You hear it over and over- ‘the quickest way to wealth is real estate.’ Self made millionaires often attribute their wealth to real estate, and retirees count on income from real estate to supplement other income sources. But how do you invest in real estate?
Traditional Real Estate Has Potential for Great Returns
A common and relatively easy way to invest in real estate is by buying a second (and third and fourth) house and renting it out. There are certainly compelling reasons to invest in rental properties. Not only does the value of the real estate increase over time, it also supplies a healthy (mostly) steady income in the mean time.
Traditional real estate also allows you to easily add leverage to your investment by taking out a mortgage. The mortgage allows you to invest in a property with a fraction of the upfront cost. Of course, your mortgage comes with a monthly payment, but in theory, the revenue from your rental property will more than cover the interest on that mortgage, and ideally will cover the entire monthly payment.
The Downsides of Traditional Real Estate
All is not roses, however, and being a landlord is not as easy as some people make it sound. For every rental property you invest in, you also acquire all the property headaches. If you are already a homeowner, think about all the little maintenance projects you do around the house. As soon as you become a landlord, these projects and headaches double.
Adding to the maintenance responsibility, you’ll have tenants to deal with. On paper, tenants are a steady source of income. In real life, tenants are people. And people are unpredictable. The majority of tenants are great people (I assume). They’ll take care of your property, or at least won’t utterly destroy it. They’ll pay their rent on time. For the most part, they won’t call you at 2 AM with maintenance ’emergencies’.
Unfortunately, not all tenants will fall in this category. You’ll have the ones that do far more damage to the property than the deposit could ever cover. There will be some who are chronically late on rent, or simply don’t pay at all. And you’ll have times when tenants are non-existent. You’ll have periods where your property sits empty, collecting no income while still producing expenses. If you leveraged your investment with a mortgage, these ‘rent-free’ periods will be even worse, since you’ll be stuck making mortgage payments out-of-pocket.
Outsourcing Responsibilities is a Mixed Bag
As a landlord, you can decide how much or how little you want to do. For a cost, there are always people willing to do what you don’t want to do. You may just have a go-to handyman for some of the maintenance jobs you don’t want to do, or you may go all out and hire a property manager to take care of it all. Of course, the biggest downside of outsourcing your duties is the cost, which will significantly cut into your return on investment. Furthermore, regardless of how much you outsource, you won’t eliminate the risk of going tenant-less. This is simply the risk that accompanies the larger potential returns.
Real Estate Investment Trusts Offer Hands-Off Investing
Real Estate Investment Trusts (REITs) are perhaps the ultimate hands-off real estate investment. An REIT typically trades much like company stock on stock exchanges. You can buy as many or as few shares in the same way you’d buy Apple or Walmart stock. Instead of functioning as a regular company, however, the REIT simply purchases properties with invested money, rents them out, and pays the profits back to investors in dividends. By law, REITs must pay 90% of their earnings back to investors.
Picking an REIT
REITs come in all sorts of varieties and categories. There are actually two categories of REITs- mortgage REITs, which buy mortgages, and equity REITs, which invest in actual properties. Since mortgage REITs don’t actually invest in real estate, we’re just interested with equity REITs for now.
Picking an REIT isn’t as simple as choosing between the mortgage and equity variety, however. Some buy properties nationwide, some are regionally focused. Often REITs focus on certain sectors, such as health care, office space, residential properties, or retail properties, while some maintain a mix. Some specialize in buying bargain properties, others focus on luxury. You can even invest in REITs that strictly own storage units.
Because of the variety, REITs offer a large range of returns and volatility. For example, I currently own shares of an REIT that only owns apartment complexes in the Midwest. Very boring with healthy quarterly dividends, but little chance that the property values will skyrocket anytime soon. An REIT that invests in shopping malls or casinos, on the other hand, can yield stellar returns when the economy is strong, but then stagnate during a recession.
REITs Offer Diversification
Much like a mutual fund spreads your risk across a large basket of stocks, REITs spread your risk across multiple properties and renters. If your real estate investment consists of a single home, and you can’t find a renter for that home for a year, your return on your investment for that year can go deep into the negative. It is highly unlikely that an REIT is not able to find any renters for any of their units, although as mentioned earlier, a weak economy can wreak havoc on a weaker REIT. For ultimate diversification, you can invest in an REIT mutual fund, spreading your risk across several REITs.
The REIT Trade-off
REITs make real estate investing easy. Once you find an REIT that fits your investment goals, investing takes no more than a click or two. You don’t need to constantly watch the market. You skip the entire buying process. Maintenance is completely managed by the trust. You don’t have to worry about collecting rent and taking care of bad tenants. Literally all the hassles of traditional real estate ownership are handled by someone else.
Shedding all these hassles is not without cost, however. Just as when you outsource responsibilities as a traditional landlord, investing via an REIT means that some revenue is lost to operating expenses. This, of course, cuts into your final return on investment. Having said that, the returns on REITs are still significant. REITs typically carry between 2% and 10% dividend yields while also giving you exposure to capital appreciation (rising property value). You can generally expect long-term returns similar to the stock market.
Investing in an REIT also means that you give up control. Even when you outsource your responsibilities as a traditional landlord, you still maintain final say over any decisions. You still can pick which properties you want to buy or sell. You can decide what maintenance or improvements are worth paying for. If you employ a property manager, and you don’t like something he’s doing, you can instruct him to do it differently. With an REIT, you put your trust in the company’s management. The only control you have is in company board elections. Since you are only one of very many investors, even this control is insignificant.
Which is Best?
There’s no single best way to invest in real estate. Deciding how you want to invest comes down to the amount of time you have and how much responsibility and control you want. In general, traditional real estate investing has the biggest potential for higher returns, but also costs you the most in time and hassle. Although I’ve personally thought about investing in traditional real estate, I’ve realized that I neither have the time or desire to be a landlord. Instead, I’ve opted for the professional management and convenience that REITs offer in return for their lower yields. However, many people who have ventured into traditional real estate don’t mind the extra work and really appreciate the extra income. It all depends on who you are and what your investment goals are.
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- While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.