It’s one of the few financial sectors where performance is almost guaranteed. Since 1960, the average sales prices for homes in the US have gone up almost without fail, so you can rely on the fact that investment property values will continue to rise.
Even when the real estate market takes a hit, it bounces back with force. It’s not just a reliable market, but you get invested in a range of ways.
Types of Real Estate Investments
- Private ownership
- House flipping
- Leasing property
- Real estate investment trusts (REITs)
Let’s go over some of the ways you can invest your money in the stock market and what they mean for you and your portfolio.
One of the most well-known real estate investment types is buying a property outright. Private ownership is the most direct way to invest in real estate; it is the acquisition of property as an individual.
Private ownership comes with its own set of advantages and disadvantages.
The investor has complete control over the asset. This means that the methods used to generate income on the assets are entirely up to you.
However, there are some hurdles to private ownership.
For one, there’s a high capital threshold for this kind of investment—property is expensive. Given how expensive property is, most investors tend to opt for residential properties as they are the most attainable for individual investment.
The average price for a one-family home in the United States is 374,900.
Even with a down payment, the seed capital necessary for this type of real estate ownership can be substantial. But the returns can be significant using common strategies to optimize your investment.
House flipping is one method investors can get larger returns on their privately owned assets.
This strategy involves an investor acquiring a property, usually a residential property like a condo or a house. They make improvements to the property or hold it for a short period, then sell it to get a profit.
The objective in house flipping is simple: buy low, sell high.
Considering that housing prices continue to rise consistently, merely holding onto an asset could generate enough value through appreciation that the home will get the investor a profit.
However, many house flippers will seek homes that could use minor to moderate repairs. In making these repairs to the home, they are added more value that will help the home sell at an even higher price.
Pros and Cons of House Flipping
This type of real estate investment can be extremely lucrative.
The average return house flipping investors received in the third quarter of 2021 was around 30%—that’s a substantial profit.
When everything goes right, house flipping can be an effective way to make huge returns using real estate.
But, these high returns depend on everything going right—and there’s a lot that needs to go right with house flipping. The risks can be extremely high and costly.
Investors can be bogged down by repairs; the location could lag in appreciation; the market could change, and the investor could be stuck with the property.
House flipping requires serious amounts of work. From acquiring the property to making necessary repairs and then finding a buyer, the process can take a long time. And with such a high capital threshold, that’s a long time to wait before you see your return.
Another strategy involving private ownership is leasing your commercial properties and office buildings for rent.
The income earned in this case is rent paid by the tenant on the property. Renters enter into a contract with landlords, each party agreeing upon the amount of rent paid and the lessee’s and landlord’s responsibilities.
More often than not, most properties individual owners rent out are residential. Rented properties must abide by specific standards of livability. These standards can vary depending on the home state of the property and even the locality.
The property owner’s return amounts to the rent paid subtracted by ownership expenses: property tax, mortgage interest, repair costs, etc.
Pros and Cons of Leasing Property
Property rental can be a steady investment.
Generally, rental demand is high. People are always looking for places to live. Real estate prices rarely decrease over time, meaning that rent will usually go up over time and make for better returns.
The tax breaks given to rental property owners can offset ownership expenses, making this type of real estate investment all the more lucrative.
Property expenses like taxes, insurance, mortgage payments, and maintenance costs that keep the residence up to livability standards can all be deducted from the taxable income earned from a rental property.
Through a process called real estate depreciation, rental property owners have the opportunity to make tax deductions that incentivize landlords to increase supply to the rental market.
But like other strategies involving individual ownership, renting property is exceptionally time-consuming and comes with a range of financial risks.
Breaches of contract on the part of the landlord or the tenant can bring both parties to civil court. Legal expenses can add up quickly for landlords if they need to take tenants to court or vice versa.
Renting out a property requires certain legal know-how to draft a watertight contract in the first place.
Rental properties can be a great source of passive income, but they are a lot of work, with additional risks that can be costly.
