January 21, 2023
Real estate as an investment can be a way to diversify a portfolio and potentially serve as a hedge against inflation. Returns typically are derived from capital gains, tax credits, and/or rental and lease income.
There are many ways to invest in real estate. Direct investment typically involves the purchase, improvement, and/or rental of land or buildings. Indirect investment typically involves the purchase of shares in an entity that invests in real estate, such as real estate investment trusts (REITs), mutual funds and exchange-traded funds that invest in real-estate related stocks and/or REITs, and real estate limited partnerships.
Here are the key takeaways of this blog:
Potential portfolio diversification
Real estate is considered an alternative asset class: an investment that may behave very differently from such major asset classes as stocks, bonds, or cash alternatives. For example, because location is such an important factor in determining the value of a real estate holding, local economic conditions can be just as important as what is happening in the national real estate market. As a result, having a portion of your overall net worth in some sort of real estate investment–including your home–can help diversify your portfolio. However, remember that diversification alone cannot guarantee a profit or protect against the possibility of loss, and there have been times when the real estate markets and other markets have had a substantial impact on one another.
Potential to hedge against inflation
Real estate can be a tool for at least keeping pace with inflation. When prices rise, real estate values often rise as well, in part because the cost of the raw materials that go into construction are increasing. However, the opposite can be true as well; a general decline in prices is likely to affect the value of land, homes, and other buildings, as well as the income stream from rentals.
Pleasure of ownership
In some cases, such as a primary residence or a vacation home, real estate ownership can represent a way to enjoy your investment. Many homeowners view their homes as providing not only a financial benefit but also the tangible psychological benefit of pride of ownership.
Potential for significant gains
Real estate investments can have the potential for significant gains if property can be developed and sold for substantially more than its original value. A barren strip of desert can be converted into an entertainment mecca. A remote tract of woodland can be developed into a large subdivision of homes. An old abandoned factory can be converted into luxury apartments. However, such gains often require significant initial outlays of cash, experience, and favorable circumstances.
Can provide stream of income
An investor can enjoy a stream of income when rental and lease payments exceed the property’s operating expenses and debts.
Can allow you to take advantage of certain tax credits
There are a number of tax credits available to real estate investors. Most relate to investment in low-income housing or the rehabilitation of certain types of property. Such investments can further legislative interests, while providing an investor with certain tax planning tools that might not be available with other investments.
Numerous ways to invest
Real estate can be purchased either directly or indirectly in many forms including shopping centers, industrial buildings, apartments, condominiums, single-family residential housing, and raw land. Each type may offer different potential advantages, so it’s possible to diversify the real estate component of your holdings.
Lack of liquidity for some forms of real estate ownership
One of the biggest tradeoffs associated with direct investment in real estate is its lack of liquidity. Direct investments in physical property are rarely liquidated overnight. For example, if you want to sell a parcel of land to cover a debt, you might not find a buyer, or a buyer might need some time to obtain financing. If your real estate is unencumbered, you may be able to borrow against it, but you will have to pay interest on the debt, and it may take weeks or months to process your mortgage. When your money is tied up in real estate, it is really tied up.
Indirect investments have more flexibility. REITs are traded on exchanges and are fairly liquid, and if you invest in am open-end real estate mutual fund, you can typically liquidate your shares on very short notice.
High initial costs
Investing in real estate directly typically involves an initial outlay of cash to cover costs such as down payments, closing costs, insurance, legal fees, appraisal fees, property taxes, building permits, zoning applications, surveys, environmental tests, advertising fees, and/or construction and repairs. These initial costs may be reasonably affordable if, for example, you are purchasing a modest condominium. But if you plan to develop a tract of raw land and put up a shopping mall, you will likely sink a great deal of cash into your investment before you ever see a dollar of the profit you’re projecting.
Prior to the 1980s, it was not uncommon to hear off-the-cuff comments like “Invest in real estate–it never goes down in value.” Although this may have been historically true for the most part in America, many such armchair investors were reminded in the late 1980s and again in the late 2000s that the real estate market can be quite cyclical, and that those cycles can last longer than anyone expects. Although real estate investments generally enjoy a low degree of price volatility compared to some other investments, there is always the risk of loss if the market for real estate takes a turn for the worse.
Many other risks are associated with different types of real estate investments. Some are typical business risks. Others are always present, but sometimes given little attention at the time of purchase. The following is a list of some of the more common risks to consider when making a real estate investment decision:
• Soil or groundwater contamination
• Local rent control laws
• Pests and insects (termites)
• Flooding, mudslides, hurricanes, tornadoes, and other natural disasters
• Eminent domain (the right of government to force the sale of your property for the public good)
• Code violations
• Hazardous conditions liability
• Hazardous materials (lead paint, asbestos)
• Competition from competing builders and real estate ventures
• Changes in the neighborhood (e.g., from residential to commercial)
• Security issues (where tenants are involved)
• Tenant-related damages or losses
Many of these risks can be avoided or minimized by choosing carefully how you want to invest in real estate. For instance, if you want to avoid landlord/tenant risks, don’t invest in rental property. Certain risks can also be minimized using insurance. Flood insurance (if available) and liability insurance can help protect you and your investment.
Choosing a real estate investment involves doing some research. First, read about the different types of real estate investments and determine whether investing in real estate is right for you. Decide whether you have (1) the financial resources to invest in real estate, (2) the temperament to accept the associated risks, and (3) the knowledge and experience to make sound real estate investments on your own. If not, consult additional resources and seek the advice of a trusted advisor.