Real Estate Investing: A Guide

When you think about buying real estate, the first thing that probably comes to mind is your home. But physical property can play a part in a portfolio too, especially as a hedge against the stock market. However, while real estate has become a popular investment vehicle over the last 50 years, buying and owning brick and mortar is a lot more complicated than investing in equities and bonds. In this article, we'll examine the leading options for individual investors, listed in approximate order of how direct a real estate investment they are, and reasons to invest.

Basic Rental Properties

This is an investment as old as the practice of land ownership. A person will buy a property and rent it out to a tenant. The owner, the landlord, is responsible for paying the mortgage, taxes and maintenance of the property.

Ideally, the landlord charges enough rent to cover all of the aforementioned costs. A landlord may also charge more in order to produce a monthly profit, but the most common strategy is to be patient and only charge enough rent to cover expenses until the mortgage has been paid, at which time the majority of the rent becomes profit. Furthermore, the property may also have appreciated in value over the course of the mortgage, leaving the landlord with a more valuable asset. According to the U.S. Census Bureau, real estate in this country has consistently increased in value from 1940 to 2006. While there was a dip during the subprime mortgage meltdown of 2008 to 2010, it has now rebounded and has been increasing overall.

An investor must know the market in which he is searching for property or hire an expert to help. For investors seeking an income stream from rental properties, the most important aspects to consider are property location and market rental rates. As for location, many successful rentals are located in close proximity to major schools. For example, if you buy a property near a state university, students are likely to want to rent it year after year. There are also many other features of a profitable rental property, and some take time to learn. For more, see Top 10 Features of a Profitable Rental Property.

There are, of course, blemishes on the face of what seems like an ideal investment. You can end up with a bad tenant who damages the property or, worse still, end up having no tenant at all. This leaves you with a negative monthly cash flow, meaning that you might have to scramble to cover your mortgage payments. There is also the matter of finding the right property. You will want to pick an area where vacancy rates are low and choose a place that people will want to rent.

Perhaps the biggest difference between a rental property and other investments is the amount of time and work you have to devote to caring for it. If you don't want to, you can hire a professional property manager. But his or her salary then becomes an expense that impact's your investment's profitability.

The Flip Side: Real Estate Trading

This is the wild side of real estate investment. Like the day traders who are leagues away from a buy-and-hold investor, the real estate traders are an entirely different breed from the buy-and-rent landlords. Real estate traders buy properties with the intention of holding them for a short period of time, often no more than three to four months, whereupon they hope to sell them for a profit. This technique is also called flipping and is based on buying properties that are either significantly undervalued or are in a very hot area.

Pure property flippers will not put any money into a property for improvements; the investment has to have the intrinsic value to turn a profit without alteration or they won't consider it. Flipping in this manner is a short-term cash investment.

If a property flipper gets caught in a situation where he or she can't unload a property, it can be devastating because these investors generally don't keep enough ready cash to pay the mortgage on a property for the long term. This can lead to continued losses for a real estate trader who is unable to offload the property in a bad market.

A second class of property flipper also exists. These investors make their money by buying cheap or reasonably priced properties and adding value by renovating them. hey then sell the property after renovations for a higher price. This can be a longer-term investment, depending on the extent of the improvements. The limiting feature of this investment is that it is time-intensive and often only allows investors to take on one property at a time.

Real Estate Investment Groups

Real estate investment groups are sort of like small mutual funds for rental properties. If you want to own a rental property, but don't want the hassle of being a landlord, a real estate investment group may be the solution for you.

A company will buy or build a set of buildings, often apartments, and then allow investors to buy them through the company, thus joining the group. A single investor can own one or multiple units of self-contained living space, but the company operating the investment group collectively manages all the units, taking care of maintenance, advertising vacant units and interviewing tenants. In exchange for this management, the company takes a percentage of the monthly rent.

There are several versions of investment groups, but in the standard version, the lease is in the investor's name and all of the units pool a portion of the rent to guard against occasional vacancies, meaning that you will receive enough to pay the mortgage even if your unit is empty. The quality of an investment group depends entirely on the company offering it. In theory, it is a safe way to get into real estate investment, but groups are vulnerable to the same fees that haunt the mutual fund industry. Once again, research is the key.

Real Estate Limited Partnerships

A real estate limited partnership (RELP) is similar to a real estate investment group: It is an entity formed to purchase and hold a portfolio of properties, or sometimes just one property – only it is in existence for a finite number of years. An experienced property manager or real estate development firm serves as the general partner. Outside investors are then sought to provide financing for the real estate project, in exchange for a share of ownership as limited partners. They may receive periodic distributions from income generated by the RELP's properties, but the real payoff comes when the properties are sold – hopefully, at a sizeable profit – and the RELP dissolves down the road.

RELPs allow investors to finance the construction or renovation of buildings, without needing to be directly involved in management or have real estate experience. However, they tend to be illiquid investments, since investors can only cash out at certain intervals – or often at all, until the RELP dissolves.
 

REITs

Real estate has been around since our cave-dwelling ancestors started chasing strangers out of their space, so it's not surprising that Wall Street has found a way to securitize it, turning real estate into a publicly-traded instrument.

A real estate investment trust (REIT) is created when a corporation (or trust) is formed to use investors' money to purchase, operate and sell income-producing properties. REITs are bought and sold on the major exchanges, just like any other stock. To keep its status as an REIT, this entity must pay out 90% of its taxable profits in the form of dividends. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed on its profits, thus eating into the returns it could distribute to its shareholders.

