Real Estate Investing: Get to know the 3rd-largest asset class in the U.S.

Real estate investing can be an alternative to stocks and bonds to help build a diversified and more resilient portfolio and can also provide cash flow.

Real estate can be a valuable part of a well-diversified portfolio. The typical investment portfolio of an individual investor may only include stocks and bonds and could benefit from the diversification that comes from adding in alternative investments such as real estate. Real estate investments are generally perceived as having a risk and return profile that falls between the risk and return profiles of stocks and bonds. Because tenants have to pay their rent every month for the duration of their lease, equity real estate investments have similar characteristics to a bond. And similar to stock prices, the overall strength of the economy can affect the value of real estate assets. The cost of entry can be high, but with the right strategy, real estate can provide investors with ongoing cash flow and help investors build a more resilient portfolio.

Learn more about diversifying your portfolio with real estate investments.

Key Benefits of Investing in Real Estate

  • It’s a hard asset.
    Real estate is a physical thing, unlike stocks and bonds. This adds stability—because it’s a tangible asset, it will always hold some value even in tougher market conditions, as opposed to some financial assets whose values can dwindle down to zero, or in some cases, negative value.

  • It’s less affected by inflation.
    Real estate values are generally tied to GDP—when the economy grows, demand for real estate tends to follow. This allows rents and sale prices to keep pace with inflation, maintaining the buying power of the invested capital.

  • Its value generally appreciates over time.
    Historically, the value of real estate in the U.S. has grown over time, meaning you can potentially earn returns by simply owning and maintaining a real estate asset for a long enough period of time before sale. Making improvements to a real estate asset can also increase appreciation.

  • It can generate income.
    Renting out real estate assets can provide predictable monthly cash flow if the total rental income is greater than the mortgage payments and operating expenses. Learn more about passive income.

  • It can build equity and wealth.
    If you finance the purchase of a real estate asset with debt, your equity should increase as you pay down the loan (assuming it’s an amortizing loan versus an interest-only loan) and the value of the asset appreciates. This means the share of the asset that you own outright grows over time. This increases your net worth and offers the opportunity to pull equity out (either through sale or refinancing) to leverage it into new investments, which can grow wealth.

How do you invest in real estate?

Most people’s experience with real estate begins with their own home, but this asset class covers much more than single-family residences. Real estate includes all land and any permanent features (called “improvements”) attached to it, including man-made structures or natural elements like water, minerals, or timber. With so much included under the umbrella of real estate assets, there are a number of ways for investors to dive in.

Real estate assets can be public, meaning anyone can purchase a stake, or private, when only a limited group can invest. Each has their own mechanisms for investing and offer different benefits and drawbacks.

Public Real Estate

Public real estate investment trusts (REITs) are publicly registered companies that own, develop, redevelop, and operate income-producing real estate for the benefit of their shareholders. REITs can be listed on a public stock exchange (Public Traded REITs) or not (Public Non-Traded REITs). Both are regulated by the Securities and Exchange Commission (SEC) and must distribute at least 90% of their taxable income to shareholders in the form of dividends, among other requirements. There are also Mortgage REITs that invest in interest-bearing mortgages, mortgage securities, or short-term loans secured by real estate, but we’ll focus on equity REITs in this section.

Anyone can purchase shares of a public REIT, so with the exception of individual homeownership, they are the most common form of real estate investing and can be useful for investors who want shorter investment hold periods or who have higher liquidity needs.

Pros:

  • Completely passive
    Every aspect of the asset is managed by professional managers and guided by boards of directors. Once you purchase shares, you can leave the investment to grow via dividends until you decide to sell.
  • Predictable returns
    The SEC requirements for dividend payouts make REITs a good option for investors looking for a steady income stream.
  • Greater liquidity
    Just like stocks, publicly traded REITs can be bought or sold at any time. Most Public Non-Traded REITs, however, have a required hold period of one to 10 years.
  • Access to superior properties
    Large, prominent properties, sometimes referred to as “trophy assets,” are typically owned by institutional owners like pension funds, private corporations, and REITs. These institutions tend to have longer investment hold periods and are less inclined to sell, so purchasing shares of REITs is the only way most individual investors can access these kinds of properties.
  • More accessible
    Access to public REITs is not restricted to accredited investors, who must have a net worth greater than $1MM (excluding primary residence) or annual income over $200K for the prior two years. The minimum investment amount to purchase shares of REITs is also much lower than investing in a single commercial property.

