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5 Things to Know Before Investing in Real Estate

There’s always been some kind of starry-eyed dream around the idea of making a big payoff in real estate investing. I’d say about half my clients have floated a real estate idea in one form or another to me over the years.

I think it’s because of the “cocktail party” effect (or “BBQ effect,” if you aren’t the cocktail party type, which I’m not). The stories are juicy. They are hard to ignore: “Yeah, my buddy Jim made $500,000 on an apartment complex in Austin. He’s asking me if I want in on his next deal.” I have a number of friends still living Austin from my engineering days at Dell, and the quote above is based on a real conversation.

I mean, it makes sense, right? You invest a bit, hold onto the property for some random length of time, then walk away with even more money when property values rise. I think it’s also appealing because it’s a physical asset. Most investors are familiar with homes, apartments, etc., and you can go see it if you want.

But before you get sucked into the latest real estate investment scheme, take a deep breath and open your eyes to these cold hard facts about real estate investing.

1. Real Estate Is Not Like the Stock Market

Unfortunately, the concept of timing your buys when the market is low and selling when the market is high, and getting caught up in the market hype does not always translate to the real estate arena.

Real estate can be profitable with patience. Homes grow in value over time, not overnight. You pay so many fees when selling property that even if you are making a bit of profit from built-up equity, you are paying out thousands when you sell. Depending on the turnaround time and the number of times you do this, you could be throwing away tens of thousands to fees that you could have invested better. (For related reading, see: Costs New Investors In Real Estate Do Not Consider.)

2. Real Estate Is a Leveraged Investment

Plain and simple, a leveraged investment is using borrowed money to invest and crossing your fingers for an even bigger return. Here’s the thing: when leverage works, you multiply your winnings. But when it doesn’t, it’s doubly bad: You magnify your losses. Remember when home values dropped to crazy lows in 2008? It wasn't that long ago. Some borrowers ended upside-down: their mortgage balances were above what their homes were worth.

Leverage isn’t inherently good or bad, but it’s risky. Are you comfortable taking on extra risk with your hard-earned dollars?

3. It Limits Your Diversification Ability

First, take a look at your assets. How much do you have set aside for retirement? What about for extra investing, education plans, contingency funds? How much additional cash are you bringing in each month that you can put towards saving?

Now answer this: How much are you willing to cut out of higher-priority investing to dump into a real estate deal? People who tend to invest in seductive real estate propositions put a disproportionate amount of their wealth in real estate. All the excitement can easily cause a concentrated, leveraged bet in real estate.

Every individual should be investing according to the asset allocation that is right for them based on their goals, risk tolerance, and time horizon. If you own your own home and have 5% of your portfolio dedicated to real estate investment trusts (REITs) via mutual funds, you have plenty of real estate exposure. Don’t make real estate an inadvertent concentrated bet.

4. Lack of Liquidity

Liquidity is a big word to describe how quickly you can get your hands on your cash. Unfortunately, real estate is considered the least liquid of assets because of how long it can take to sell. If you are investing too much of your wealth in real estate, you might end up banging your head against a wall if you ever need quick access to funds.

5. The Real Estate Market Is High

Unlike a mere five years ago when the housing market was slowly recovering from the 2008 crash, house values are currently quite high. That’s great news for you if you purchased a home anywhere between 2008-2012, but not great if you want to get into real estate investing right this second. If there is growth in the coming years, it probably won’t be as drastic as it has been. 

False Comfort Won’t Get You Far

The stock market can be confusing. It’s this weird entity, seemingly controlled by unknown factors, and that freaks a lot of people out. Real estate, on the other hand, can be seen and touched. It makes sense. You can see what factors add up to increase the value of a home, and to that end, you feel a sense of control. But false comfort does not equal true peace of mind. Don’t be lured into so-called once-in-a-lifetime real estate schemes without understanding the risks. Rise above the hype, educate yourself and build wealth smarter.

(For more from this author, see: It's Time to Gain Control of Your Finances.)