July 1, 2021

Why Invest in Real Estate

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Apply some leverage to a real estate investment and you'll be surprised by the wealth you can build. Discover the top 4 reasons to invest in real estate.

High returns, tax advantages, and a hedge against inflation.

All things considered, real estate is an attractive investment.

But what are the potential downsides?

Before investing, get a deep-dive into this potentially lucrative asset class. Review the main benefits, drawbacks, historical returns and how to get started.

How Do Real Estate Returns Compare to Stocks?

Historical returns for U.S. stocks average roughly 9% per year[1], while U.S. real estate only appreciates by 3% - 4%/year.[2]

Some think this is a fair reason to avoid real estate investments. However, remember that the average property purchase involves leverage in the range of 60% - 80%.

This results in ROI 4-5x higher than the property appreciation rate. And that's without even accounting for rental income. Real estate investments could earn you 12% - 15% per year in appreciation alone, outpacing stocks by a safe margin.

What is leverage in real estate? Leverage is borrowed capital that you use to increase your return on investment. Because you're investing in real estate with more money than you might have yourself, your potential returns may be higher.

The Benefits of Investing in Real Estate

Real estate, as an asset class, has a lot going for it. Review some of our top reasons why real estate investing can be a smart move.

1: Leverage Can Maximize Your Returns

Let's say you pay cash for a $500K condo. Assume you can rent it out for $20K/year and that the property value appreciates by 2%/year.

Your return on investment (before expenses) would be 6%/year ($20K in rent income + $10K in appreciation/$500K). 6% isn't bad, but it's also nothing to write home about.

Now, instead of paying for the condo in cash, let's say that you only pay $50K in cash. For the rest, you take out a mortgage of $450K at a fixed rate of 3%/year.

After you subtract the mortgage interest ($450K x 3% = $13.5K), your net annual gain is only $16.5K.

But get this: since you only paid $50K in cash, your return on investment (before expenses) is now 33% ($16.5K/$50K=33%).

This doesn't account for maintenance costs and taxes, but those expenses apply regardless of how the property is paid for.

The key takeaway is that the use of inexpensive leverage capital allowed you to increase your annual return significantly.

Applying Leverage to Other Asset Classes
You might be thinking, "Couldn't I use leverage to magnify the return on any investment?" Technically, yes. But it would be more costly and risky.

Keep in mind that the U.S. government subsidizes mortgages. It's why you can get a $500K mortgage and only pay 3% interest.

If you borrow money to invest in stocks or anything else, the interest rate charged by your lender would easily be 2-3x higher.

2: Returns from Two Sources

With real estate, you get returns from:

  1. Rental income
  2. Property appreciation

Rental income
Whether you have long-term or short-term tenants, you will likely be collecting rent money each month.

This money can be used to partially (if not entirely) offset your monthly expenses on the property (i.e., the mortgage payment, maintenance and repairs, etc.).

Property appreciation
Your property value will appreciate over time, but this gain won't be realized in cash until you sell it.

Historically, U.S. property values increase by 3% - 4%2 annually. However, they're still subject to shorter-term volatility, like we saw during the 2008-2009 financial crisis.

Plus, your property appreciation will largely depend on its location. For example, condos in popular cities with high-paying job markets, like Boston and San Francisco, tend to appreciate more than houses in rural Kansas.

3: Hedge Against Inflation

Any physical asset that has limited supply and real-life uses, such as real estate and commodities, is a natural hedge against inflation.

Other asset classes, such as bonds, tend to lose value during periods of high inflation. Their value is derived from future cash flows that are fixed and predetermined.

There is, and always will be, demand for real estate. People will always need a place to live. So, the price that people are willing to pay for real assets will reflect a premium for any inflationary pressures.

4: You'll Get Tax Advantages

Tax deductions for real estate investments also sweeten the deal.

Many monthly costs associated with a rental property are tax deductible. For example, you can deduct all of the following:

  1. Interest expenses
  2. Maintenance and repair costs
  3. Building depreciation from your rental income

And once you sell the property for a gain, it can be taxed at the preferable long-term capital gains tax rate (as long as you owned it for at least one year).

What are the Drawbacks of Investing in Real Estate?

As with any investment, there is obviously the risk of loss, which is why it's important to do your research.

Investors should also consider the potential drawbacks below.

1: Low Liquidity

Selling property is a long, complex process. If you have money tied up in property and need it quickly, you're out of luck.

Unlike selling stocks and bonds in just minutes, selling a house can take roughly 70 days in total.[3][4]

When buying property, use money that you don't need for anything else. That way, if the economy sours, you aren't forced to sell your property to raise cash.

