Including real estate as an asset class in your investing portfolio adds diversity to reduce your overall investment risk. There are many real estate investing strategies to achieve this. Like real estate investment trusts (REITs), some options are as passive as holding dividend-paying stocks.
Like any investment, taking on real estate in your investment portfolio has pros and cons.
The Pros Of Real Estate Investment
Real Estate Appreciates Over Time
Well-chosen Real Estate appreciates over time, generally at a far outpace of annual inflation. Yes, there are occasional market corrections, and people can buy the wrong type of property at the wrong time. But I’ve found there is always a chance to buy a quality property at a discount, make improvements to increase equity and eventually sell for a profit.
It’s the real estate equivalent of the stock market mantra to “buy low and sell high.” And real estate always has an intrinsic value. A stock can go down to zero, but a property is a tangible asset that will always have value derived from the raw land and the “improvements” (the building structures attached to the ground).
Real Estate Has Unique Tax Benefits
Real estate’s unique tax benefits allow investors to grow their wealth over time. For example, rental income is not subject to self-employment tax, and the government offers tax benefits to real estate investors. These include depreciation and significantly lower tax rates on long-term profits. And depending on your income level and classification as an investor or real estate professional, there is a good chance your rental property will give you an overage of tax deductions you can use against your other income. In addition, rental real estate is a business, which means many expenses, such as travel costs to check on your properties, are tax-deductible expenses of running your business.
Real Estate Provides A Steady Cash Flow
Rental properties can provide a steady flow of monthly income called “cash flow.” The extra money is left after all the bills have been paid. Once your property is set up, cash flow provides ongoing, monthly income that is mostly passive, allowing you to spend your time building a business, spending time with family, or reinvesting in more real estate.
Real Estate Lets You Use Leverage
You can use the power of leverage to quickly grow your real estate holdings and accelerate your wealth-building results. Leverage is the use of borrowed capital to purchase and increase the potential return on investment. When used wisely to minimize risk, leverage is a powerful advantage of real estate investing. You can buy an investment property with a 20% down payment using a conventional loan.
So, for example, with an initial investment of $30,000, you get the opportunity to control — and get all the benefits of owning — an asset worth $150,000. Done with proper due diligence, you can build your wealth exponentially using leverage, especially in the low interest-rate market we’re currently enjoying.
Real Estate Builds Equity
When you use leverage wisely, your tenants are essentially buying the property for you. Rental income pays down your loan each month and builds equity for you. When you buy a rental property using a mortgage, your tenant is the one paying the mortgage payment, thus increasing your net worth each month. Think of it as a savings account that grows automatically without your depositing money each month.
Today you might owe $200,000 on a rental property, but next year you might owe only $195,000 because the tenant is making the payment for you, making you $5,000 richer. Thirty years down the road (or whatever the term of your loan), it’s paid down to $0. You own a significant asset that you can sell or continue renting, thanks to your tenant paying the mortgage.
Real Estate Gives You Control
You have more control over your overall investment success with real estate than with other investing classes. You can’t sit in the boardroom and steer management decisions that influence the value of the stocks you own. You are in the driver’s seat of many decision-making with real estate investing. You can mitigate risks and grow your portfolio at a much faster pace by investing in real estate. As a real estate investor, I control my success or failure. When I want to find deals, I can hustle. I employ strategies to ensure the best tenants are attracted to my properties in a competitive rental market. I can make strategic improvements to increase rental income.
You Can Purchase Real Estate At Below-Market Prices
It is sometimes possible to acquire real estate at a below-market price – especially when the seller needs to sell quickly and you have sufficient cash on hand to fill this need. Taking advantage of these anomalies requires a deep knowledge of local market prices, which is easier to obtain when committing to real estate investing full-time. Real estate agents are especially good at locating properties available at below-market prices.
Real Estate Generates Steady Cash Inflows
When a property is rented out, it generates a stream of monthly rent payments. In addition, some properties may have additional payments associated with them, such as washers and dryers, storage, and parking. Depending on the offsetting cash outflows for mortgage payments, property taxes, maintenance, and so forth, the net cash inflows may be substantial.
Real Estate Provides A Depreciation Tax Shield
The depreciation expense that you can claim on a real estate investment involves no cash outflow and yet reduces the amount of taxable income – thereby shielding you from a portion of the taxes that would otherwise be due. Currently, the depreciation period for residential real estate is 27½ years, while the depreciation period for commercial buildings is 39 years.
