Owning real estate investments can help diversify your portfolio, generate cashflow and appreciation, and provide attractive tax benefits. While there are risks, as with any investment, with some good research and due diligence you could enjoy many years of attractive returns.
Why Real Estate
When you think about where to invest, what usually comes to mind? Stocks and bonds. For many decades most investors have done well by focusing on those two asset classes. But in today’s world of very low interest rates (and negative in some countries in Europe), adding real estate to your portfolio could help you diversify and generate income.
Benefits of Real Estate
Diversification
Diversification is the strategy of owning multiple types of investments with the goal of reducing risk. One way of achieving diversification is by owning multiple funds across different asset classes. The downside of owning only stocks and bonds (or funds) that are publicly traded is that your portfolio’s performance will be tied to the general economy.
By owning real estate you can diversify market risk. If you own a property that has a tenant paying you rent every month, it doesn’t matter if the stock market goes up or down. Your performance will be driven by how well your tenant pays.
If you own stocks of a large company, Apple for example, how much can you influence the company? Zero. On the other hand, if you buy a property, you control the outcome of your investment. As an example, you can remodel the kitchen to add value, select a great tenant that will always pay in time, or take great pictures and use it as a short-term rental.
Appreciation
One benefit of owning real estate that gets ignored is the appreciation potential.
Appreciation is the increase in value in your property. According to the S&P CoreLogic Case-Swiller Index, through the end of May 2020 properties in the United States appreciated 4.5% on average. If you buy a property for $100,000 today, and it appreciates 4.5% every year over the next 10 years, it will be worth around $155,000 by then. Granted, this number can vary depending on the location. While it may not seem like a lot, real estate appreciation tends to be steady and serve as a hedge against inflation. Furthermore and to this point, there is an important factor that we haven’t discussed, which is leverage.
Leverage
Leverage is the use of borrowed capital (a loan) to buy an asset. In real estate most purchases are done through a mortgage loan.
Using the $100,000 property as an example, if you put down 20% for down payment ($20,000), you would be leveraging 5 times. In other words, you would be buying something 5 times the value of the money you are investing. The benefit (and risk) of using leverage is that the return is magnified by the amount you are levered. If your $100,000 property appreciates 5% this year ($5,000), and you are levered 5 times, your return on investment will be 25% ($5,000 on a $20,000 investment). The opposite also holds true, if the property depreciates 5%, you would lose 25%.
Cash flow
Probably the most popular reason why people invest in real estate is cash flow. In some markets, the income you can generate through real estate is very attractive compared to other alternatives (bonds, dividend paying equities, etc).
The cash flow in residential real estate is generated through rental payments. In a typical long term rental you receive monthly rent payments from your tenants, you pay your property expenses, taxes, insurance, and mortgage. The amount left is your net cash flow.
Take a look at some of our properties for examples of the cash flow potential of some real estate investments.
Tax benefits
Last, but not least, taxes. Real estate investments have multiple tax benefits. Starting with the tax breaks and deductions from owning, operating, and managing a property. Additionally, you can also take an annual depreciation cost (27.5 years for residential properties) that can help you offset the income generated. Finally, you can also defer capital gains by using the popular 1031 exchange, which is usually done for larger commercial properties, but can also be used for smaller properties when you have a large capital gain.
Risks of Real Estate Investments
While the benefits significantly offset the drawbacks of owning real estate, it’s important to also take into consideration the risks.
Lack of Liquidity
The first one is the lack of liquidity. While a stock or bond can be sold almost immediately in the public markets with minimal transaction cost, a property usually takes at least a month to be sold and you incur significant transaction costs.
Maintenance
Depending on the conditions and age, some properties require ongoing maintenance to keep it operational. These are usually covered by the rental incomes, but sometimes issues come up with the roof, HVAC, and appliances that can require a significant expense.
Tenant Issues
A third risk is the fact that you will be working with people (unlike when you invest in stocks and bonds). You are likely to work closely with a property manager or with your tenants. Hence, you will need to conduct a thorough background check on your prospective tenants or due diligence in selecting your property management team. In some cases, you may experience difficulties, like having to evict a tenant. But, with the appropriate systems and procedures in place (or with a good property management team), these issues can be resolved or avoided.
Conclusion
Owning real estate investments can help diversify your portfolio, generate cashflow and appreciation, and provide attractive tax benefits. While there are risks, as with any investment, with some good research and due diligence you could enjoy many years of attractive returns.
