Financial Planning Guides

Guide to Investing in Real Estate

Understanding Real Estate Investments

Understanding Real Estate Investments

Real estate has always been an attractive asset class. Some of the primary reasons investors are drawn to this asset class is due to the benefits it can provide such as diversification, income generation, inflation hedge, and low volatility. There are a myriad of ways to invest in real estate. Geier Asset Management provides specialized attention and support as you build out your investment portfolio and manage your assets. Here, you’ll find an array of resources, strategies, and tips for investing in real estate. If you have any questions about your investment portfolio or strategies, please reach out to our team.

Who should invest in real estate?

All investors should consider having real estate exposure in their portfolio. Its uncorrelated nature, the enhanced income produced, and the positive tax benefits available make this asset class enticing. It is important to select the type of real estate investment most suitable for you based on your financial landscape. Understanding your cash flow and liquidity needs, along with a thorough knowledge of the tax impacts of real estate, should be your first step.

Should your portfolio be more diverse than just real estate?

Yes, your portfolio should be more diverse than just real estate. Real estate should serve as a supplemental component in your investment portfolio. Its presence in conjunction with more traditional asset classes such as stocks and bonds will lower the overall volatility of the portfolio while yielding additional income.

Top 5 Reasons to Invest

Top Five Reasons to Invest in Real Estate

1. Uncorrelated Asset Class for the Portfolio

A key to minimizing volatility in a portfolio is to diversify your holdings. Diversification is achieved by investing in a variety of assets classes that are uncorrelated to one another, typically generating positive results in at least one of your positions regardless of market conditions. Stocks and bonds comprise the majority of your portfolio. An asset class that yields uncorrelated results to both stocks and bonds, thus adding diversification to your portfolio: real estate

2. Hedge Against Inflation

Inflation is a sustained increase in the general price level of goods and services in an economy over time. Subsequently, inflation causes your purchasing power to decline. Most people purchase their home with a fixed mortgage—their monthly payments remain level for the term of the loan, thus the price to maintain the property generally remains stagnant. However, in inflationary times, real estate tends to appreciate. If you purchase a house for $100,000 and over a ten year inflationary period it’s now worth $200,000, your investment has grown dramatically despite your “lack of purchasing power” over the investment time period. Owning a rental property in an inflationary time period is even more beneficial as an investor. An incremental increase in monthly rent with level monthly expenses leads to excess cash flow.

3. Tax Benefits

Owning real estate can assist in reducing your income tax liability. The mortgage interest and property taxes of your primary residence are tax-deductible. For example, suppose you are in the 33% federal and 7% MD tax brackets respectively and pay $15,000/year in mortgage interest and $5,000/year in property taxes. You are able to deduct $20,000 on your income tax return, thus saving yourself (by your tax liability) 40% of these housing expenses, or $8,000.

4. Fixed Cash Flow

In retirement, you will want an income stream to support your lifestyle. Whether it is a pension, social security, or investment income from your portfolio, having that structure is preferred. Interest rates are at generational lows; therefore, producing meaningful income from bonds is a tough task. Stocks do not provide the same level of income regularity and are more volatile and unpredictable than bonds. Therefore, rental real estate is a great source of fixed, retirement income that usually pays more than a bond. In addition, because of your ability to offset rental income with the depreciation deduction, most of your rental income is tax-free.

5. Leverage

As your real estate appreciates in value, so does your equity. With equity comes leverage. If your rental property is worth $300,000 and your mortgage is $200,000, your have $100,000 of equity in the home. You have the ability to use that equity to put a down payment on another rental unit, thus increasing your monthly income. Leveraging your real estate does add risk to your portfolio, but the enhanced yields are often justifying.

Investment Types

Breakdown of Real Estate Investments

Type of Investment Advantages Disadvantages
REITs • Liquidity – traded on stock exchange
• High yielding asset class for portfolio
• Own a collection of different real estate
• More correlated to stock market than direct investment
• Dividends are taxable
• Reduced management flexibility — required to pay out 90% of dividends vs. re-investing
Direct Investment • Control over physical property
• Uncorrelated to stock market
• Able to leverage equity
• Tax deductions available
• Increased capital requirements
• Illiquid investment
• Responsible for ongoing maintenance
Rental Real Estate • Control over physical property
• Uncorrelated to stock market
• Able to leverage equity
• Ability to generate monthly income
• Able to shelter rental income from current year taxes via depreciation
• Use of 1035 exchange to defer taxation after sale of property
• Increased maintenance costs
• Issues with poor tenants
• Illiquid investment
• Increased personal liability unless held in LLC
REIT Mutual Funds • Exposure to real estate without the capital
requirements
• Liquidity – daily pricing
• Active management by a team
• More correlated to stock market
• Higher management fee than ETF or
individual REIT
• Less tax-efficient
REIT ETFs • Exposure to real estate without the capital
requirements
• Liquidity – daily pricing
• Inexpensive exposure to real estate
• More correlated to stock market
• Less tax-efficient
Real Estate Private
Equity
• Interest in a variety of properties with less
capital requirement
• Professional management team overseeing
operation
• No physical involvement on your behalf, but
own actual property
• Higher risk to individual investor
• Management fee
• Even more illiquid than owning property
solely – locked into a term
• Less control