Real Estate Appreciates Value
Real estate tends to appreciate depending on the area depending on local demand levels. Of course, this can vary substantially within even a short distance, but if you choose property carefully, it can appreciate quite substantially over a long period. Also, if you are good at fixing up real estate, doing so may trigger a substantial increase in property value.
Real Estate Provides An Inflationary Hedge
Ongoing increases in inflation tend to cut into the earnings generated from most forms of investment. However, it has historically not been the case for real estate, which tends to appreciate faster than inflation. Part of the reason for this is that investors see the Real estate as a hedge against inflation and are more likely to bid up its price when inflation is high. Real estate prices may also increase during uncertainty since it is considered a safe investment.
Real Estate Financing Creates Leverage Benefits
Real estate is usually purchased with the assistance of a substantial mortgage, typically in the range of 70-80% of the purchase price. It means that the amount of this debt magnifies any returns from the property. For example, if you use a $50,000 down payment to acquire a $300,000 rental property and then earn $25,000 per year, you have generated a return of 50% on your $50,000 down payment – because so much debt was used to fund the purchase.
Real Estate Defers Taxes
You do not pay income tax on any increases in property value until you sell it, which may not occur until years after the initial investment. In addition, under the current tax laws, it is possible to roll the gain over into another real estate investment, thereby extending the tax deferral period even further. These mechanisms make it possible to potentially avoid income taxes on the sale of a property for your entire life.
Real Estate Income Gradually Increases
If it is possible to increase rental rates at the inflation rate, your income gradually increases since the fixed-rate mortgage is paid off (your primary expense) and does not increase at the inflation rate. It results in a gradually increasing rate of return on the property. This advantage only applies if you avoid variable-rate mortgages.
Real Estate Allows For Active Investment Control
Most investors buy shares or bonds, for which the related income can go up or down without their having any control over the proceeds. It is not the case with real estate. However, an active investor can search for the best deals, control costs, judge which applicants will become tenants, and decide when to sell. By participating in every aspect of the investment process, you can impose more control over how much you earn. In short, your actions determine how much you make.
The Cons Of Real Estate Investment
Real Estate Requires Money
You need money to make money. Forget the gurus who promise, “You can get rich buying real estate with OPM (Other People’s Money).” While you can buy shares of stock with a minimal cash outlay, real estate investing requires money. You’ll need a down payment plus closing costs and money to repair and update the property to maximize rental income to get started. And once you own the property, there will be ongoing expenses like property taxes, insurance, mortgage payments, and property maintenance.
Real Estate Takes A Lot Of Time
It would help if you spent time learning and managing your real estate investments. There’s a learning curve, and you can lose a lot of money in real estate if you don’t know what you’re doing. On top of that, actively managing your rental properties can be time-consuming.
Real Estate Is A Long-Term Investment
It would help if you always bought real estate with a longer-term strategy. You’re buying a tangible asset that you can’t quickly liquidate for cash if you need emergency funds. It takes time to sell a property, and the transaction costs are higher than selling stock shares.
Real Estate Can Be Problematic
Tenants can cause problems and cost you money and valuable time wasted in court. If you own rental properties, your cash flow can take a significant hit if you rent to a tenant who doesn’t pay, leaves the property in very poor condition when they move out, or both.
Real Estate Investing Is A Long Grind
The returns from the real estate generally investing accrue over an extended period if you purchase judiciously and invest enough to maintain properties properly. Also, depending on the types of properties acquired and the nature of your tenants, it may be necessary to spend a substantial amount of time managing the properties. If you plan to manage properties directly, this may mean that you will not be able to take any vacation time for years.
Real Estate Income Can Be Variable
You may lose money in some periods. It is especially likely when you made only a small down payment, resulting in larger mortgage payments. Also, when demand is soft, you may not rent a property at all, or it will not be possible to raise the rental rate as much as you would like. It is especially the case if you have acquired the property in an area with fundamental weaknesses, such as a reliance on one local employer that subsequently closes and lays off its employees.
Real Estate Requires Maintenance
There may be unexpected maintenance issues, such as a failed water heater or a leaky roof. The associated repair or replacement costs may be substantial and could wipe out your cash reserves. It can come as a particular surprise when the home inspection on a recently acquired property did not spot the issue.