2: Cash Reserves are a Must

Property may be illiquid, but you'll still need cash reserves just in case. Keep at least enough to cover the mortgage for six months in the event that you unexpectedly lose a tenant.

You may think that losing a tenant is unlikely, but consider recent events. When vacation rentals sat empty for months during the COVID-19 pandemic, property holders lost a lot of income.

3: Large Capital Requirements

Real estate is a capital-heavy investment. If you are buying a property to live in, the bank might offer you a loan for as little as just 5% down (assuming you are a prime borrower with a steady job).

But if you are getting a mortgage for an investment property, the bank will generally want at least a 20% down payment.

However, many real estate investors use this to their advantage. You can buy your first property with 5% down and live in it for one year, before buying and moving into another property (also paying 5% down again) while renting out the old property.

This allows them to qualify for the smaller down payment compared to if they had applied for the mortgage as an investor, with the only drawback to this strategy being that you have to move every year.

4: Potential Financial Crises

No risk assessment would be complete without mentioning the 2007-2008 GFC, which saw U.S. property prices plunge by as much as 25% (note that stocks fell more than 50% during the GFC).

Lending standards became so relaxed that everyday folks were buying multiple properties to rent out, sometimes with 0% down.

As some people lost their jobs, they lost the ability to pay their mortgages, prompting the banks to foreclose on them. This flooded the market with a seemingly endless cascade of properties for sale. With few willing and able buyers around, prices fell sharply.

The bright side is that real estate prices eventually recovered and even reached new highs in the following decade. While short-term real estate prices can be unpredictable, this asset class has seen steady, positive returns over the long term.

Plus, the U.S. government and the Federal Reserve still support and heavily subsidize the U.S. housing market by keeping mortgage rates low. No matter what your stance is on government subsidies, it is always a good thing when Uncle Sam is investing alongside your hard-earned dollars.

How Does Real Estate Fit into My Portfolio?

Historical real estate returns not only exceed stocks, but they do so with less volatility.

This is because, during economic downturns, everyone is looking for liquid cash - fast.

The fastest and easiest way to get cash from investments is to sell the most liquid assets first, like stocks and bonds. Homeowners tend to hold onto their homes and only sell those as a true last resort, making real estate prices less volatile than stocks and bonds.

Real estate can also benefit your overall portfolio due to its low correlation with stocks. If two assets are highly correlated, it means their prices generally move in the same direction.

For example, stocks and bonds are more correlated to each other, so if your stocks are all down, your bonds are likely in the red as well. Since real estate prices are generally not correlated with stocks, this asset class can help keep your portfolio afloat when stocks and bonds are taking a dive.

How to Invest in Real Estate

In the past, real estate investing was only accessible to wealthier people. Now, there are multiple ways to invest in real estate that require far less capital and less effort on your end. Here are a few options to consider.

Buy a REIT
Real Estate Investment Trusts (REITs) are companies that own and operate real estate assets, such as residential and commercial rentals. Since properties typically appreciate in value, REITs can generate substantial returns over time.

You can invest in them just like a stock (such as the Vanguard REIT). All you need is an account with a brokerage or with a free stock trading app.

Try Real Estate Crowdfunding
Real estate crowdfunding involves pooling your funds with other investors to purchase properties together.

Many crowdfunding platforms let you invest with a little as just $500, or even $5. They take care of all property management and tenants. You get returns either via dividends or when the property is sold off (and sometimes both).

Keep in mind: These kinds of investments are usually at least a 5-year term. You can't just sell at any time.

Below, compare popular real estate crowdfunding platforms:

Rent Out a House
Being a landlord is the most common way to generate rental income. However, all the responsibility is on you.

You list the property online, show potential renters the space, conduct credit checks, and process rental documents. You also have to take care of any property maintenance and repairs.

Once you begin collecting monthly rental payments, you can use it to pay for the home's mortgage and other fees.

Fix and Flip a House
This approach involves buying a home, fixing it up to increase the value, and quickly reselling it. It can be risky, but it can also be very lucrative.

Your renovation costs can't exceed what you eventually sell the house for. If the market slows down or the home is hard to sell, the investment can easily lose a lot of money.

Buy and Hold
If you're in no rush to get returns on your investment, you can always wait for your house to naturally appreciate in value. When it reaches that point, you can sell and keep the profit.

Keep in mind, this is a very long term investment. For a more regular cash flow, consider renting out a spare room.

The Bottom Line: Real Estate Can Enhance Your Portfolio

There are so many reasons to consider real estate investing and so few reasons not to. Historical real estate returns in the U.S. are some of the highest, most consistent, and least volatile among all asset classes. Plus, they have very low correlation to stocks and bonds.

And with Uncle Sam's blessing in the form of low interest rates and down payments, real estate has never been more accessible and attractive to investors than it is today.


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