01 Nov Should I Invest in Real Estate?
I consider it a sign of the times that more and more of our clients are asking us about real estate as an investment. Tangible property – residential, commercial property, cars, and art– have always held an appeal. First, they are physical assets and easy to understand. There is something inherently satisfying about being a property owner. Many wise investors have made their fortunes by investing in real estate when prices were low. Here on Hilton Head Island, one need only look to Charles Fraser for a great example of a real estate visionary. Finally, real estate prices have risen substantially since their lows in 2008 and people want to jump on the bandwagon.
However, is real estate the right investment for you and is now the right time to invest? I want to look at some of the pros and cons of real estate to answer this question.
- The addition of real estate to an investment portfolio provides diversification. Real estate is a separate asset class and returns are not directly correlated with the stock market.
- Residential (rental) and commercial real estate (leases) can provide cash flow. For this reason, it is appealing to retirees and those looking to boost their income.
- Real estate provides a hedge against inflation. Commercial and rental income are typically structured to increase with inflation and increasing these cash flows tends to boost the value of the underlying property.
- There are tax advantages to owning real estate. Maintenance to a commercial or rental property are tax deductible, capital improvements add to the cost basis and losses may be used to offset current income.
- It is an imperfect market and there can be opportunities for those with special knowledge or skills. Real estate agents, appraisers, builders, and others who can seize on such properties may be able to enhance their returns.
- Rental property may have personal benefits that are worth considering. Purchasing a condo for your children (for example) and having them rent it may provide more affordable housing for them and provide you with some growth potential from the underlying investment.
- Real estate is a relatively illiquid investment. Buying and selling property can be a slow and cumbersome process. Contrast this with the purchase and sale of a stock which can be sold in a day on the open market. It is also all or nothing; real estate can be difficult to sell piecemeal if you need to raise cash.
- Many investors tend to purchase real estate in one geographic area which can expose them to additional area specific risk. Consider property owners in North Carolina after Hurricane Florence, or coastal Florida after Hurricane Michael. Aside from natural disasters, there can also be risks to an area if a major employer suddenly pulls out or the economic situation changes.
- Real estate has significant holding costs. Property taxes, maintenance expenses, insurance, tax accounting and financing expenses can seriously limit the net income and need to be considered when evaluating the return on investment.
- Real estate demands a time commitment. When you own investment property you are essentially starting a small business. Even if you outsource parts of the job (e.g. by hiring a property manager and accountant) you will be the ultimate party responsible.
- Periods of vacancy in rental properties can be costly. Prudent landlords budget for less than 100% occupancy and have enough cash reserve to cover the fixed costs when vacant.
- Real estate commission charged during the sale of properties (traditionally at 6% of the sales price) reduces the profitability as does the costs incurred during the purchase. These include application fees, appraisals, inspections, legal fees and closing costs. If property is sold for a gain, then capital gains taxes will also apply and depreciation that was taken may be recaptured.
- Investing in real estate in addition to owning your own home may overweight your portfolio in this asset category. Remember to factor in the value of your home when considering a purchase to avoid undue risk. For most younger clients their home is their single largest asset. It makes sense to diversify and add other investments such as stocks, bonds, etc. to your portfolio.
- Real estate pricing is often cyclical and among the various asset classes has the highest variability (or standard deviation). This means that timing of purchases and sales can be critical. Individuals who purchased condos in 2007 at the peak may still be under water 11 years later.
For those who desire to own real estate indirectly, real estate investment trusts (REITs) might provide an interesting alternative. REITs are companies that own income producing real estate, property mortgages or some combination of the two. REITs can be purchased in a variety of ways: traded on the stock exchange, through a mutual fund or ETF or privately. They can be specialized by sector (such as healthcare REITs) or location; in general, they are more diversified than a direct single holding of real estate. REITs are marketable investments and inexpensive to buy and sell. By law, a minimum of 90% of the taxable income from a REIT must pass through to its shareholders as dividends so they are attractive from an income perspective. As a category REITs were down -17.83% in 2007 and -37.34% in 2008, but over the last 20 years (since 1998) they have an average annualized performance of +8.67%. Like direct holdings of real estate, REITs tend to be more volatile than other asset classes, but the long-term returns are impressive.
Real estate certainly has its place in an investment portfolio but be sure understand all the potential costs and benefits before you invest. Want a personal evaluation of your situation? Call us for an appointment!