Real estate has a reputation for being a profitable albeit complex investment if done correctly. Investing in real estate has historically been an attractive asset class for those willing to take on more risk within this market segment. According to Standard and Poors, the S&P Global REIT index had 15-year annualized returns of 11.22% as of 9/30/2014. There are various methods available for investing in real estate and each has their own unique benefits and drawbacks.
Real Estate Mutual Funds and ETFs
There are hundreds of mutual funds and ETFs whose underlying holdings are real estate based. These funds may directly own Real Estate Investment Trusts (REITs) or companies that deal solely in real estate. They can provide a level of diversification and liquidity which supplies an investor with exposure to the real estate market without putting too much exposure in any one property or property manager.
This method of investing does not present the owner with any control over the actual property and offers no direct tax benefits associated with property depreciation. Risks are inherent in all investments and real estate mutual funds are no exception. Typical risks include market risk, interest rate risk, default risk of debt-related investments and a drop in real estate values.
Publicly-traded REITs are another option for those who’d prefer not to be as actively involved in the purchase and upkeep of properties. The majority of REITs are Equity REITS where they own and operate income-producing real estate. Additionally, some REITs may offer higher dividend yields than some other investments. While they can present a diversification opportunity for a portfolio, they tend to be more narrow in their focus than an index-based mutual fund.
As with mutual funds, there are no direct tax benefits from property depreciation. The restrictions regarding liquidity can also be more expensive from a fee-perspective to the owner than divesting a mutual fund. Another risk associated with REITs is that they are largely interest-rate sensitive, which can result in higher volatility when interest rates change. Publicly-traded REIT share prices can also fluctuate wildly based on regional, national and stock market influences and trends. REITs are a complex product and investors should research the appropriateness based on their individual circumstances prior to investing.
In addition to REIT’s, it’s possible to further diversify a real estate portfolio by investing in a private-equity real estate fund. There are multiple private-equity funds to choose from with varying philosophies and degrees of risk. A conservative fund would typically involve lower risk equity investments in stable U.S. properties using relatively little leverage. A more aggressive fund would typically involve high risk equity investments in U.S. or international properties while using higher leverage.
Private-equity funds are traditionally only open to accredited investors and are not offered to the general public. They do not offer the liquidity and transparency of publicly-traded REITs. The fees and expenses incurred from private-equity real estate funds can be higher than one would normally expect with conventional investments such as mutual funds.
One challenge of the private equity real estate fund model is that investing strategy could be in response to capital flows rather than market conditions, with liquidating assets at predetermined fund termination dates for closed-end funds being a primary example. There are also scenarios where an asset could be sold to meet redemption demands in open-ended funds, which may result in less strategic decision making on acquisitions and divestitures. Be prepared to invest for at least 10 years before being able to realistically evaluate the success of the investment.
An investor also has the option to independently secure a property in their own name by paying in cash or obtaining a loan to purchase the asset. Buying real estate within an LLC may also offer increased asset protection. This could be a rental home or a building occupied by the LLC.
Investors who prefer to have direct ownership and control of their assets might find this strategy advantageous. However, the increased autonomy comes with a cost. A large repair or vacancy could potentially erode monthly or even annual profits. The task of researching properties and the maintenance and upkeep once purchased can easily take up a greater amount of time than anticipated. Many physicians who go that route may erode their investment returns by outsourcing these responsibilities to a property manager.
To match the diversification offered by many REITs, an individual would need to own multiple properties. A drawback of this strategy is that a lot of cash will be tied up in assets that are illiquid. Another risk is loss of money on the sale of the property or assuming full liability for any incident that occurs on the property past the limits of insurance coverage.
Risk is inherent with real estate, as with any investment. It may offer an opportunity to supplement and/or diversify income. Leveraging tax deductions and other asset protection strategies can increase the likelihood of having a consistent income stream from real estate investments. As with any investment, carefully consider the associated risks and your own financial situation before investing.
This article was written by Larson Financial Group, LLC and provided courtesy of Paul Larson, President and CEO. Advisory Services offered through Larson Financial Group, LLC, a Registered Investment Advisor. Securities offered through Larson Financial Securities, LLC, Member FINRA/SIPC.
Information gathered from sources believed to be reliable but is not guaranteed. This is not an offer to sell nor a solicitation to buy any security or investment vehicle described herein. Diversification does not guarantee a profit or protect against loss. Consider objectives, risks and associated fees and expenses before investing. REITs and real estate investing are complex in nature. Carefully review the prospectus or other offering documents. Quoted index performance is for illustration purposes only. Indices are unmanaged and it is not possible to invest in an index itself.