What Role Should Real Estate Play in Investing?
In my work with clients over the years, one of the most common questions I get is, “Should I purchase investment real estate?” Most of the time, the client’s interest is in purchasing a single-family residence as a rental property with the strategy of rental income paying down the mortgage for the end goal of having a paid off rental property, generating passive income. Diversity, tax benefits and future equity are part of the real estate conversation and, while this might sound like a great idea, there are downsides that can outweigh the upsides.
Incorporating Real Estate into Your Portfolio with Reduced Risk
Shares in real estate investment trusts (REITs) are the form of investment real estate exposure we commonly recommend in our client’s portfolios. These are diversified funds that hold securitized real estate holdings. REITs pool together dollars to invest in income-producing real estate or real estate related entities. The exposure covers many different areas including but not limited to retail, office, residential, industrial and hotels. This broad exposure provides for diversification and a reduction of risk. The funds we utilize contain a few hundred different holdings which are publicly traded and the fund shares can be bought or sold on a daily basis, thereby providing liquidity. Ownership of shares in a REIT carries no direct liability to the investor for the property held in the REIT. The percentage exposure in most of our recommended portfolios will typically range between 1% and 10%, depending on the goals of a particular client. While most of our clients’ accounts will include real estate as a component piece to their portfolio, there are cases where the client already has exposure to investment real estate in the form of residential or business properties. In these cases, we would exercise caution in purchasing a real estate fund, so as to not overweight their overall portfolio.
Costs Associated with Real Estate Investment
Ownership of shares in a REIT is very different than owning a residential rental property. There is a saying in the real estate world that there are two ways to really get to know someone; one way is to marry them, the other way is to rent to them. The risk and return of direct ownership of rental property requires direct participation by the investor in a myriad of factors such as property repairs, maintenance, credit-worthy tenants, responsible tenants, tenants that pay rent on time, consistency in zoning, taxation and regulations. The likelihood of having different tenants over the years involves costs in time and money for cleaning, additional repairs, relisting and vetting of new renters. The investor/landlord can do this work but it requires time, energy, and liquid reserves.
Perhaps most importantly, does this work bring you happiness or stress? Does it match your lifestyle? Is it time well spent? These are important considerations; direct ownership of rental real estate is a very “hands on” proposition. Many investors hire a property management company, the net result being less profit or return. No matter who the investor hires, the liability for the property remains with the investor. Rental income is taxed at ordinary tax rates and the earnings can be offset with related rental expenses. Depreciation may be a tax benefit of owning rental property because it allows the owner to spread out the cost of buying the property over multiple decades, thereby reducing their tax liability. Of note, if the property is sold for greater than the depreciated value, then you could owe tax on the gain, this is called the depreciation recapture tax.
Maintaining Income with Real Estate can be Difficult
Calculating the Capitalization Rate quantifies the return on a rental property. It is calculated by dividing the net income from the property by the current value of the property. For example, if a property generates $12,000 per year in income and the property value is $150,000, the Cap Rate would be 8%. This return can be improved upon in two ways: either the net income goes up while the property value holds steady or the net income is held steady while the property value decreases. Stated in different terms, owners should strive to increase rent when the property value goes up. Increasing rent is not always an easy task and it is dependent on comparable properties and vacancy rates. Also, owners may want to keep the current tenants, and not price them out of the property with a rent increase. Direct ownership of rental property is investment in an illiquid asset. Access to equity is gained through leverage or selling the property and the value of the property is affected by the various aforementioned factors and how quickly the seller needs to liquidate.
TCI’s firm-wide preference for clients who are not professional real estate developers/investors is to have real estate exposure in a fund with globally diversified holdings, tax sheltering of capital gains, and publicly traded with liquidity at a moment’s notice. Rental properties can be a good investment but there are many potential downsides that make them much riskier than the alternative. Having witnessed both successful and unsuccessful rental experiences, it’s a big decision to take on a rental property. A thoughtful conversation with your financial advisor, CPA and attorney about how real estate best fits into your overall financial plan will be time well spent.