Have you been considering investing in real estate, but aren’t sure how to start? It can seem daunting at times, but knowing the fundamentals of real estate strategies can help you build long-term wealth. Per a Gallup survey, real estate was the most favored asset class among investors since 2013.
This comprehensive guide will walk you through the fundamentals of real estate investing, including its pros and cons, types of physical real estate, REITs, REIT ETFs/mutual funds, and alternative real estate investments.
Table of Contents
- Advantages Of Real Estate Investing
- Disadvantages Of Real Estate Investing
- Commercial Vs. Residential Real Estate
- REITs, ETFs and Mutual Funds
- Alternative Real Estate Investing Options
Advantages Of Real Estate Investing
Having real estate in your portfolio will diversify it, which reduces investment risk. Real estate has a low correlation to other asset classes like stocks and bonds. Correlation refers to how assets perform against each other in certain market conditions. Since real estate has a low correlation to stocks and bonds, it could produce high returns when those assets don’t and vice versa.
For example, bonds are negatively impacted by inflation, while real estate is seen as an inflation hedge.
Incorporating real estate strategies into your investment plan can offset inflation. Inflation refers to the increase in prices over time and usually fluctuates between 2-3% annually. Real estate is an inflation hedge because landlords can raise rents and home values appreciate over the long run. Unlike cash or paper assets (i.e stocks or bonds), real estate has a finite supply, which increases demand.
Real estate investments like REITs, REIT ETFs or REIT mutual funds are paper assets that don’t offer the same protections against inflation as physical property. These assets are more exposed to the overall stock market’s performance.
Physical property has uses beyond investing like providing a place to live. Everyone needs a place to live, so this asset class will always be in demand. You can rent out your real estate or you could use it as a vacation home throughout the year, which is referred to as mixed-use property. Consult your tax professional about the potential tax consequences of mixed-use property.
While dividend paying stocks can provide steady income, real estate strategies have the potential for higher, more sustainable yields. The average dividend paying stock yields approximately 2%, while most REITs offer yields between 4-5%+. Monthly rents can offer greater yields than these amounts and are a source of consistent, passive income.
Investing in physical property offers many tax advantages such as being able to deduct depreciation, rental expenses, property taxes, and mortgage interest (up to certain thresholds). These tax breaks can shield most, if not all, of your real estate income.
You can also obtain tax breaks with REITs, REIT ETFs, and REIT mutual funds in retirement accounts. If you have these investments in an IRA or 401(k), you won’t pay taxes unless you take distributions from those accounts. Having these investments in a Roth IRA could let them grow tax-free!
Disadvantages Of Real Estate Investing
Real estate investing, especially with physical properties, is very illiquid. You can’t buy or sell homes with a click of a button, commission-free, unlike with stocks. Physical real estate also has high transaction costs, including agent commissions, title fees, and mortgage expenses.
Even real estate paper assets like some REITs can be illiquid if they’re close-ended funds. REITs that are closed-ended issue the original shares at the IPO and don’t create additional shares after this event.
Both tangible and intangible real estate can have significant expenses. Some of these include repairs, maintenance, and down payments.
Intangible real estate investments have costs like investment minimums along with high expense ratios that include assets under management (AUM) fees and performance-based fees (i.e carried interest).
Some standard ETFs and Index funds have no investment minimums and expense ratios as low as 0.10%! Conversely, real estate funds with total expense ratios of roughly 1-2%, can cost you tens of thousands of dollars long term!
Most real estate strategies are more time consuming than “set it and forget it” investing with index funds. You need to research property values, fundamentals, zoning regulations, real estate professionals, and more.
It’s also prudent to do due diligence on fund managers, underlying investments, investment tactics, and ongoing expenses with intangible real estate strategies.
Tenants can cause problems if you own real estate directly or have exposure to a real estate fund. Poor tenants can damage the property, not pay rent, diminish investment returns, and can cause legal issues. Some states like Maryland are “tenant-friendly”, meaning that you have to take a tenant to court three times before you can evict him or her.
Commercial vs. Residential Real Estate
Commercial real estate refers to properties that are used for business purposes like shopping malls, office spaces, and industrial centers. It also refers to a property that has five units or more.
Some advantages of commercial real estate strategies include:
Larger corporations are savvier about real estate transactions and laws compared to the average person buying a home for the first time. These higher qualified tenants are more likely to respect the property and reduce stress for the owner.
Triple net leases can be helpful for the owner as the tenant pays for expenses like real estate taxes, insurance, maintenance, and utilities. This can also save the owner significant sums as he or she would only need to pay the mortgage principal and interest.
Residential property values are mainly impacted by comparable properties. Yet, the value of commercial properties is closely related to the revenue it produces. Investing in a high cash flow commercial property can lead to greater returns than residential real estate.