Rent Control Impacts Real Estate
If you are investing in residential units, there is a possibility that the local government will impose rent controls, which severely limit your ability to raise rents. Though it may be possible to apply to a rent control board for a targeted rent increase, these requests are usually only granted grudgingly.
Real Estate Requires Your Time
Investing in Real estate requires a significant amount of time. You will need to learn about the neighbourhoods you want to invest in, identify problems with prospective investment opportunities, and deal with maintenance issues. It is possible to hire a property manager to deal with tenants, but dealing with the property manager will still require a certain amount of time.
Real Estate Transaction Costs Are High
The transaction costs associated with buying and selling properties can be quite steep. These costs, which include commissions, title insurance, loan origination fees, and a variety of closing costs, can easily wipe out the appreciation in market value. These costs can only be offset by holding onto properties for an extended period so that they can appreciate to a substantial degree. A large part of these costs is the real estate agent’s commission, which varies by property type. The commission on a free-standing home is among the highest rates a realtor charges.
Real Estate Income Is Subject To Taxation
Ongoing income from real estate and gains from the sale of a property are all subject to federal and state income taxes, which can be substantial. However, there are situations where gains from the sale of a property are not immediately taxable, as noted earlier.
Real Estate Values Can Decline
The market value of the real estate may decline sharply over the short term, especially when it was preceded by a bubble in property values that sent prices surging higher than the long-run trend. If you buy property near its peak price with a modest down payment, experience a valuation decline and then sell at the bottom of the market, you may lose your down payment.
Real Estate Rents Can Decline
During economic contractions, it can be not easy to find quality tenants. If the contraction is prolonged, you may face ongoing mortgage, maintenance, and utility payments without offsetting rental payments. Or, you may be faced with a series of delinquent tenants.
Real Estate Leverage Effects Can Be Negative
The leverage effect already noted as an advantage of investing in real estate can also be a disadvantage, magnifying your losses. To return to the earlier example of using a $50,000 down payment to acquire a $300,000 rental property, what if the result is a $25,000 loss in the first year? You will have generated a return of -50% on your $50,000 down payment, wiping out half of the investment. Thus, using debt to buy properties can work in your favour – or against it.
Real Estate Is Not Liquid
It can be not easy to sell off real estate within a short period. It can be a problem if you have an immediate need for a significant amount of cash. When you are pressed for cash, a vulture investor may swoop in and offer cash immediately at a steep discount to the property’s market price. It can result in a significant loss on the sale.
These disadvantages can be mitigated by holding real estate for many years, maintaining a cash reserve to keep you solvent during any negative cash flow situations, and rolling your gains from property sales over into new property investments (to avoid taxes). In short, there are disadvantages to Real estate investing, but there are ways to keep them from overwhelming you.
So, is real estate investing right for you? The pros of real estate investing are obvious: the potential to make a lot of money if done correctly. But there are also some cons to consider before making your decision. It can be difficult to get started as an investor – you need a lot of capital and knowledge to get started in the industry. And even if you do have the capital, there’s no guarantee that you will see a return on your investment. In addition, real estate markets can be volatile, so it’s important to do your research before diving in.
FAQs About Builders Melbourne
Is Real Estate Investing worth it?
Real estate is generally a great investment option. It can generate ongoing passive income and be a good long-term investment if the value increases. You may even use it as a part of your overall strategy to begin building wealth.
What is a disadvantage of real estate investment?
Real estate investing can be lucrative, but it’s important to understand the risks. Key risks include bad locations, negative cash flows, high vacancies, and problem tenants. Other risks to consider are the lack of liquidity, hidden structural problems, and the unpredictable nature of the real estate market.
Is real estate investing hard?
Real estate investing is also hard! Real estate investing requires an initial investment of personal effort and time. And while it can be passive eventually, buying and owning properties is more like a part-time or full-time job at first.
Can you lose money investing in real estate?
It is very common for first-time investors to lose money in real estate. Many problems can occur – from water leaks that damage your walls to bad tenants that won’t pay up. If you’re looking to invest in real estate, there are many factors to consider.
Is real estate riskier than stocks?
Investing with debt is safer with real estate. Also known as your “mortgage,” you can invest in a new property with a 20% down payment or less and finance the rest of the property’s cost. On the other hand, investing in stocks with debt, known as margin trading, is extremely risky and strictly for experienced traders.