Despite the volatility and uncertainty of the housing market over the past three years, real estate remains a valuable part of an investor’s portfolio.
Potential homeowners are understandably left unsettled as mortgage rates are sharply higher and house prices are slowly declining after a decade-long surge. However, in the long run, we have proven that Real estate returns tend to do well. Ideally, your investment portfolio should allocate between 5% and 20% to real estate, but the best way to achieve that exposure depends on your situation.
Below, we show a continuum of real estate investments for the degree of personal involvement and responsibility. And here, we explore the benefits and drawbacks of each.
Pros and Cons of Investing in REITs
More than 45% of American households own REITs, nearly double the estimate two decades ago. They can be a good fit if you want the diversification benefits of real estate without the commitment and responsibilities of directly owning the property.
REITs can be a good choice because:
- Buying and selling REIT shares is easier than with physical property.
- They eliminate the need for specific market knowledge and property management while making it easier to diversify your real estate portfolio. Instead of owning a concentrated position, own a fraction of tens, hundreds or thousands.
- They don’t require you to start a mortgage on an investment property and make it easier to invest in out-of-state real estate.
Finally, the issue of taxes. REITs enjoy favorable corporate tax treatment, avoiding them entirely if they pass an appropriate portion of earnings directly to investors.
However, this typically means that REITs have large dividend yields, and dividends are taxed unfavorably relative to capital gains for high-income investors. For those in higher tax brackets, this could be unpleasant. In contrast, direct real estate ownership provides exceptional tax benefits if managed carefully.
Pros and Cons of Investing Directly in Real Estate
On the other hand, if you prioritize the agency in an asset limiting the intermediaries, the direct purchase of a property could be right for you.
Substantial tax benefits can be associated with owning, managing or “flipping” a property. Depending on how actively involved you want to be, you may be granted additional tax breaks for passive losses.
There is also a wider range of potential outcomes, depending on the type and location of your property, relative to diversified REITs.
Investing directly in real estate can be financially rewarding, but it usually requires significant cash, due diligence and time. Some may rely on a property manager, but this comes at the cost of profit margins. If you need money, selling a property can take months and be expensive, especially if you are not reinvesting the proceeds in another rental property.
With more than 70% of rental properties in the United States owned by individual investors, not companies, this investment strategy can be appropriate if you have extra time and money.
Should I invest in real estate directly or indirectly?
Unraveling the nuances of the housing market can be confusing. Below, we leverage various people to guide investors toward the right choice.
A successful and busy professional: Owning property could be expensive or impractical if you don’t have time to deal with tenants or maintenance, so passive investing is probably the right choice, as REITs minimize time and effort while improving returns. risks in a mixed asset portfolio.
Sophisticated or wealthy investors may consider becoming a silent partner to an active investor, which could generate higher returns but comes with substantial risk.
A flexible professional: Early careerists or those with flexible work may consider making real estate a part-time job or hobby. Risk appetite, liquidity needs, and your desire to earn sweat equity will inform the appropriate choice.
Buying a rental property might make sense if you’ve already built a traditional investment nest egg and have excess savings. Your free time and capital can be invested in a specific asset in the right market, and you can take advantage of the tax treatment of real estate to enhance your returns after tax. The choice of tenants and work with maintenance providers is the cost of time to actively invest in real estate.
Active investors have a wide range of opportunities to pursue. For example, if an investor has an appetite for remodeling, a fixer-upper might be an option. Between the tax benefits and the leveraged nature of housing, this approach can compound returns quickly.
However, the purchase of an illiquid asset could be a costly mistake if you do not have an adequate financial cushion or suddenly need money. On the other hand, buying shares of a diversified REIT at the right price could provide the diversification benefits you seek without limiting portfolio liquidity.
Retired or self-employed: Professionals planning for retirement or without guaranteed income can turn to real estate for a steady income. Depending on the investor’s willingness to take over, either a traditional investment or a REIT may be appropriate.
Empty nesters who are thinking about downsizing or those who want to relocate may benefit from turning their current home into a rental property, especially if property prices are soft. If you buy a home with a low interest rate and transition into a rental, your investment property retains this perk and increases your positive cash flow. Also, since a rental property is not treated as earned income, it is exempt from self-employment tax, or FICA tax. If time is a factor, then hiring a property manager for day-to-day decision-making might be right for you, but it will offset the returns and may also take up some of your time.
Shifting your investment strategy to REITs might be appropriate if free time is important to you, but you want a stable income. Maybe you already have a passive income stream or a large investment portfolio. Taking advantage of diversified REITs is a strong choice to keep your real estate assets liquid and easily invest in properties in different markets.