With more and more people than ever taking an interest in investment opportunities, there’s never been a better time to learn about how you can grow your money in the market.
But which one?
There are so many ways to invest that it can be challenging to know where to start. But the more you know about your options, the better equipped you are to make the right decision that fits your financial needs.
So many new investors are going to the stock market to grow their wealth while neglecting the potential of real estate investments because it seems inaccessible.
There are more options in real estate than you think.
Let’s look into the differences between real estate investment and mutual funds and how they intersect so you can get the best of both worlds.
What Are Mutual Funds?
Mutual funds allow investors to pool together their money into profit-earning assets.
Most mutual funds use their pooled resources to invest in securities–stocks and bonds are the most common resources traded by mutual funds.
Directing the decisions behind these funds are its money managers. These professional financial agents use the pooled money in the fund to earn their investors money in numerous ways.
In short, the better the fund does, the more money the investors make.
Because there is a larger pool of money, the potential of capital gains made on the assets traded in the fund exceeds what an individual investor could do with the same amount of money.
The appeal of mutual funds lies in the fact that investors gain access to portfolios run by financial experts at an affordable price. By pooling together resources, the fund becomes sturdier—able to endure losses and increase earnings for investors.
How Do Mutual Funds Work?
Before you invest your money in a mutual fund, it’s worthwhile to understand how they function.
Mutual funds are like companies whose business is an investment.
When you acquire a given company’s stock, you become a shareholder of that company. If you buy a share of Ford Motor Company, for example, your investment increases or decreases based on the company’s value.
When Ford sells more automobiles, the company’s value increases. When Ford’s value increases, your share prices increase, earning you more money.
Mutual fund investments operate in the same way.
In the same way, you buy a share of Ford; you buy shares of the fund when you invest. The performance of funds assets determines the value of your return. Instead of gaining a profit off automobile sales, a mutual fund earns money from the performance of the securities in its portfolio.
How the fund pays you out can vary.
How Do You Earn Money From A Mutual Fund?
As a shareholder in a mutual fund, there are three ways you can get a return on your investment.
Firstly, there are dividends.
The fund will pay you a dividend based on the value increase of the securities in the portfolio. Dividends are payments determined by the company’s annual performance. A company will give its shareholders dividends when its company is performing well through cash or additional stock.
When funds liquidate securities for a profit, those profits are often passed on to shareholders. Like dividends, these profits will be distributed to shareholders.
Lastly, the price increase of a well-performing fund can be a profitable opportunity for investors. Like when the value of a stock goes up, selling that stock generates a profit for the investor. The same goes for mutual funds. When the fund’s price rises, investors can sell their shares for a profit increase.
So, what about real estate?
What is Real Estate Investment?
There’s more to real estate investment than one might think. There’s a whole world of investment opportunities in the real estate market, some not all different from how mutual funds work. But more on that later. Let’s get into a few types of real estate so you can see the differences and similarities yourself.
What Is Property Ownership?
This is the type of real estate investment most people are familiar with: the real estate investor’s direct ownership of real estate property.
Investors will acquire a property, usually a residential property, and utilize the property as an investment asset.
Methods of Owning Property
There are a few ways property owners can use real estate assets.
House Flipping
Many residential property owners will flip houses for a profit.
The investor acquires a home or residential property at a low value, then makes repairs that add value to it. It helps that home values are appreciating at a rapid rate. Some house flippers could merely hold on to the property for even a short amount of time to increase its value to a sufficient level.
When the property has risen to a sufficient value, the investor will sell for a profit, earning them a return on their initial investment.
Rental Properties
Another way property owners can earn income on their real estate assets is by renting their property.
The investor will acquire a property, list that property for rent, then enter into a contractual agreement with the tenant about how much rent is to be paid each month for the space. Property rentals come with all sorts of tax breaks that can make them more lucrative for the investor.
