For many of us, the real estate market crash of 2008 is still quite fresh. How do we avoid getting burned when the next crash inevitability happens again?
With property values and rents going up significantly again in recent years, and in some cases, already topping previous 2006 peak levels, it’s more important than ever to make sure you have a solid grasp what you’re doing before diving into the world of real estate investing.
But first, why even invest in real estate?
Why do so many people invest in real estate? More importantly, why should YOU invest in real estate?
I’m sure you’ve heard experts talking about how stocks have outperformed real estate over the long term.
Taking stock market data from 1950 to 2009, the return the overall stock market by looking at the S&P500 (the Standard & Poor’s 500 stocks that as a basket of stocks is taken to be a good gauge of the overall stock market), and when factoring the dividends issued and adjusting for inflation, we get almost exactly 7% a year in returns over that period.
If you can average 7% returns consistently, that is excellent investment returns! That means nearly doubling your investment every ten years. Over a 40-year investment horizon, you’d get approximately 15X your initial investment back–turning $100K into $1.5 million!
But know that in any shorter time frame, the returns in any given year is often higher or lower. However, over a very long-time investment horizon, assuming 7% is a reasonable expectation for the stock market.
So what about real estate? Factoring in inflation, the real growth in real estate property values from 1970 to peak in 2006, even before factoring in the crash, is less than 2% a year! And that is excluding the crash of 2008!
Comparing apples & oranges
Well, there’s a BIG problem with that comparison. That comparison, as is often done when people compare stock market returns to real estate returns, ignores some crucial factors.
Those real estate returns assume you’d just buy a residential home and sit on it and hope to profit from it based solely on appreciation when you do sell it. What is left out? It ignores rental income and the impact of leverage.
When done right, real estate investors can often get 10%+ returns. And if they track the market cycles as well as utilize smart strategies to buy higher quality investment properties, investors could do even better.
Even in a real estate market that has recovered and are getting quite expensive in some markets, we can still find 7%+ returns from rental opportunities across the country. And that is all before leverage. Add in the right kind of debt financing and double-digit investment returns become achievable.
Are these returns achievable in with stocks? Yes, but it is much harder to do for most investors. Even professional hedge fund managers can’t beat the market!
Advantages of investing in real estate
The potential for attractive investment returns is just one of many advantages to real estate.
Other primary benefits include:
- Diversification – investing in real estate, whether directly or indirectly, allows investors to diversify their investment portfolios, especially given that real estate has historically experienced low correlation to stocks and bonds.
- Cash flow – through rental income properties, an investor can build a source of reliable passive rental income. With a large enough portfolio, investors could supplement or even replace their primary source of income.
- Building equity – whether through the potential of property appreciation or through the principal paydown on the mortgage with rents collected from tenants, investors can build equity towards their net worth through real estate.
- Inflation hedge – as the prices of goods and services increase over time due to inflation, rents from income properties tend to increase as well. And as rents go up, so too does the value of the property.
- Tax advantages – owning investment real estate could provide multiple tax benefits from special tax exceptions and 1031 exchanges to tax write-offs on depreciation, insurance, taxes, and many operating expenses.
- Leverage – through financing, investors could potentially increase their investment returns.
- Agency – real estate gives investors the option to be actively involved in the investments, giving them the potential influence the investment performance of their investments because the underlying asset can be improved to add more value.
Disadvantages of investing in real estate
But before you plow your life savings into real estate, there are some disadvantages to consider.
- Lower liquidity – compared to stocks and bonds, directly owning real estate can tie up capital and make it more difficult to convert into cash equivalents.
- Higher transaction costs – compared to buying and selling stocks, transaction costs for buying and selling real estate is much higher.
- Requires ongoing management – properties wear and tear, requiring regular repairs and maintenance.
- Taxes and insurance – depending on the asset and the market, property taxes and insurance can be a significant cost.
- Susceptible to outside forces – the performance of a property can be impacted by forces outside the control of the investor, such as changing market cycles, new competition in the market, etc…
Real estate is just ONE of many investment assets you have the opportunity to utilize. It has its own advantages and disadvantages, but when utilized responsibly, it can help you build wealth and passive income in addition to diversifying your overall investment portfolio.
Why do you invest in real estate?