I know many people who invested in single-family homes 10-15 years ago, and when asked, they all say the same thing: “I should have bought more.” So, why invest in real estate?
Below, I’ll discuss why so many people choose real estate as a vehicle to build wealth and how adding it 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
We’ll also cover some potential downsides every investor needs to be aware of.
Why Invest In Real Estate: 3 Important Reasons
#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 planned, you’re now forced to sell 200 shares monthly to raise the same amount of cash. That means you’ll burn through your nest egg much sooner than expected. That’s just bad timing, and it’s not something you can control.
In addition, it doesn’t help if your other investments crash alongside the stock market. That’s why you need diversification or investments in asset classes that are uncorrelated. 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% yearly. But that comparison overlooks four critical 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, can help you achieve returns far above the national average. Like investing 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 Charlotte or Orlando. This is because you can put down 25% with real estate 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 appreciates. If your asset appreciates at 4.0%, you’re getting a 16.0% return on your down payment.
3) Hedge against inflation
With inflation, home prices and rents tend to rise, 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 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 real estate. Congress wants investor capital directed toward real estate to promote societal goals of providing housing and preventing urban decay.
The bottom line is that 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 feel 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, dropping 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 a 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
Diversification, higher returns, and lower risk all sound great. What’s the catch? Here are some potential downsides of owning rental property.
1) Not Liquid
The major caveat to direct real estate ownership 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 the 2008 financial crisis, you might not be able to sell it at all.
Additionally, the closing costs are significant and could cost $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.
2) Time Commitment
With a good property management company, a rental property will usually run on autopilot, but occasionally, it will demand 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 applies to 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 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 risk, there’s a place for real estate in your portfolio.
Final Thoughts
I’ll end this article with the question that started it—Why invest in real estate? While 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 person who says, “I should have bought more.”
To learn more about this investment strategy and connect with property teams selling turnkey properties, join RealWealth. Membership is 100% free and gives you access to educational resources and industry connections. When you are ready, you can speak to an experienced investment counselor like me, who can show you what a real estate portfolio would look like.