Residential real estate has a lower barrier of entry compared to commercial real estate. For instance, a down payment on a $100,000 home is more feasible compared to a downpayment on a shopping mall.
All real estate strategies have regulation, but residential has less red tape than commercial investing. Zoning laws are less strict and it’s easier to obtain building permits.
Regardless of the economy, everybody needs a place to live. This makes residential real estate in higher demand than commercial. Due to COVID-19, more people are working remotely, which reduces the need for office space.
REITs, ETFs and Mutual Funds
REITs or Real Estate Investment Trusts combine investor funds to invest in various properties. Some REITs focus on sectors like healthcare or retail. They are similar to mutual funds and ETFs since they collect funds from numerous investors and are led by a portfolio manager.
One of the biggest advantages of REITs is the high dividend yield. Per the SEC, REITs must payout at least 90% of their income to investors. This leads to REITs having yields that can range from 4-5%+.
It’s important to know that these yields will be taxed at higher ordinary rates, not the favorable rates with qualified dividends. So, it could be prudent to include REITs in tax-advantaged accounts like Traditional and Roth IRAs.
As mentioned previously, REITs are inversely correlated with stocks and bonds, which can diversify your portfolio. They’re also more liquid than physical property, since you can buy REITs like the Diversyfund Growth REIT online.
Equity REITs own income-producing property and most publicly-traded REITs fall under this category. The underlying assets earn money via rents and asset appreciation.
Mortgage REITs provide financing for commercial real estate properties and earn revenue via loan interest. Besides originating mortgages, they can also refinance them and some might have exposure to mortgage-backed securities (MBS), which provide additional interest income.
Hybrid REITs are a mix of equity and mortgage REITs. They generate revenue from loan interest from MBS investments and income properties. These diverse funds can produce more revenue with less risk than investing in just pure property or mortgage-backed REITs.
Public And Private REITs
Public REITs are listed on national exchanges and are easy to trade. They also have more publicly available information.
A public, non-listed REIT is registered with the SEC but doesn’t trade on the exchanges. Since it’s public, you can still access plenty of information about the fund, but it’s more difficult to trade.
Private REITs aren’t registered with the SEC and don’t trade on public exchanges. These are limited to institutional and accredited investors. They can offer higher returns but come with higher risks and fees.
REIT ETFs and Mutual Funds
REIT ETFs and Mutual Funds are some of the more accessible real estate strategies. Some REIT ETFs like Vanguard’s VNQ fund, have low fees, and can be traded intraday. Intraday trading lets you buy or sell an investment throughout the day at any price. Mutual funds can only be purchased when the markets close at the end of the day.
Both REIT ETFs and mutual funds are exposed to various types of real estate investments like equity, mortgage, or hybrid REITs. These investments might not have investment minimums, high expense ratios, or transaction costs (i.e commission). You can also invest in these funds with brokerage accounts, IRAs, Roth IRAs, and even 401(k)s.
Alternative Real Estate Investing Options
One of the more popular real estate investing strategies is crowdfunding. Crowdfunding uses technology and fractional ownership to make real estate more accessible to lower-income investors and small business owners.
Platforms like Fundrise facilitate this and have a $1,000 investment minimum. You can select properties based on criteria such as development phase, location, financing type, and goals (dividend vs. capital appreciation).
These small amounts are similar to shares of stock in a public company. They can add up and help businesses that have insufficient resources with their real estate needs. You’d receive appreciation and dividends based on your investment amount and the property’s performance.
Real Estate Limited Partnership (RELP)
RELPs are limited partnerships that focus on real estate investing. They’re managed by a general partner who assumes full liability and plays an active role in managing the limited partnership. Limited partners provide financing in exchange for higher returns and the most they could lose are their initial investments.
RELPs are different from REITs as they don’t pay taxes directly. Like limited partnerships, it passes its income and taxes to the partners who must then report those items on Form K-1.
Generally, RELPs are only available for institutional or accredited investors. They can also have high-end, specific niches, like retirement development communities for a certain neighborhood. Unlike some REITs and REIT ETFs; investors can’t withdraw their funds at any time.
House flipping is simply buying a property that is undervalued and refurbishing it so that you can sell it for a profit. This is one of the more well-publicized and risky real estate strategies. It’s not as easy or lucrative as shows like Fixer Upper make it seem.
There are many factors to consider when flipping homes including hidden costs, working with the right contractors, understanding complex paperwork, and financing for investors. Small details like additional repairs or waiting too long to sell can make a seemingly large gain unprofitable.
Real estate can be a powerful tool to build long term wealth and diversify your investments. There are many real estate strategies besides investing in physical property like REITs, REIT ETFs, and even crowdfunding platforms. These new options allow most investors, even those with limited funds, to gain real estate exposure.
Before investing in real estate, consider its advantages, disadvantages, and which method is best for your unique background.