Incorporating Investment Real Estate Into Your Investment Strategy
When one thinks of real estate, the first thing they think of is usually their personal residence. While this is technically real estate ownership, one’s personal residence is not an investment. It is a “use” asset. It is where you live, and everyone has to live somewhere.
Investment real estate can take many forms, but is the act of buying a piece of property with the express goal of profiting from the ownership.
Common real estate investments types include:
- Rental - Buying a single family house and renting it out.
- Flipping - Buying a “fixer upper”, fixing the issues and then selling it.
- Development - Buying a vacant lot, building a house on the property and then selling the house.
- Commercial Leasing - Buying shopping centers, office/medical buildings, industrial buildings and storage lots and renting them to businesses.
- Multi-family - Buying an apartment building or complex and renting to individuals and families.
Anyone who buys an investment hopes to profit from that ownership. Profiting through an increase in value or “capital gain” is something real estate investment has in common with most other types of investments. We would say that there are three main reasons one might choose to invest in real estate:
- It’s tangible - You can touch it and it exists outside of a computer hard drive (unlike shares of stock or bonds).
- Rent/Lease Income - Tenants have to pay the owner this in order to live there or run their business. It’s a higher order expense than interest from a bond and it’s subject to a legal agreement regarding payment unlike stock dividends.
- Depreciation - The loss in value (on paper) that the owner gets to deduct each year against any income they receive like an expense. But it’s not an expense. The result is deferred income tax until the property is sold.
The real estate investment universe is large and varied. And, like other types of assets, there are ways to invest directly in real estate and there are ways to invest indirectly.
Direct Real Estate Investment
We define direct real estate investment as direct ownership of the asset.
- Most real estate is owned by a company created to purchase the property. The purpose is to protect the investor owners from personal liability.
- The property (or the company) can be owned by an individual or multiple people.
- The property can be managed by the owners or a separate property manager.
- Larger investors might also hire a company to manage the business as well.
Indirect Real Estate Investment
If one doesn’t have the time, experience, money or even the inclination to own real estate directly, the good news is that there are other options. In these cases, investment companies have done all the heavy lifting:
- They choose what properties to purchase and when to sell.
- They take out the mortgages/loans.
- They hire property managers to maintain the property and find tenants.
- They hire the accountants to do the book keeping and file tax returns.
- They hire attorneys to draw up contracts, lease agreements and deal with non-paying tenants.
When investment companies solicit investors and pool the money together to purchase property, they are considered securities and there are rules that must be followed. There are several different types of securities used for real estate investments and each have their own characteristics.
- Mutual Funds and Exchange Traded Funds (ETFs) - These are the simplest form of real estate investments. The investor buys shares in the fund. The fund hires a manager to buy shares in companies that own real estate. The manager takes a fee from the fund for their services. The investor can buy and sell shares very easily on a daily basis.
- REITs - Publicly Traded - Public Real Estate Investment Trusts (REITs) are pooled investment vehicles that can be bought and sold on public stock exchanges. REITs have special tax rules that require the trust to pass through 85% of the income they receive to the owners. Otherwise, they are similar to other investment securities.
- REITs - Private - These REITs are ones that have not registered to be bought and sold on stock exchanges. Investors have to buy shares directly from the investment company, and if they want to sell their interest, it can be very difficult to find someone to sell them to. In return for this lack of liquidity, investors expect a greater return.
- Limited Partnerships and Pooled Investments - These securities are the closest to direct real estate ownership. The managing partner collects money from investors and then purchases a property on their behalf. Selling an ownership interest is very difficult. The benefit is that investors can more fully participate in the investments. They receive K-1s at the end of the year for their share of the rental income, expenses and depreciation that they can declare on their personal tax returns.
We believe all investors should consider owning some real estate in their portfolios. It’s diversified from stocks and bonds and can offer a steady source of income.