Cons:

  • No control
    As minority shareholders in a REIT, investors can’t choose what individual properties are included in the REIT, or what the managing company does with the assets.
  • Tax burden
    EIT dividends are taxed at the normal income tax rate, rather than the 15% qualified dividend rate. Also, unlike with direct property ownership, REITs typically can’t pass on tax losses or deductions from their taxable income, nor do REIT shares qualify for tax-deferral policies such as a 1031-exchange.
  • Higher fees
    Some REITs have higher management and transaction fees, which can cut into return on investment.
  • Modest income growth potential
    With the dividend distribution requirements, only 10% of the REIT’s profit is available to be reinvested back into the business, which implies slow income growth potential.

Private Real Estate

Private real estate is essentially any real estate asset not bought, sold, or traded on a public market. Generally private real estate gets split into residential and commercial, based on the asset’s intended use. 

Residential real estate is primarily used for housing. For many investors, investing in income-producing real estate often means buying and renting out single-family homes or small multi-unit properties (generally fewer than four units).

Pros:

  • Total control
    You get to decide exactly which properties to buy, what improvements to make, how to market the property, whom to rent to, and how much to charge in rent.
  • No splitting profits
    You are the sole beneficiary of both the monthly income and appreciation at sale.
  • Options to finance
    Whether through a traditional mortgage, private loan, home equity loan, or other financing methods, individual investors can finance the purchase of residential real estate investment properties with debt rather than tying up their own capital.

Cons: 

  • High effort
    The flipside to control is the hands-on nature of a residential investment. When the furnace breaks in the middle of the night, you’ll be the one answering the call.
  • Harder to diversify
    Unless you can afford to purchase multiple types of properties in many locations, you’ll be overexposed to the market factors that affect your asset.
  • Higher risk to cash flow
    With individual residential properties, your property is either leased out or it’s not. That means you can quickly go from positive cash flow to negative. Residential property leases are also often much shorter than commercial leases, which are often signed three to 10 years at a time.

Commercial real estate (CRE) is intended for commercial use, including office buildings, large multifamily properties, warehouses, hotels, retail stores, and more. Individual investors can access commercial real estate via private REITs, CRE funds, or direct investing in individual properties, which were once limited to only institutional or high-net-worth investors but are now available to individual investors through online real estate investing platforms like CrowdStreet.

Pros

  • Hands-off
    Individual investors aren’t responsible for the day-to-day management of commercial real estate assets—you get to leave the work to the professionals.
  • Ability to pick and choose
    Unlike public real estate options, private CRE investing allows you to hand-select the types of properties, locations, and business strategies you invest in.
  • Diversification
    By investing in a wide variety of private CRE opportunities, you can more easily diversify your portfolio away from the stock market, potentially providing some buffer against market volatility.

Cons

  • Illiquid investment
    CRE investments typically have a hold period of two to ten years, and typically individual investors can’t pull their money out before the developer or sponsor sells or refinances.
  • Lack of control
    Because the assets are controlled by the sponsor, you as an investor don’t get a say in the management of the properties you invest in.
  • High transaction costs
    Before buying or selling real estate there is an extensive evaluation process, called due diligence, that typically requires several third-party consultants such as appraisers, lawyers, environmental surveyors, and construction managers. This creates a higher transaction cost relative to trading other types of assets that do not require such a rigorous and expensive process.
  • High minimums
    Depending on the project, the investing minimum could be tens of thousands of dollars. It might not be much more than the down payment on a single-family residence, but it’s likely a lot more than buying a few stocks or bonds.

Learn more about the differences between commercial real estate, REITs, and residential real estate >>

How do you earn money from real estate investments?

Some real estate investments generate monthly or quarterly distributions, also known as cash flow, through rent payments or other income. If you own a residential property, your income is based on the rental rates you charge your tenants. If you own shares in REITs, your income is determined by the dividends distributed by the REIT.

For many commercial real estate investors, the big payday is when the investment is fully realized, meaning the property sold or refinanced.

Tax implications

Like most aspects of the U.S. tax code, the tax implications of real estate can be complicated. Each individual circumstance will be different, depending on the particulars of the investment.

With the exception of your primary residence, most of the profit you earn from selling real estate assets will be subject to capital gains tax. If you’ve owned the property for longer than a year, you’ll get the benefit of the friendlier long-term capital gains tax rates. However, if you owned the property for less than a year, the net profit will instead be taxed at your normal income rate.

Rental income and dividends will also be subject to taxes—likely as regular income, depending on your unique situation.

However, if you own a real estate asset directly, you’ll get the benefit of expense and depreciation deductions, which can offset some of your taxes owed. There are also pass-through deduction options that can allow you to deduct up to 20% of rental income as qualified business income on your personal taxes, if you own a rental property as a sole proprietorship, partnership, LLC, or S Corp.

Learn more about real estate investment taxes >>

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