There was once a time (pre-2006 to be exact) when real estate appeared to be the near- perfect investment. Its value rose dependably over time, and the more borrowed for investment, the higher the return. It was also a wonderful way to store (as well as to advertise) wealth. While business ventures and financial assets might become worthless over night, the same was never true for land. As eager real estate salesmen never grew tired of saying, “They are not making any more of it, you know…”
How our perspectives changed with the financial crisis of 2008. Leverage became a dirty word, and “underwater” a term no longer relevant just to shipwrecks. Meanwhile, liquidity (which real estate decidedly lacks) became increasingly important to investors.
The concept of land as a scare commodity has become less compelling as innovation and technology have allowed much more to be done with less. Banks, for example, are now trading their vast brick-and-mortar footprints for a virtual presence and tidy 6”x 4” ATM machines. Similarly, enormous homes are no longer regarded purely as status symbols of great wealth, but are also seen as black holes of upkeep and maintenance expense. For millennials, in particular, the cost of traditional home ownership can be unacceptable in terms of foregone freedom and experiences, prompting the more plucky to create living spaces out of converted boxcars or storage units.
But a pendulum always returns to a midpoint between extremes, and such is the case with the real estate market. Investing in real estate is again attracting interest, due, in part, to an improving economy, still-low interest rates, and investors’ emerging concerns about a volatile and aging bull stock market. Retiring baby boomers are looking at rental properties as a way of generating needed income. As landlords, they can collect rents or leases to supplement Social Security benefits or, better still, delay taking these benefits until they turn 70.
So without forgetting the sobering lessons from the real estate bubble, is it time for you to add investment property to your portfolio?
The answer may be yes, as long as you fully appreciate the unique aspects of owning real estate as an investment. You need to understand what real estate IS and what it IS NOT:
- Real estate IS NOT an alternative to the stock market. There is a tendency, particularly among realtors and successful real estate investors, to think that the stock market is unreliable and irrational, while investments in real estate are completely under their control. They emphasize the “real” aspect of real estate: something that can be seen, touched, and managed. However, the stock market offers you the essential risk-reduction aspect of diversification – the ability to cancel out the “irrationality” of individual holdings by holding many different issues. To achieve similar diversification in real estate would require you to hold properties in a variety of locations, for a variety of purposes: rental, commercial, industrial. The costs of this diversification is generally well beyond the means of a single investor.
- Real estate IS expensive. It takes money to make money in real estate, even with the ready availability of mortgage loans. As a result of the real estate bubble, lenders require more “skin in the game” from borrowers. But beyond the necessity for larger down payments, there are the ongoing costs of interest, taxes, insurance, maintenance and repair. It is not enough to rely on the income generated by the property to cover these expenses as they occur. You will need to set aside reserves to cover these expenses for times when the property may be vacant.
Real estate is NOT a passive investment. The IRS may term it so, but in reality it takes time, attention, and availability to be a landlord. Your stocks and bonds won’t call you in the middle of the night, but your tenants can and will. Certainly, you may choose to hire a property manager to address this issue, which could be a good decision. But if you do, go back to bullet #2.
Real estate IS a business. You need to have the drive, stamina, and head for analysis to be a successful real estate investor. No such thing as “buying and holding” with this investment. You’ll need to constantly adjust your business strategy: weighing the expected return from rental increases against the possibility of increased tenant turnover; doing a cost/benefit analysis of property improvements; keeping accurate records of all expenses; staying current with tax rules for rental properties, such as allowable depreciation periods for buildings, fixtures, and appliances, and the recapture of certain depreciation write-offs as income upon sale of the property. Further, as with any business, you will need a carefully considered exit plan. Under what circumstances will you sell the property or do you plan to leave the property as part of your estate? How might this impact your beneficiaries?
Bottom line: real estate is a unique asset class unto itself. It takes a unique investor to make this investment both profitable and worthwhile. Yes, it is possible to earn good returns from an investment in real estate in the form of ongoing income and appreciation at sale. But the upside does not come easily or automatically just by virtue of making the investment. Do your homework and talk to a CFP® professional about whether and when purchasing real estate for your portfolio makes sense.