If you have questions about how real estate can play a part in your financial plan, you are not alone. You may have heard that investing in real estate is one of the most common ways to become a millionaire or how real estate returns are generally not correlated with stock market returns.
For those investors that are used to a traditional stock and bond portfolio, the idea of real estate may sound intimidating — but it doesn't have to be. Here are three great ways to get in the game:
#1 Direct Ownership
This is probably what most people think of when they think about investing in real estate. The process here involves purchasing a property and either renting it to a tenant or holding it for personal use. In either case, the investor owns and manages the property. The advantage here is really three-fold: The property itself can appreciate; if the property is occupied by a tenant, it will produce income; and it can be an effective use of leverage.
However, there are plenty of risks associated with real estate. Most obviously, there is no guarantee that the value of property will go up. Even if it does, real estate is not as easy to sell as stocks or mutual funds. Moreover, the owner of the property must either maintain it themselves or pay another property management company. In either case, maintenance can take a huge portion of the returns and even push them into the negative. Finally, the biggest risk to a landlord is that the property will sit vacant. Every day that an investment property is unoccupied, the investor loses money. This is compounded even further if the investor is paying a mortgage while the property is not producing income.
It should be obvious at this point that the landlord game is not for everyone. But what about buying that second home in your favorite town? A vacation home can provide generations of enjoyment to your family and give intangible returns beyond the possible appreciation on the property. This is where talking to a well-versed financial planner can be invaluable. Sure there are complex tax and estate considerations, not to mention a substantial amount of money involved, but a good advisor can help you wade through those complexities to provide a clear strategy that is right for you and your family.
#2 House Flipping
Renovating houses in trendy neighborhoods can be a lucrative endeavor for the right investor, but the prerequisite skills to succeed in this type of investing are substantial. Investors must be able to identify an undervalued property and either oversee contractors or complete repair and renovations on their own. The return can be massive; but as with any investment, huge potential return means huge risk.
Almost every homeowner knows the troubles that can come with a home renovation project. You never truly know what is under that old carpet until you rip it up. Even if you get lucky with an undervalued property and avoid any unexpected problems, you are at the whim of the local real estate market. The freshly renovated house you just listed today may be accompanied by five others, and it may be harder to attract a buyer at the price you want. If you have taken out a loan to buy the property or pay for the renovations, every day it sits on the market cuts into the possible return on your investment.
The number of investors who possess the skills necessary to make money by flipping properties, is small; but if you fit the bill, a good financial advisor can be vital to your success. Your advisor can help you analyze your cash flow needs, the effects of the real estate purchase and sale on your overall financial plan, and the unique tax implications involved.
#3 Real Estate Investment Trusts
Real Estate Investment Trusts (or REITs) are the easiest way to take advantage of the real estate market without the hassle of buying, managing, or selling a property yourself. Generally speaking, when you invest in a REIT you are investing in a company that either owns a number of properties or owns a number of mortgages. Hybrid REITs also exist that own both. In any case, the investor is paid a dividend based on either the rent collected from the properties held in the trust or the interest received from mortgage payments. REITs are extremely popular among all types of investors because they are so versatile. You can invest in a REIT that specializes in nearly any type of property. If you want to invest in hospitals, cell towers, oil pipelines, fast food restaurants, or nearly any type of commercial, industrial, or residential property, REITs may be the answer. Some are traded publicly, and some are sold privately. Some are registered with the SEC, and some are not. The options are nearly endless.
While it is true that a REIT may be your ticket into the real estate game, it is not without risk. Like all investments, past performance is no indicator of future returns, and REITs certainly have their own unique risks. Just like owning a rental property, any vacancy in the properties owned by the REIT will cut into the possible return, and any time a mortgage held by the REIT gets paid off early, the interest payments will drop. Finally, the investor has no real control over the management of the properties and relies entirely on the quality of the REIT's management.
It is important to be keenly aware of the quality of the company itself as well as the characteristics of the underlying properties, and this is where a financial planner can be crucial. A good advisor should not only be able to tell you how a REIT would fit into your financial plan, but also give you detailed information on any REIT they would recommend. This includes information on how often the underlying properties sit vacant, what types of properties are held by the REIT, the average length of their leases, and the expected expiration of their current leases. It can be an intimidating amount of information to wade through but a critical step for your financial health.
Real estate can be a great addition to a well-diversified investment portfolio. Every day we help clients shape their financial plans, and real estate can certainly play an important role in one's path toward financial autonomy — and living a good life. Be sure to consult with a professional advisor to learn more.