There are two main ways to invest in real estate: buy a home to live in and hope it appreciates or purchase real estate in order to obtain rental income or sell at a profit. Real estate can be a great way to build wealth through leverage while hedging against inflation. But it requires proactive management and is notoriously illiquid. It’s a good idea to review the pros and cons before you dive in. If you don’t want to invest in physical real estate, you can pursue other methods of real estate investing, such as home equity investments (aka shared equity agreements), or real estate investment trusts.
Real estate is an asset class that many people invest in without consciously doing it for investment purposes. This means that, unlike financial markets, the real estate market is driven by both investors and regular people simply looking to put a roof over their heads. For those who do view real estate as an intentional investment, it can be one of the easiest ways to generate a substantial return by using leverage to obtain a mortgage.
Investing in real estate has some incredible benefits, as most real estate agents will attest. Real estate acts as an income-producing asset, a hedge against inflationary pressure, and can be utilized to reap some serious tax benefits. However, on the flip side, real estate is notoriously illiquid and management intensive, among other drawbacks. If buying a physical property puts you off, you have other options. You can invest in real estate investment trusts, become an equity partner in a development, or invest in related industries. Whether you want to buy a home to live in, acquire multiple investment properties, or just want exposure to real estate, this article will guide you through some of the pros and cons.
Investing in physical real estate
Most people, when they think about real estate investments, are contemplating buying a home, apartment, land, townhouse, or some other physical asset. Here are some of the pros and cons of investing in physical real estate.
Many people who own a home have already taken advantage of leverage. Leverage is the act of borrowing money from another entity to buy or invest in something. In real estate, you use leverage to obtain your mortgage. We go into this more in-depth in our article on using leverage to build wealth, but to explain it more simply, we can use this example. A real estate investor buys a property for $100,000 and puts 30% in ($30,000); mortgage finance the other 70% ($70,000). If the property value then grows by 30% to $130,000, the investor makes a $30,000 profit. This translates to an ROI, or ROE, of 100%. They can then use this profit to buy more properties.
New value: $130,000
ROI/ROE: $30,000, or 100%
Looking to use leverage in your own property investment adventures? Here are some mortgage lenders that can help you get started.
Everyone needs a place to stay or live, and thus renting out a physical property can create significant cash flow for rental property owners. Of course, you need to take costs like mortgage interest, maintenance, and HOA fees into account. But if structured properly, an investor can receive significant cash flow on a monthly and yearly basis. Buying a rental property or an Airbnb model can be a great way to have extra income on top of your current employment.
Real estate tends to appreciate over time and works well if you want a medium- or long-term investment. Furthermore, you can improve the real estate to increase its value exponentially, regardless of the market. For example, if you are able to convert an old house into two modern duplexes, the returns can be outstanding.
Real estate can offer some significant tax benefits through programs like an IRS 1031 exchange (U.S. only) and depreciation. A 1031 exchange allows investors to defer capital gains tax when they sell their property by investing in a new “like-kind” property. Depreciation allows investors to gain further tax benefits by calculating how much of an asset’s value has been used over time.
Hedge against inflation
Real estate, historically, is an asset that either keeps up with or beats inflation. The value of the property will, in most cases, increase along with inflation. Furthermore, in an inflationary rental environment, the tenant will pay more rent while the cost of ownership does not increase (as long as the mortgage has a fixed rate).
Diversification with financial markets
As mentioned above, the interesting part about investing in real estate is that the market is driven primarily by owner-occupiers. According to the U.S. Census Bureau, 65% of U.S. homes are owner-occupied. This means that real estate is not as directly correlated to the financial markets as many other asset classes. It can be a great complement to an overall portfolio.
Real estate is notoriously illiquid. It’s almost impossible to have a piece of real estate that you can turn into cash the next day, like a stock or ETF. First, there needs to be a buyer for the real estate. In a booming market with people queued up for viewings, this can seem easy. However, in a not-so-good market, this will seem very difficult. Furthermore, the due diligence involved in the title process, as well as possible improvements that need to be made for sale, can take even more time.
Real estate requires management
Real estate requires proactive management. If your tenant reports a broken pipe, it’s usually up to the landlord or management company to replace it. Likewise, someone has to screen prospective tenants, as well as follow up if rental payments are missed. Likewise, there might be changes in the county, district, or HOA requirements that will force an owner to make costly upgrades.
