property, such as a condo in a resort area, that gives you access to the property for a specific amount of time. They are popular as a way to avoid the responsibilities of owning a second or vacation home, and they are sometimes marketed for their investment value. However, as an investment, they can be problematic, and there are several considerations you need to be aware of. Perhaps the most important is the potential resale value of your investment; timeshares can be extremely difficult to resell. It’s worthwhile to check prices on units that are being resold; not only will your research give you an idea of what you might be able to get for yours, but prices for resold units typically are much cheaper than those for new ones. Also, there are usually ongoing maintenance and management fees; make sure you factor them into your calculations. Finally, if your timeshare is part of a network that allows you to trade your time for time in another location, be sure to check on availability; many of the most popular locations are difficult to book.
Commercial real estate
Commercial real estate (e.g., retail and office buildings) is more difficult to analyze than residential real estate because there are many more details to be concerned about, including the stability of rental income (commercial property is more vulnerable to downturns in the economy) and competition. These details are analyzed in a process known as due diligence. In addition to the common sense items listed above under residential real estate (e.g., economic and market conditions, site, value), an investor in commercial real estate should carefully examine all documents concerning the building and its operations. Such documents may include:
Further, investors in commercial real estate should also:
Buying unimproved land for its development potential is highly speculative. If you’re interested in a specific piece of property, be sure to factor the property taxes you’ll pay into your calculations of the potential return on your investment. If you’re counting on nearby development to increase your land’s value, remember that a change in the economic climate can affect not only commercial development but government priorities and funding for infrastructure projects such as roads, sewer and water lines. Zoning issues may also be a factor.
Real estate investment trusts (REITs)
A real estate investment trust (REIT) is a real estate investment company that pools capital from many investors and that may or may not be publicly traded on one of the stock exchanges. Many investors find REITs attractive because they must distribute 90 percent of their net income as dividends to shareholders. Thus, when analyzing a REIT, an investor should ascertain the company’s dividend rate and dividend-paying ability. Also, keep in mind that the income potential depends upon income derived from the underlying property, and low occupancy rates will affect a REIT’s return.
The primary performance and valuation gauge for a REIT is funds from operations (FFO). FFO is net income plus depreciation and amortization plus extraordinary losses (or minus extraordinary gains). To determine the company’s dividend rate, divide FFO per share by dividend per share. To ascertain safety, determine the company’s dividend coverage ratio (DCR), which is calculated by dividing FFO per share by its current dividend.
The higher the DCR, the more sustainable the current dividend. Think about whether you want an REIT that concentrates in one sector of real estate, such as office buildings, shopping malls or apartment buildings, or one that is more diversified or that has multiple sources of income. Also, think about whether a non-traded REIT or exchange-traded REIT is more appropriate for you. Non-traded REITs are considered relatively illiquid compared to exchange-traded REITS, and you could have difficulty selling your shares quickly. Also, fees associated with the sale of a non-traded REIT can be high.
Real estate mutual funds and exchange-traded funds
There are multiple ways to use mutual funds and exchange-traded funds to invest in real estate. A mutual fund may be actively managed, selecting specific real-estate developers’ stocks or REITs in which to invest. Or it may simply invest according to an index of various REITS, as exchange-traded funds do. Popular real estate indexes include the Dow Jones Wilshire Real Estate Securities Index, the Dow Jones Wilshire Real Estate Investment Trust Index, the FTSE EPRA/NAREIT Global Real Estate Index, and the S&P/Citigroup Global REIT Index. In addition to these broad-based indexes, which can be used as a basis for comparing the performance of individual REITS or REIT funds, there also are regional indexes for various parts of the world.
You should read the fund’s prospectus (available from the fund) and carefully evaluate a real estate fund’s expenses and fees, investment objective, holdings and performance before investing, just as you would any other fund. In addition, think about whether you want a closed-end mutual fund, which issues a fixed number of shares and may use leverage as part of its investing strategy, or a more traditional open-ended mutual fund, which issues shares continuously.
Real estate limited partnerships
Limited partnerships offer investors who do not have the expertise or time to select and manage investments on their own the ability to seek opportunities in real estate. Investors should carefully review the financial information contained in the offering documents, including fee structures. Additionally, because limited partners have no say in management, investors should research the credentials of the general partner, including his or her knowledge and experience, and willingness to keep the limited partners informed on the status of the partnership’s holdings. The general partner should have a good track record. Review past deals to determine whether projections were met. Talk with current limited partners about the profits they have earned.