Investing in Real Estate

TL;DR

  • Real estate investing was once relegated to the well-to-do, but the advent of modern assets has made it possible for anyone to invest with REITs, real estate mutual funds and ETFs, and other options
  • The costs of traditional real estate investing can outpace the costs of stock market investing in a hurry; real estate requires far more upfront capital and a bigger time investment than most securities
  • At the same time, it’s harder to determine average returns on real estate investment due to all the variables, including location, the type of property, how long you’re invested, and more
  • Where stocks carry benefits of increased liquidity, lower costs, and easy diversification, investing in real estate provides tangible benefits, such as owning property, leveraging against debts, and hedging against inflation
  • Still, investing in real estate comes with its own risks, such as decreased liquidity and lower returns in poor markets

Until recently, investing in real estate was seen as a luxury for the well-to-do – those who could afford investing at all, let alone the expenses related to buying, maintaining, and selling property. As a result, those who had the time, money, and a financial advisor were most likely to reap the benefits. The average person, on the other hand, usually stopped at buying the family home (if that).

But in the last few decades, real estate has become increasingly popular. As modern technology advanced, the investing landscape changed, too, introducing us to real estate-based ETFs, mutual funds, and REITs. Now, there are myriad ways to get involved with this lucrative asset – without breaking the bank.

Real Estate Vs the Stock Market

It’s important to note that investing in traditional real estate is not quite like investing in the stock market. Where – and how much – you invest depends on your personal life, financial situation, and future goals. But owning property requires a level of time and attention that many securities simply do not.

Investing Costs

Robo-advisors have made investing increasingly affordable over the last decade. Even if you’re not wealthy, you can still throw a few hundred dollars a year into a portfolio and enjoy modest returns. And though such services and traditional brokers charge fees, they’re usually a small percentage of the potential profits.

Of course, there are still tax implications to consider. The average investor will likely pay capital gains tax at some point. Some may also spring for a financial advisor to navigate the complexities of the tax system (and avoid being slapped with a surprise bill come April).

On the other hand, traditional real estate requires a much larger investment on multiple fronts. For one, you’ll likely spend a lot of time researching what you can afford and where. If you plan to flip or rent property, you’ll need to consider the costs of repairs, renovations, and maintenance. And while hiring a property manager to deal with the inevitable exploding toilet saves you time, it also cuts into your bottom line.

Then, of course, there’s the unavoidable fact that real estate requires more capital. Whereas most stocks run a few dozen to a few hundred dollars, you can easily spend hundreds of thousands of dollars on one house. And even if you only put down a few thousand on a property you intend to flip, you’re on the hook for the mortgage if the market goes belly-up.

Investing Returns

With stocks, your returns depend on a variety of factors, such as:

  • When (and what) you buy and sell
  • Overall market performance
  • Global and national political and economic circumstances
  • How long you hold securities

Q.ai Says: The S&P 500 averages about 10% return annually. Of course, there is some room for fluctuation, but as a long-term benchmark, 10% is a safe(ish) bet.

However, the factors that contribute to real estate profits make predicting average returns more difficult. While you may sell your property for more than you paid, real estate is a uniquely involved asset. It’s important to keep in mind:

  • You’re usually investing in a smaller number of higher-cost assets
  • Mortgage interest, inspections, and listing and selling fees cut into your profits
  • The cost-benefit of rent against maintenance, repairs, and taxes
  • Variable housing costs and taxes
  • How long you own property (and what you do with it) plays an outsize role
  • Retail versus housing properties generate different returns

However, you can more easily examine the average returns of nontraditional assets. In particular, a quick peek at modern real estate ETFs can shed some insight into past and current housing market returns. Examples included below:

Vanguard Real Estate ETF 5-Year Returns: Largest real estate ETF with $33.72 billion AUM

Image Credit: Screenshot from Marketwatch.com

Schwab US REIT ETF: Top 3 real estate ETF with $4.87 billion AUM

Image Credit: Screenshot from Marketwatch.com

Benefits of Investing

Stocks have several benefits unique to liquid securities. For instance, they’re typically fairly affordable, and long-term market performance often produces gains. But they also come with other benefits, such as:

  • Dividend payments and ownership rights
  • Increased liquidity in case of emergency or sudden market uptick
  • Diversification potential across verticals, niches, and international borders

However, real estate produces tangible benefits in a literal sense. Investing in property grants you the rights of a landlord, which means you can sell or rent to tenants as you see fit. And unlike stock, you can leverage real estate against loans, debts, and future investments. This provides investors with opportunities to expand their portfolios without draining their savings accounts. Not to mention, owning property hedges against inflation in a way that securities can’t.

Risks of Investing

Unfortunately, no asset class is completely risk-free. In particular, stocks carry an inherent risk of volatility. Market unpredictability can be caused by any number of factors, from a foreign country’s new import laws to the whims of a corporate CEO thousands of miles away. For those investors who don’t diversify, these risks are even greater.