Much like regular dividend-paying stocks, REITs are appropriate for stock market investors who want regular income, though they offer the opportunity for appreciation too. REITs allow investors into non-residential properties such as malls (about a quarter of all REITs specialize in these), health-care facilities, mortgages or office buildings. In comparison to the aforementioned types of real estate investment, REITS also are highly liquid. For more details, see The REIT Way.

Real Estate Mutual Funds

Real estate mutual funds invest primarily in REITs and real estate operating companies. They provide the ability to gain diversified exposure to real estate with a relatively small amount of capital. Depending on their strategy and diversification goals, they provide investors with much broader asset selection than can be achieved in buying individual REIT stocks, along with the possibility of fewer transaction costs and commissions.  

Like REITs, these funds are pretty liquid. Another significant advantage to retail investors is the analytical and research information provided by the fund on acquired assets and management's perspective on the viability and performance of specific real estate investments and as an asset class. More speculative investors can invest in a family of real estate mutual funds, tactically overweighting certain property types or regions to maximize return.

Why Invest in Real Estate?

Real estate can enhance the risk and return profile of an investor's portfolio, offering competitive risk-adjusted returns. Even factoring in the subprime mortgage crisis, private market commercial real estate returned an average of 8.4% over the 10-year period from 2000 to 2010, based on data from the National Council of Real Estate Investment Fiduciaries (NCREIF). And usually, the real estate market is one of low volatility especially compared to equities and bonds.

Real estate is also attractive when compared with more traditional sources of income return. This asset class typically trades at a yield premium to U.S. Treasuries and is especially attractive in an environment where Treasury rates are low.

Diversification and Protection

Another benefit of investing in real estate is its diversification potential. Real estate has a low, and in some cases, negative, correlation with other major asset classes – meaning, when stocks are down, real estate is often up (see Diversification Beyond Stocks). In fact, In 14 of the 15 previous bear markets, going back to 1956, residential real estate prices rose, according to data from Yale University’s Robert Shiller, the co-creator of the Case-Shiller Home-Price Index. Of course, there are exceptions: real estate tanked along with equities during the Great Recession (though this was an anomaly, Schiller argues, reflecting the role of subprime mortgages in kicking off the crisis).

This means the addition of real estate to a portfolio can lower its volatility and provide a higher return per unit of risk. The more direct the real estate investment, the better the hedge: More indirect, publicly traded, vehicles, like REITs, are obviously going to reflect the overall stock market's performance (and some analysts think the two will become ever more correlated, now that REIT stocks are represented on the S&P 500). Interestingly, though, this also has been changing of late. The correlation between listed REITs and the broad stock market hit a 12-year low in 2015, according to research by the National Association of Real Estate Investment Trusts (NAREIT), "suggesting that whatever factors happen to drive the non-REIT part of the market will not necessarily spill over to affect the REIT market," an article on Reit.com, the association's website, concluded.

Because it is backed by brick and mortar, real estate also carries less principal-agent conflict, or the extent to which the interest of the investor is dependent on the integrity and competence of managers and debtors. Even the more indirect forms of investment carry some protection: REITs for example, mandate a minimum percentage of profits be paid out as dividends.

Inflation Hedging

The inflation-hedging capability of real estate stems from the positive relationship between GDP growth and demand for real estate. As economies expand, the demand for real estate drives rents higher and this, in turn, translates into higher capital values. Therefore, real estate tends to maintain the purchasing power of capital, by passing some of the inflationary pressure on to tenants and by incorporating some of the inflationary pressure, in the form of capital appreciation.

The Power of Leverage

With the exception of REITs, investing in real estate gives an investor one tool that is not available to stock market investors: leverage. If you want to buy a stock, you have to pay the full value of the stock at the time you place the buy order – unless you are buying on margin. And even then, the percentage you can borrow is still much less than with real estate, thanks to that magical financing method, the mortgage.

Most conventional mortgages require a 20% down payment. However, depending on where you live, you might find a mortgage that requires as little as 5%. This means that you can control the whole property and the equity it holds by only paying a fraction of the total value. Of course, the size of your mortgage affects the amount of ownership you actually have in the property, but you control it the minute the papers are signed.

This is what emboldens real estate flippers and landlords alike. They can take out a second mortgage on their homes and put down payments on two or three other properties. Whether they rent these out so that tenants pay the mortgage or they wait for an opportunity to sell for a profit, they control these assets, despite having only paid for a small part of the total value.

The Drawback of Real Estate Investing: Illiquidity

The main drawback of investing in real estate is illiquidity, or the relative difficulty in converting an asset into cash and cash into an asset. Unlike a stock or bond transaction, which can be completed in seconds, a real estate transaction can take months to close. Even with the help of a broker, simply finding the right counterparty can be a few weeks of work. REITs and real estate mutual funds offer better liquidity and market pricing, but come at the price of higher volatility and lower diversification benefits, since they have a much higher correlation to the overall stock market than direct real estate investments.

The Bottom Line

In the context of portfolio investing, real estate is traditionally considered in an "alternative" investment class. That means it is a supplementary investment used to build on a primary portfolio of stocks, bonds and other securities. But it can be a significant counterbalance to other instruments, as well as a source of income and, eventually, appreciation.