Real Estate Investment Trusts (REITs)
Not all real estate investments involve outright property ownership from investors.
Real estate investment trusts, or REITs, offer investors a more accessible way to get into real estate. Where private ownership has high threshold costs necessary to get started, investors can buy shares of REITs with as little as $1000.
They are companies whose earnings are generated through financing or ownership of the income-producing real estate.
REITs, created in the 1960s, were designed to give everyday investors the chance to participate in the real estate market without the high entrance fees. These trusts operate like publicly-traded companies on the stock market. Investors can buy REIT’s publicly traded shares like any other stock or security.
They operate under strict standards to prevent fraudulent behavior that could manipulate the real estate market.
The IRS guidelines for REIT qualification are as follows:
- Must be a corporation, trust, or association.
- Must be managed by one or more trustees or directors.
- Must have beneficial ownership (a) evidenced by transferable shares or by transferable certificates of beneficial interest, and (b) held by 100 or more persons. (The REIT does not have to meet this requirement until its 2nd tax year.)
- It would otherwise be taxed as a domestic corporation.
- Must be neither a financial institution (referred to in section 582(c)(2)) nor a subchapter L insurance company.
- It cannot be closely held, as defined in section 856(h). (The REIT does not have to meet this requirement until its 2nd tax year.)
These standards prevent the REIT from being controlled by a small number of shareholders while also guaranteeing investors a fair return.
REITs have performed decently since their inception in the 1960s. Their average annual return for REITs is around 13.3%—occasionally more competitive than the S&P 500.
The Pros and Cons of REITs
REITs can give investors an accessible, low threshold opportunity to get into real estate.
Furthermore, REITs have high liquidity. It can take months to liquefy the capital tied up in property assets. Alternatively, REIT shares can be bought and sold with great ease.
Because REITs legally have to pay their shareholders 90% of their taxable income, dividend yields are consistently high for REITs. Returns have high potential as well, and together with the dividend yield, they can make them solid investments.
However, REITs are at risk from outside factors affecting their performance. They have a high degree of correlation to the stock market — for example, research indicates that REITs have a 70% correlation to the S&P 500.
When the market trends down, REITs tend to do so as well.
Real estate is generally insulated from outside market trends; REITs don’t have that same benefit.
Interest rates are another outside factor that negatively affects REITs. Because REITs must have a high degree of value determined by US Treasuries, increasing interest rates cause them to decrease in value.
REITs offer the benefit of giving investors an accessible option to get into real estate. For instance, it would be far more challenging to invest in commercial real estate without REITs.
But because they are so affected by outside factors, they don’t possess the same benefits that investors want from real investment: an asset that diversifies their portfolio, protecting it from external trends.
Private Equity Real Estate Funds
Striking a balance between private ownership and REITs, private equity real estate funds allow investors to enjoy the benefits of real estate investment without exorbitant costs.
These funds comprise a select number of accredited investors pooling their money to acquire high-value properties in competitive areas.
The private nature of the funds means that investors have actual equity in the real estate assets in the fund. This translates into higher returns, as the investors have more stake in the properties.
Managers of the funds acquire a wide range of assets: income-earning commercial real estate and residential properties that can generate income or be sold for profit.
On average, funds like these get their investors returns of around 14% or higher. Depending on the fund, returns can get even higher.
Pros and Cons of a Private Equity Real Estate Fund
Private equity real estate funds offer accredited investors the opportunity to access high-value properties, but without the diminished equity of a REIT.
Private equity funds are collectively private ownership opportunities led by professional managers.
They are less affected by external factors than REITs because they are private. This means that investors looking for real estate assets to diversify their portfolios can do so through participation in these funds.
Private equity funds are more illiquid than REITs. But considering that real estate investments produce better returns over longer periods, the illiquidity of private equity funds may, in fact, be a benefit. Investors are compelled to commit to their investment and get better returns.
Because they are so selective with their funding, most funds have a high threshold required to participate. If you’re interested in investing in a private equity fund, finding out if you qualify is as simple as contacting Christina.
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