As distance between the real estate collapse and the financial crisis that followed in the late 2000s increases, do you wonder whether it’s time to consider investing in real estate now that property values have begun their recovery?
The arguments for investing in real estate are compelling. It allows you to achieve better portfolio diversification with an income-generating asset that has a lower correlation to the stock and bond markets. It is often viewed as providing a hedge against long-term inflation and can offer tax advantages when bought directly.
But, real estate investing, even when everything goes well, is not a shortcut to riches. It requires buying at good prices, the patience to hold for the long-term, and having realistic expectations regarding its potential return, says Leonard Baron, MBA, CPA, a San Diego State University lecturer, and Zillow blogger, who also offers help with real estate questions at ProfessorBaron.com.
Here are some other considerations Baron thinks you should have in mind before investing directly in real estate:
1. Don’t invest in real estate unless you are thinking of making at least a ten-year commitment.
The cost of ownership—transaction fees alone are roughly 15 percent—make it a very long-term investment when it comes to earning equity. Baron estimates that it typically takes about five years of ownership just to break even.
2. Ignore location, location, location.
Prime, showy properties tend to be over-valued for what you get. Baron thinks it is better to go with something basic—always in demand and easier to own.
3. Skip the fixer-uppers.
Because the cost of remodeling is higher than its value to the next buyer, Baron recommends buying properties needing minimal additional investment after they are purchased.
4. Rent should always cover the cost of ownership for investment properties.
Owning income property is a business…a business based on cash flow. Unless an investment property is cash flow positive, Baron advises against it.
5. Read all documentation that goes along with the property.
The devil is in the details, as are the potential defects of the investment. “Buying real estate is risky,” says Baron. As with any financial commitment, you bear the responsibility for fully understanding what you are getting into before committing.
While investing in real estate can resemble fixed income investing in that it converts your invested dollars into a stream of future rent payments, your bond portfolio will never call you in the middle of the night to come fix a clogged toilet. Owning rental properties is essentially a second job.
This may be why the second most popular alternative investment choice in the Morgan Stanley survey was adding real estate investment trusts (REITs) to portfolios.
REITs give you access to pools of professionally managed income-generating investment properties without the responsibilities of ownership. REITs are also a way for non-millionaires to gain rental property ownership without making a large dollar or time commitment.
But, like any investment, REITs—or real estate mutual funds or ETFs, for that matter—you still need to make the effort to fully understand the underlying details and form realistic expectations regarding potential risks and returns.