Today we have a guest post from Chris Weber of Utopia Management.
According to the United States Census Bureau, nearly two-thirds of American households have investment portfolios with a blend of stocks and real estate. The Bureau of Labor Statistics says more than 55 percent of American workers participate in some form of a retirement plan, which means they have at least some exposure to the stock market.
Adding real estate to your investment portfolio seems to most like a fiscally sound strategy, but how does it compare to traditional stocks? Utopia Management, an established property management company with a presence in over 30 cities on the West Coast, share their perspectives today regarding real estate as an investment.
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Benefits of Investing in Real Estate
Real estate investments can be separated into two broad categories: Commercial and Residential. To define the benefits of investing in real estate, let’s focus on the benefits of investing in residential real estate.
Many lenders finance real estate investment deals by requesting a down payment of between 20 percent and 25 percent. However, purchasing a primary residence home can significantly lower a down payment; a great example would be the FHA loan, where you can typically provide a down payment worth as little as 3% of the property cost.
Now, let’s assume you secured a residential investment property (not a primary residence) worth $300,000 by putting 20 percent down ($60,000). Your lender would approve a loan for the other $240,000, on which they will earn interest (typically 2-4%). If the value of the property increases by $9000 (3%) three percent, it takes to form of equity that belongs to you. If you were to then sell the property for $309,000, you would have netted a 15% return on the $60,000 that you originally put down with your own money.
Another way that investing in residential real estate can deliver healthy returns is via rent as a form of passive income. This can, of course, apply to both residential and commercial real estate. It’s essential to account for property management expenses (as well as monthly payments for any outstanding debt) to calculate the actual profit earned, but these gains would, in ideal cases, compound on top of the increasing value of property.
These aspects of a successful real estate investment are some of the basic reasons that so many smart investors have successfully invested in real estate.
Easy to Understand
You can spend hours re-watching a webinar that discusses how to invest in the stock market and still walk away not knowing what you are about to do. Although buying a parcel of real estate can be complex, the fundamentals of the process are relatively straightforward to understand. You purchase the rental property, maintain units that you rent, and then eventually you’re able sell the property at a higher price than what you paid for it. Of course, as with any investment, there are risks associated with such prospects, but the general idea is that property values increase over time in areas that attract buyers.
Investing in a tangible asset like real estate gives you more control over your investment as well.
Hedge Against Inflation
If you have listened to any of the stock market gurus on CNBC lately, you probably have heard multiple warnings about the likelihood of a dramatic uptick in the rate of inflation. Inflation is a killer for intangible assets such as stocks and bonds. However, real estate investments are highly effective as hedges against volatility, both since housing is a necessity, and property is not as easily traded as stocks. Generally speaking, the value of real estate increases with inflation–and then some.
(Editors note: Stocks and bonds are actually good hedges against inflation, but an increase in inflation can cause an immediate dip, so you need to hold onto them for them to be effective. When inflation picks up, the price of both stocks and bonds will fall because investors will require a larger gain for the risk they are taking. For example, if they were expecting a 10% return without inflation, they would now require a 20% return if inflation rises to 10%. With the stock they further discount the price so that when a profit is realized the change in price will be larger to overcome inflation. With a bond the price falls to increase the effective yield to take inflation into account. If you continue to hold, however, stock prices will climb as the value of the company will remain the same, so it will take more deflated dollars to buy each share. If you hold a bond long enough, it will eventually repay the original loan. After that, new bonds will pay a higher interest rate to account for inflation. – SmallIvy)
Property owners might qualify for a mortgage interest tax deduction on the first $1 million of debt owed. The federal tax code also permits the avoidance of the capital gains tax for the first $250,000 made on the selling of a primary residence. If you buy and sell commercial real estate, you might be able to avoid the capital gains tax through a 1031 exchange. To take advantage of a 1031 exchange, you have to reinvest your profits in a similar commercial property. Real estate investments also benefit from the tax break called depreciation, which involves writing down the expenses of wear and tear to a property.
Not everything is all roses with real estate investments. Although investing in real estate is generally straightforward to understand, and you have more control over the tangible asset, you must account for the hard work it takes to maintain the property. Even hiring a credible property management firm comes with its own drawbacks in the form of fees. This is especially pertinent if you want to invest in one or more rental properties. There are also relevant transaction costs, which can run between six percent and 10 percent of the sale price of a property.
These two factors, while not being ideal, do not affect the immense potential associated with investing in real estate. However, it is necessary to carefully consider all variables that come into play, especially as you tally up the amount of work needed in order to acquire, maintain, and sell property.
Core Benefits of Real Estate compared to Wall Street
Stocks bring two positives to the table: They are easy to liquidate and there are few, if any transaction fees. Nonetheless, you have to consider the cons of investing in stocks before leaping into the stock market.
Stock prices move up and down at a much faster rate than the prices of real estate. The bell can ring in the morning on Wall Street with your portfolio looking stellar, only to hear the final bell ring in a dramatic loss for the day. The factors that caused the high volatility are not always easy to understand. Why real estate prices move is much easier to explain.
(Editor’s note: Actually, the issue is that stock prices are constantly presented, where real estate prices are only known when buying or selling the home. Because that usually only happens after a period of five years or more, after inflation and growth in the local economy has occurred, real estate prices appear to mostly only go up. If real estate were constantly priced like stocks, you’d see fluctuations in their prices too as different, short-term factors influence their price. You can see a bit of this by looking at the the price estimates on Zillow. – SmallIvy)
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The Stock Market Roller Coaster
Like the most thrilling roller coaster rides at your favorite amusement park, actively investing in stocks (be it day-trading, swing trading, etc.) is not for the faint of heart. Of course, short-term investing and speculation are only some of the ways investors leverage the stock market for gains, but even the most diversified, conservative investors can be in for a very rude awakening during a market correction, dip, recession, or depression. Investing in the stock market is very much like a roller coaster, as investors have virtually no control over stock prices. All one can do is take a calculated risk and hope for the best, while making decisions about the level of activity they want to bring into their investment strategy. Real estate is much more forgiving, in terms of the tangible control someone has of their assets, though debt can be a formidable burden to bear. The plus side for real estate, however, is that its debt is associated with much lower risk. After all, there are significant risks to purchasing stocks on margin, especially in volatile markets where a bearish lender might make important decisions for you.
Making Emotionally Motivated Decisions
One of the most difficult factors to understand when investing in the stock market has to do with human emotion. Many who are not familiar with investing see the practice as trivial and binary. After all, the stock either goes up or down, right? However, they might soon discover that the financial world is full of opinions, trends, and influences. In the blink of an eye, you might succumb to emotional pressures, turn away from any pre-existing strategy you set out to implement, and put all your hard-earned cash in jeopardy. It is generally accepted that a long-term, buy and hold strategy historically provides better returns than attempts at timing the market. Making an emotionally motivated decision when investing in stocks is a reliable way to miss out on gains and lose your initial investment.
Regardless of the direction you decide to take as you tackle investing, the value of real estate is universally recognized. While it may not be right for everyone at certain times in their lives, the ownership of property is something that any savvy investor could benefit from. This is true even if it comes down to having a mortgage on a house. While debt can be a massive source of stress, it can also be managed. In the best of cases, debt can even be leveraged to realize substantial gains and create wealth.
Disclaimer: This article is not investment advice and Utopia Management is not associated with any investment organizations or financial advisors. The views expressed herein are intended for educational and expositional purposes only and should not be considered as authoritative perspectives on any form of investment. All readers are responsible for consulting with an accredited financial advisor, attorney, and/or accountant prior to making the right investment decision for their needs.
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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.