Owning real property is a goal for many investors. When done properly, investing in real estate can offer a number of benefits for individuals including the ability to diversify income streams and capture long-term capital appreciation. However, there are a number of ways investors get it wrong when it comes to real estate and the costs can be quite significant.
As you consider whether investing in real property is right for you, keep these key considerations in mind.
Do: Consider real estate as a diversification tool. One of the benefits of owning real property in addition to traditional investments like stocks and bonds is the diversification it can provide to your income and asset holdings. Having multiple sources of income helps reduce the impact on your finances, should one stream dry up. The real estate market isn’t directly correlated with the stock market either, so holding both types of assets can be a good thing.
Keep in mind that real estate can only help diversify your assets if it’s a component of your net worth – not a big piece of it. Also, consider location as part of your diversification strategy as physical location is a main driver of a property’s relative value. It is important to be familiar with the local market, but don’t overlook the added risk if your own home is in the same community. Of course being a long-distance landlord carries a different set of risks, so try to find a balance.
Don’t: Over-concentrate in one asset class. Just as real estate can provide diversification, it can just as easily concentrate your holdings in one volatile asset class. Investors just starting out may have a higher risk of real estate concentration risk as the property may represent a much larger piece of their overall net worth. Why may this be a bad thing? The real estate market can be volatile and while you can control how the property is maintained, the majority of factors that drive local and national markets are outside of your control. These factors can range considerably. Consider the impact of a major employer moving in (or out) of a community, changes in interest rates, sharp increase to property taxes, and changes to the public services offered in a community.
Do: Consider an investment property if your cash flows are already strong. Real estate can be quite cash-intensive so if you’re holding too much excess cash and find yourself with a large surplus each month, an investment property can be one way to put those funds to work for you. Real estate is unique in that it requires a lot of cash upfront (down payments greater than 20 percent are common) and ongoing cash reserves to maintain and cover for ordinary expenses, but the investment self is highly illiquid. Unlike a traditional investment where you can sell off some of your stocks as needed to raise a lump sum, you cannot sell a room in your property. Unexpected repairs, prolonged vacancies, or past-due tenants can lead to financial problems if cash reserves are light.
Don’t: Rush through your cash flow projections. As any professional real estate investor would tell you, the numbers have to work. Particularly when investing in a buy-and-hold property, your cash flow assumptions must be solid to help ensure you’re making a good investment. Do extensive research to obtain accurate income and expense figures and consider building out a model to tie it all together. A standard model should include provisions such as the cost of capital, expected vacancy rate, taxes, and a discount rate, which is essentially your required rate of return on the investment.
Cash flow modeling is a critical step before making a purchase, as real estate investing carries more risk than traditional investments. Not only is real estate illiquid, but it can actually have a negative value (being “underwater” for example) whereas with stocks, you can’t lose more than your investment.
Finally, consider scenario analysis as part of your cash flow projections. What if you were to invest cash in the market instead of buy property? What tax benefits may you sacrifice by renting your former primary residence instead of selling it? Depending on your specific goals, real estate may or may not be the best way to get there, and cash flow modeling can help you figure that out.
Do: Talk to someone who already owns an investment property. One of the best ways to educate yourself is to speak with someone who’s already faced the same challenges. New real estate investors are often surprised how much work being a landlord can be. It isn’t as easy as it looks on HGTV!
Hiring a property manager is an option, but will impact your cash flows. As a landlord, you’ll also need to ensure compliance with the numerous local and federal laws. Some states, such as Massachusetts have very strong tenant rights laws. Landlords may expose themselves to financial and legal risks if they don’t comply with housing discrimination laws, proper escrow procedures, building codes, and so on.
Investing in real estate is attractive to many individuals who like the idea of having a tangible asset with passive income potential. However, it is important to objectively assess the opportunity and be realistic about your potential net income after taxes. As an individual investor, it can be challenging to find properties with sufficient cash flow potential to justify the risk and opportunity cost, especially as there are many professionals with a whole infrastructure behind them that are trying to do the same thing.