Sometimes, the rental market goes down, and an investor receives less income than they originally thought they would. Furthermore, there can be lapses in tenancy when the landlord or investor receives no income. Then they are forced to pay out-of-pocket expenses, such as mortgage interest, property taxes, maintenance, and HOA fees, with no income to fund them. It’s important to keep a buffer of money available to compensate for a loss of income.
As real estate for most investors is typically a medium- or long-term hold, a lot can happen in that time. Sometimes this can be a good thing if the real estate is part of an overall rejuvenation project. For example, the Elitch Gardens amusement park in Denver, CO is being torn down and redeveloped. It will encompass commercial, residential and mixed uses, which will probably increase values for properties nearby. However, the opposite happened with the Luna Park amusement park extension in Sydney, Australia. The builders put amusement park rides in front of some of the most expensive, multimillion-dollar flats in the country, leading to a decrease in property values.
Here is a list of the benefits and the drawbacks of real estate investing.
- The ease of using leverage to obtain a mortgage and eventually multiple properties.
- You can rent out the property for a steady income.
- Real estate tends to appreciate over time and makes an ideal long-term investment.
- There are potential tax benefits.
- Real estate is a good hedge against inflation.
- Real estate is not very liquid, so it is hard to cash out your investment.
- If you rent out your property, you will have to manage and maintain it.
- Your income can be inconsistent if the property is vacant.
- You could face an unexpected development that is out of your control.
Investing in real estate without a physical asset
If you don’t feel comfortable purchasing physical real estate, here are some other ways to invest.
Become an equity partner in a development
When developers build something, they rarely fund the equity portion of the development themselves. Instead, they have investors, or equity partners, who invest money in the development and receive a return once the property sells. In many cases, the investor will receive a preferred return as well as a portion of the profits, typically in a structure called a waterfall.
Pro: Correlation with sales
The investment is not related to the real estate appreciating at a certain level but instead to the developer’s ability to sell the property. For example, after the 2008 financial crisis, many developers raised money in the U.S. and sold their properties to investors in Asia before they were ever built.
Con: You can lose all of your money
If the developer is unable to sell the property, they might not be able to afford their construction debts, which can put the whole project at risk. Depending on how the capital stack is structured and the seniority level of the investor, theoretically, they could lose everything.
A real estate investment trust, or REIT, is a popular way to invest in the real estate market. You invest in a company that owns, operates, or funds various real estate. There are many RETIS on multiple stock exchanges, such as the NYSE.
Don’t want to invest in rental properties, but would rather have a hands-off REIT in your investment portfolio? These advisors can help.
Pro: Hands-off management
Investing in a REIT eliminates the downside of proactive management that comes with physical real estate. Instead, the REIT manages everything, and the investor can receive both a dividend and an increase in value by the increase in the value of the REIT.
Con: Sensitivity to interest rates
REITs are sensitive to interest rates, and rising interest rates can lead to a devaluation of REITs, even if the housing market is doing fine. As REITs use a tremendous amount of leverage, higher interest rates can translate into a huge cut in profit. Furthermore, some investors will move out of REITS into treasury bonds due to the attractive risk/reward ratio on treasury bonds. This will then translate into a drop in the value of the REIT.
What are the disadvantages of investing in real estate?
A big issue is that it’s illiquid. The cash flow can also vary, you can have unexpected costs pop up, and there might be future development that hurts the investment property’s value.
What are the advantages of investing in real estate?
The ability to use leverage to obtain a mortgage, tax advantages, and hedging against inflation, are some of the advantages of investing in real estate.
Can you lose money on real estate?
Of course! You can lose money in real estate, just like any other investment. The trick is to do your due diligence. Make sure all your bases are covered in case there is a downturn in the market or you suffer a tenancy lapse.
Is it worth it to invest in real estate?
Yes, investing in real estate with a medium- to long-term mindset is most definitely worth it. The ability for normal people to use leverage when real estate appreciates is one of the easiest ways to generate wealth.
Is it better to invest in land or a house?
This all depends on the investor’s strategy. If you want rental income or cash flow, it can be difficult to obtain that from land unless you are renting agricultural land to a farmer. However, the entry point on land is potentially much lower than that of a completed property, such as an apartment or house.
- Both people looking for a home to live in, as well as investors looking for a return on investment, will invest in real estate.
- Investing in physical real estate has some significant benefits, including the utilization of leverage, tax advantages, and the ability to receive stable cash flow.
- There are downsides, too, such as its illiquidity, possible declines in rental income or lapses in tenancy, and other unexpected developments.
- There are more ways to invest in real estate besides buying physical assets, such as becoming an equity partner in a development or investing in a REIT.