Investing in real estate can be a smart move and a great way to grow your money. It offers many benefits, such as increasing diversification1 in a standard stock-and-bond portfolio.
Real estate can also be a great hedge against inflation, as property values tend to increase with inflation. Along with price appreciation, real estate usually offers continual income and, for direct investment, significant tax benefits and the advantage of having tenants pay down a mortgage note.
Real estate investing, for the sake of simplicity, comes down to one of two choices, each with pros and cons: passive investment in a Real Estate Investment Trust (REIT), or active involvement in directly purchasing and managing income-producing property.
Investing in a REIT consists of purchasing shares in a company that invests in its own real estate holdings and trades on exchanges similar to stocks. A REIT uses the pooled capital of many investors to buy and manage income property. This route offers convenience, ease, and liquidity. Additionally, most REITs pay dividend income; investors, however, have little or no control over the management of the real estate.
Active, or direct, real estate investment offers income potential and an increase in building value over time. Directly investing in real estate such as a rental home or commercial property includes having tenants who pay rent, which pays down an investor’s mortgage note and offers multiple ways to save on taxes, including depreciation.
However, investing directly in real estate is not as liquid as a REIT, so it’s important to avoid the mistake of overpaying. Income-producing property can be valued based on income generated or by looking at recent comparable sales in the market. To value property based on income, familiarize yourself with the net operating income of the property. Also, talk with other investors and look at recent sales to gauge cap rates in your area.
While the first rule in purchasing real estate is not to overpay, you must also remember to buy on cash flow, not speculation. This means, buy property where the numbers work. Don’t assume you’ll get a certain annual appreciation to justify your purchase price. Also, have an exit strategy before you buy.
An exit strategy is the method by which you intend to cash out of a property. Are you buying the property for the long term? If it is a rehab, do you plan to rent it or sell it once the project is completed? The answers to these questions will influence other property purchase decisions, including how best to finance an acquisition.
Managing property actively can be time-consuming, but it allows more control over the property, which can lead to more control over the return generated.
No matter which strategy you choose, it’s important to assess your real estate in relation to your complete financial picture. A Certified Financial Planner with experience in both passive and active real estate investing can help guide you in the direction that makes the most sense based on your situation.
Diversification does not protect against loss of principal.
REIT Disclosure – Investing in real estate entails certain risks, including changes in: the economy, supply and demand, laws, tenant turnover, interest rates (including periods of high interest rates), availability of mortgage funds, operating expenses and cost of insurance. Some real estate investments offer limited liquidity options.