I know many people who invested in single-family homes 10-15 years ago, and when asked, every one of them says the same thing: “I should have bought more…”
In this article, I’ll discuss why that is and how adding real estate to your portfolio could complement your existing investments.
Here are three benefits of real estate investing we’ll cover….
- Diversification from the stock market
- Higher Returns
- Lower Risk
…. as well as some potential downsides that you should be aware of.
3 Reasons Why You Should Invest in Real Estate
#1 - Diversification from the Stock Market
What would you do if, in the year you retire, the stock market crashes? Instead of selling 100 shares per month to pay your living expenses as you planned, you’re now forced to sell 200 shares per month to raise the same amount of cash. That means you’ll burn through your nest egg a lot sooner than you expected. That’s just bad timing, and it’s not something you can control.
It doesn’t help you if, when the stock market crashes, your other investments crash too. That’s why you need diversification, that is, having investments in asset classes that are uncorrelated with each other. Residential real estate and stocks are two such assets that move independently of each other.
Note: That’s not the case with Real Estate Investment Trusts (REITs): Yes, REITs pool investor capital and invest in commercial real estate, but they are financial instruments listed on the stock exchanges and have a 70% correlation to stocks. When stocks go down, REITs usually go down too.
To achieve true diversification through real estate, you need direct ownership i.e., buying a house or other property and holding Title yourself, not through a REIT. A portfolio of such real estate can offer a more reliable income stream and help stabilize your overall portfolio.
#2 - Higher Returns
“Returns” are defined as the compounded rate of return over the life of the asset.
Historically, the stock market (measured by the S&P 500) has returned 7.0% per year on average, while residential real estate – nationwide – has returned 4.0% per year on average. But that comparison overlooks four important factors:
1) Many growth markets appreciate much higher than the national average
By picking metros with exceptional job and population growth where the demand for housing is outstripping supply, you can achieve returns far above the national average. Invest in Dallas, not Toledo.
2) The Power of Leverage
Investing $250,000 in stocks will get you a $250,000 stock portfolio. Investing that same $250,000 in real estate will get you a $1,000,000 real estate portfolio – such as four new-construction homes in growing metros like Dallas or Orlando. This is because with real estate, you can put down 25% and have the bank finance the other 75%. A $1,000,000 portfolio growing at even the conservative 4.0% rate of return will outperform a $250,000 portfolio growing at a 7.0% return.
Here are the numbers:
At 7.0% per year, your $250,000 stock portfolio will grow to $1.9 million after 30 years and, after paying 15% capital gains tax, you’d net $1.6 million.
At a conservative 4.0% per year, your $1,000,000 real estate portfolio will grow to $3.2 million after 30 years and, since your tenants will have paid off the mortgage debt for you, you’ll own that $3.2 million portfolio free-and-clear with 100% equity
That’s the power of leverage: You put only 25% down, but 100% of your asset is appreciating. If your asset is appreciating 4.0%, you’re getting a 16.0% return on your down payment.
3) Hedge against inflation
Home prices and rents tend to rise with inflation, offering a valuable inflation hedge.
4) Tax Advantages
Rental property income can be shielded from taxes by deductions on mortgage interest, taxes insurance, property management and depreciation. Income from stock dividends is not shielded (unless owned within an IRA). Capital gains taxes on appreciated properties can be deferred by using a 1031 exchange; capital gains on stocks are not protected (again, unless owned within an IRA).
The tax code tells us where the government wants us to invest and it’s not even close: it’s real estate. Congress wants investor capital directed toward real estate to promote societal goals of providing housing and preventing urban decay.
Bottom-line, leveraged real estate’s total returns from cash flow, appreciation, loan paydown, and tax write-offs are hard to beat.
#3 - LOWER RISK
Risk is defined as the potential for a permanent loss of capital. The stock market’s gyrations are unsettling and feels risky, but that’s just volatility. It’s the permanent loss of capital that you should focus on.
Using that definition, real estate has the edge over stocks. As we’ve seen in the last year, even bellwether stocks like Amazon and Google can decline by 40%. During the dot-com bubble, some stocks lost all their value, going down to zero!
That doesn’t happen with real estate. A single-family home is a real (not paper) asset, a building with economic value for which there is a demand. While home prices may decline during soft markets, they also recover and go up again.
Consider this: Real estate is so safe that banks are willing to lend you 75% of the capital required to purchase a property, requiring you to put only 25% down. And insurance companies are willing to insure your property to cover all losses – even if the property burns to the ground.
They won’t do that for your stock portfolio. What does it tell you when someone who lends money for living won’t lend you 75% of the money you need for a stock portfolio – because it’s too risky? What does it tell you when someone who sells insurance for a living won’t insure your stock portfolio – because it’s too risky? Is that where your retirement nest egg should be?
When considering the potential for a permanent loss of capital, residential real estate in a growing metro is the safer bet.
The Flip Side of Owning Real Estate
The major caveat to direct ownership of real estate is that it’s not liquid. With stocks, you could go online 24/7 and liquidate your position, at most paying a small transaction fee.
With real estate, selling your property requires upgrading the paint and carpets, listing the property on MLS, waiting for an offer, and then waiting for the buyer’s financing to come through. On rare occasions such as during the financial crisis of 2008, you might not be able to sell it at all!
Additionally, the closing costs are significant and could run you $5-$20K depending on the property and the financing.
This is why real estate should be for the non-liquid portion of your investment portfolio.
With a good property management company, a rental property will usually run on autopilot, but occasionally it will make demands of your time.
This usually happens when a tenant leaves and you must approve the property manager’s repair estimate to get the property ready for rent, or to give guidance about your policies on pets and tenants. While the property management company does the heavy lifting, you’ll still need to provide direction.
The same is true of your insurance agents and local tax assessor’s office – they usually run on autopilot but will periodically make demands on your time.
But when you compare the overall benefits of adding real estate to your portfolio against the possible negatives, the pluses far outweigh the minuses. For long-term wealth building and diversification while minimizing your risk, there’s a place for real estate in your portfolio.
I’ll end this article where it started. The best time to buy real estate was 10-15 years ago. The second-best time is right now. Fifteen years from now, you don’t want to be that guy who says, “I should have bought more…”.
To see if real estate investing is right for you, sign up for your free RealWealth membership. You’ll have access to over 900 educational videos and articles that can answer most of your questions. If you decide to investigate this further, you can even speak to an experienced Investment Counselor who can show you what a real estate portfolio would look like for you.