In the middle of a housing boom, especially during a period of high inflation, many people are tempted to explore the idea of investing in real estate. Real estate tends to carry a certain allure due to the concept of passive income, but talk to anyone who owns rental property, and they will tell you it is anything but passive. Like everything else, this decision is not entirely straightforward, and one should be aware of the costs and risks before jumping in. There are many avenues to access a real estate investment, so we will explore each individually.
This might be controversial, but I do not believe a home should be considered an investment in the traditional sense. Many people will disagree with this by saying they sold their house for more (sometimes much more) than they bought it. In fact, the long-term average appreciation in home prices published by Standard & Poors is 5.22% per year. Not too shabby. The problem is that price appreciation doesn’t account for input costs like taxes, maintenance, and mortgage interest. This isn’t to say everybody should just rent. Ask anybody selling the house they watched their kids grow up in, and they will tell you it is so much more than four walls and a roof.
Rental real estate can be great for regular income and a hedge against inflation, but it also carries drawbacks. In an ideal world, a rental property owner would have perfect tenants along with minimal upgrades and repairs. Being a landlord on a small scale sometimes means getting a call at 2 a.m. because the toilet is overflowing. If you are handy, this might not be too big of an obstacle, but the inconvenience of answering these calls can become a bit much. You might outsource these issues to a management company to solve this problem. The average cost for these services is about 10% of the rent. Then there are the issues of liquidity and transaction costs. Selling a house is far from an overnight process, and paying realtor or broker commissions can eat into your profit margin. Despite these issues, rental real estate can be a great addition to a portfolio – just be sure to enter the venture only after considering all the nuances.
The other option for real estate exposure is via Real Estate Investment Trusts (“REITs”). These are designed and mandated to pay at least 90 percent of their income to shareholders. These come in various flavors, from those invested in shopping malls to those invested in cell towers. REITs can be accessed privately or publicly. Private REITs typically have higher fees, less liquidity, and a greater chance of picking a relative underperformer. However, those with a keen eye for real estate might be able to enhance their returns by going this route. Publicly traded REITs are more liquid and can be combined into a fund to diversify your risk among different geographical areas and types of REITs.
In conclusion, real estate is a perfectly fine investment under the right circumstances. There are plenty of success stories of people who built their fortune with real estate as the main driver. Ultimately, success comes down to timing and location if you go the route of physical real estate. You could generate a decent stream of income along the way, but the price appreciation you were expecting may not occur at the rate you were hoping for. If you are investing in REITs, they should be part of a diversified portfolio that is monitored and rebalanced. As with anything, make sure you have analyzed the investment from every angle before deciding to make the move.
Author: David Rath, CMT, CFA
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