Q.ai Says: It’s also important to consider that humans are emotional creatures who often respond strongly to financial misfortune. For some investors, anything more than a company-matched 401(k) provides too much instability for their financial comfort.

On the other hand, real estate is a much stodgier investment. We mentioned liquidity as a benefit of investing in stocks – with real estate, it’s the opposite. In a hot market, it’s possible to flip or rent property on a dime. But in times of economic turmoil, like during a global pandemic, it’s possible to see your assets sit empty for months or even years. This lack of liquidity makes real estate investing trickier for those who may need a quick out. And at the end of the day, there’s still no guarantee you’ll get what you paid for your investment.

Getting Started with Real Estate Investing

Up until now, we’ve primarily assumed that investing in real estate means buying traditional property. However, modern investing has introduced new methods to diversify your portfolio without signing a deed. We’re going to discuss both types of investments here.

Traditional Ways to Diversify with Real Estate

There are two primary ways to invest in physical real estate: buying rental properties and flipping houses.

Buying rental properties comes with the caveat of becoming a landlord. For some, collecting passive income via rent checks is the dream life. But you still have to be on call to deal with every exploding toilet and broken water heater – unless you’re willing to shell out thousands for a property manager.

Flipping houses is a whole ’nother beast entirely. Typically, this process involves one of two strategies:

  • Buying, repairing and updating, and selling property as quickly as possible
  • Buying, holding, and selling property when the market ticks up

Each of these strategies comes with their own benefits and risks. It’s also possible to take on both roles at once – buying and fixing up a property in a rising market, and then selling when you believe the market has peaked. However, neither option guarantees that you’ll see returns.

Modern Real Estate Diversification

Of course, modern markets have presented new options to circumvent the binary juxtaposition of investing in the stock market or real estate: real estate securities and trusts.

  • REITs: With a real estate investment trust, a corporation or trust uses investor funds to buy, rent, and sell properties. 90% of the profits go to shareholders as dividends, while the remaining 10% pays operating costs. REITs often invest in malls, office buildings, and even mortgages.
  • Real estate mutual funds: These funds typically invest in REITs and other operating companies. Unlike a single trust or fund, they provide broader market diversification and increased liquidity – similar to how traditional mutual funds provide broader diversification than buying 10 shares of Microsoft.
  • Real estate ETFs: Exchange-traded funds also provide investors with broad market exposure in a single unit. Real estate ETFs provide the same benefits as traditional ETFs, but they focus on REITs and real estate stock.
  • REIGs: Real estate investment groups are similar to mutual funds. Investors buy individual units of living space through a company that owns apartment buildings and housing units. The company takes a percentage of the rent to manage all maintenance and advertising, while the investors collect passive income.
  • RELPs: Real estate limited partnerships are similar to REIGs, but they only exist until the properties under ownership are sold.

Fees and Taxes of Real Estate Investing

The taxes and fees associated with real estate investments are determined by the type of investment.

Buying and Selling Property

The U.S. tax code often rewards long-term investments, and the same is true of real estate. If you’re buying property to flip, you’ll pay one of two types of capital gains taxes:

  • Long-term capital gains taxes apply to investments held for more than one year. The tax is calculated according to your taxable income. So, if you buy a house for $100,000 and sell it for $200,000, but put in $50,000 in repairs and commissions, your taxable profit comes to $50,000.
  • Short-term capital gains taxes apply to investments held for less than one year. This profit is counted as part of your overall income and will be taxed according to your personal income bracket. So, if you make $50,000 per year at your day job and sell your real estate investment at a $50,000 profit, Uncle Sam considers your income to be $100,000 for the year.

It’s important to note two things. The first is that higher-income individuals must pay an additional 3.8% on top of their net investment income for both long- and short-term investments.

The second is that capital gains do not apply to the sale of your primary residence (up to $250,000, or $500,000 for married couples) if you’ve owned and lived in the home for two of the last five years.

Rental Properties

With rental properties, landlords face a different set of taxes and fees for their properties. Of course, you’ll have to pay property taxes on any real estate you own. You’ll also have to pay income taxes on your rental income.

But while you can deduct expenses related to repairs and maintenance – say, if you need to replace the roof or the boiler – but you cannot deduct expenses related to improvements. In other words, if you install a hot tub in the backyard, you can’t deduct $5,000 for “improving the ambience.”

ETFs, Mutual Funds, and More

When it comes to nontraditional real estate assets, taxes and fees follow the guidelines for those assets. For instance, if you invest in an ETF or mutual fund that pays dividends, you may be responsible for paying both dividend taxes and capital gains taxes. For investments such as REITs, REIGs, and RELPs, you typically pay capital gains taxes, but it’s essential to do your due diligence before you take the leap.

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