In the end, the return on the asset is determined by subtracting the property tax from the rental money paid by the tenant, mortgage interest, and other fees that come with ownership—that’s where the tax deductions come in handy.
Differences Between Real Estate Investment and Mutual Funds
- Accessibility
- Liquidity
- Correlation
Property ownership and mutual funds give investors completely different options for investing their money.
Let’s break down a few key differences between these two options so you can better understand which one fits your needs.
Accessibility
Having access to these kinds of investments is a huge difference between property ownership and mutual funds.
Mutual funds are highly accessible; the only costs to investors are the annual fees on the investor’s money. Most funds will charge investors a fee somewhere between .5% to 2.5% of the asset value.
Other than that, mutual funds rarely have an upfront cost. Investors can participate with modest amounts of capital.
Property ownership has very high upfront costs, making them less accessible to the average investor.
The average price of a home in the United States is $374,900. Even if the investors want to put 10% down on the property, that’s still $30,000 required just to get started—a steep entrance fee to real estate investment.
Furthermore, property ownership requires a lot of work. If the investor is going it alone, they are the one doing the due diligence in assessing the property’s needs, arranging and paying for repairs, and finding prospective buyers or tenants.
Between the steep costs and the work involved, property ownership is far more inaccessible to the average investor than mutual funds.
Liquidity
Liquidity describes the ease with which an asset’s value can be liquidated into pure capital. The easier it is to liquidate an asset, the more liquid it is; the harder it is, the more illiquid.
Property ownership and mutual funds stand at opposite ends of the liquidity spectrum.
Mutual funds, like shares on the stock market, have a high level of liquidity. Depending on your broker, you can sell your shares in the fund and receive that capital within mere days, sometimes hours.
Property investment is far more illiquid.
For one, finding a buyer for the property can be a long, drawn-out process. It’s a seller’s market now, with some listings going within mere weeks in the more competitive markets. But in general, finding the right buyer and the best price for your property can take quite a while, even under ideal conditions.
What’s more, after closing on the property—another drawn-out process—the seller may have to wait over a month before they see that money.
Liquidity is often seen as an advantage for investors. However, the illiquidity inherent in the real estate market can make it a more stable financial environment. When investors can pull out their money at the drop of a hat, the market can turn on a dime. That kind of seismic change is a rarity in real estate.
Correlation
Correlation is a metric that describes how the performance of one asset affects the performance of another.
A positive correlation between assets means that when one asset moves up or down, the other moves in the same way. A negative correlation between assets means that when one asset goes up, the other goes down.
High correlation means two assets are correlated to either extreme, negative, or positive, with the highest scores possible at +1 or -1. The low correlation is closer to zero.
Correlation can be an advantage or a disadvantage depending on how you’re investing. Investors can make decisions based on market performance to make gains on assets that respond accordingly based on their relative correlation.
However, that style of trading is more short-term and can be riskier.
For long-term investments, assets with low or neutral correlation levels are ideal because fewer external factors determine their performance.
Mutual funds tend to have high degrees of correlation. Stocks and bonds correlate with other market trends.
Alternatively, real estate investment tends to have a low correlation to other market factors, making it a solid, long-term investment that consistently remains stable.
Private Equity Funds: The Best of Both Worlds
There are advantages to real estate investments and mutual funds, but there are investment options that merge the best that both of these investments have to offer.
Private equity real estate funds allow investors to pool their resources in a similar way they would in a mutual fund only for high-value real estate investments.
Investors gain access to properties that would be virtually impossible to do independently. Funds like these don’t just invest in hyper-prime residential properties but commercial and even industrial properties.
Because they aren’t publicly traded, investors have more stake in the fund. Furthermore, these funds have a lower correlation to other markets due to their real estate assets and their distance from the stock exchange.
Private equity real estate funds are the best possible option for investors who want the benefits of real estate investment without the burdens of property management.
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Sources:
Average House Price By State in 2021 | Motley Fool