Should You Add Real Estate to your Portfolio?


Many individuals invest in real estate, even if just buying a home.  As
the old saying goes, your home is “the biggest investment you’ll
ever make.”  Hopefully this will not be the case, but for many
people their home is the only asset they have as they near
retirement.  In the past the standard practice when retiring was to
sell the big family house and move into an inexpensive condo, using
the proceeds from the house to pay for expenses.  Unfortunately, in
the current culture of no-money-down loans and home equity lines of
credit, more and more people are never building up equity in their
homes.

Real estate investing is a bit different from simply buying a home.
Income from real estate investing typically takes the form of either
rental income or capital appreciation.  In either case a great deal
of knowledge is needed about the real estate markets and home values
in the area.  To quote another old saying, “All real estate is
local.”

Looking at the risks and returns of real estate investing, investing in
paid-for real estate, where there is no mortgage, is less risky than
individual stock investing and more risky than buying income
securities.  The return will also lag behind individual stock
investing and the hassle factor is much larger.  Real estate markets,
however, tend to be less transparent than stock markets.  This means
that it is possible to find people selling real estate at well below
what others are willing to pay, so an individual who is able to
correctly price real estate and thereby know the difference between a
great deal and a fair deal, can do very well.

As many have discovered recently buying real estate with a mortgage can
be very risky.  For years it was generally accepted that the price of
houses always went up.  Taking out a mortgage was therefore seen as
safe as long as nothing happened to one’s income stream such that she
could no longer afford the mortgage.

Buying real estate with a mortgage, however, involves a substantial amount
of what is known as “leverage.”  This is the use of a little bit
of money to control something much more valuable.  When the value of
the thing increases, one is able to make huge profits due to the
large value of the thing being controlled.  For example, if one buys
a $500,000 house for cash and the value of the property increases by
$5000, or 1%, one only makes 1%.  If one puts $500 down on a $500,000
house, however, and the value of the home increases by $5,000, one
will have made a 1000% profit.

During boom times, this meant that an individual could make huge profits by
buying and selling houses, and there were many individuals who used
the available no-money-down loans to speculate, buying several homes
at a time with interest only loans.  The trouble is that leverage
cuts both ways.  If that $500,000 home goes down just 10% in price,
suddenly one has lost $50,000 on what seemed to be a $500 investment.
Couple this with a loan that one could barely afford in the first
place for which the payments increase after an initial introductory
period, and you have the housing crisis in which we currently reside.

For the small investor, buying real estate with mortgages, other than
one’s home, is far too risky.  Adding some real estate to a portfolio
once it is large enough to pay cash for properties (say a $500,000 portfolio) can be very useful.
The advantages are that they provide a steady source of income
through rents, and the appreciation should at least keep pace with
inflation.  Again, if one buys in the right markets or finds
properties that are selling at a bargain, one can even beat
inflation.

The second advantage is that real estate does not tend to be correlated
with the movements of other investments (2008 excepted).  This means
that the price and rental income received from the properties usually
moves independently of the prices and returns of other assets.  This
adds protection to a portfolio since when your stocks are down your
real estate may be up or vice-versa.

As with buying individual stocks, one will tend to do better buying
individual properties, particularly if one has the knowledge to
select the good properties.  This requires a substantial amount of
time and energy, however, since the properties must be found and all
of the activities required when buying or selling a house must be
performed (including paying all of those various people who have
their hands out when a house changes hands).  In addition, if renting
one must deal with tenants who may decide to not pay the rent, trash
the place, or simply call at 3 AM about the hot water heater.

For those not wanting to deal with individual properties, Real Estate
Investment Trusts, or (REITs), may be the solution.  These are
similar to mutual funds, in that the funds of individuals are pooled
together to purchase a set of properties.  The holders of the REITs
then receive a share of the rent and appreciation income.  Like a
mutual fund, the price of the REIT will increase or decrease
depending on the return, value of the properties held, and other
factors.  The main disadvantage is that the fees paid to the
administrators of the REIT will eat into profits.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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