REITS

A Look at Real Estate Investment Trusts

Real estate is a crucial element in a well-diversified portfolio. This asset class’ uncorrelated nature, hedge against inflation, and income generation provide stability to the portfolio. The main hurdle to obtaining exposure to real estate in a portfolio is the hefty capital requirements. Therefore, real estate is absent in the portfolios of many smaller investors. However, real estate investment trusts (REIT) provide access to this asset class indirectly. REITs invest in different types of real estate such as office buildings, hotels, apartment buildings, and shopping malls. While you do not own the property directly, many of the positive impacts that real estate has on your portfolio are present through these instruments:

  • Lower volatility relative to stock market
  • Income generation to supplement bonds
  • Uncorrelated movements to traditional asset classes

Many investors often ask, “Should I buy a REIT or the property directly?” Each type of real estate investment has benefits to your portfolio. Your individual situation should dictate which to purchase, if not a combination of the two.

Investing in REITS

REITs are much more liquid—they are priced and traded daily on the stock exchange. You have the ability to use a small amount of available cash to purchase a few shares of a REIT, thus gaining real estate exposure with only a small commitment. In contrast, buying property directly will require a substantial capital investment up-front. Also, buying directly results in a long-term, illiquid component to your portfolio. If you decide that you are no longer interested in owning the property, you must list the property, find a qualified buyer, and go through the transfer process. If cash is needed immediately, liquidating your primary residence, a rental property, or a piece of land is not an option. Therefore, the two biggest benefits to investing in a REIT is the minimal capital requirement and the daily liquidity provided.

Buying Property as an Investment

Despite its illiquidity and the capital needed to purchase, buying property directly is an excellent investment for many investors. Owning a property outright is the ultimate uncorrelated asset class. REITs, while invested in real estate, are still traded in the stock market on a daily basis. Therefore, market bias’, fluctuations, and headline news tend to increase the volatility and correlation of this real estate investment to stocks, which offsets a primary benefit of investing in this asset class. In addition to the true uncorrelated nature of direct real estate, the tax benefits of owning property outright are superior to those of REITs. Deductions such as mortgage interest (limited to $1M of debt on your primary residence) and property tax are income tax deductible. High income earners who are taxed at approximately 40 – 45% (federal and state) welcome the ability to reduce their taxable income through real estate deductions.

Rental properties satisfy the generation of income for the investor, similar to a REIT. However, if you own the property outright, you have an additional tax-deduction available (in addition to interest & taxes)—depreciation. This depreciation deduction on rental properties often allows investors to completely offset their excess cash flow from rent, making their rental income tax-free in the current year (REIT income is taxable).

These are just a few of the pros and cons to each type of real estate investment. You should analyze your complete financial situation prior to investing in real estate to ensure the investment is most suitable to you.

Investment Strategies

Real Estate Investment Strategies

Focus on Your Specific Financial Situation

What is the purpose of real estate for you? How long is your time horizon? What is your current income tax situation? The various real estate options fit different investors for different reasons. Make sure you are aware of how each fits your unique situation.

Understand the Various Real Estate Investment Options

Each investment offers unique benefits and drawbacks. Make sure you are aware of the structures, the cost associated, and the tax implications of each.

Conduct Due Diligence on the Investment

If you are considering purchasing a property, understand the area, the market for rentals, and the appreciation capabilities. If you are purchasing a REIT, understand the strategy of trust, the properties it invests in, and the tax implications of the dividend payments.

Consult an Advisor for Guidance

Discussing real estate investments with your financial and tax advisors is beneficial, as they both understand your financial situation: How does real estate fit into your asset allocation? What are the tax implications specific to YOU of investing in a property directly vs. buying a REIT or mutual fund? They will be able to guide you in the right direction.

Risk & Reward

Limiting Your Risk & Maximizing Your Reward

Investing in real estate requires more knowledge, understanding, and patience than traditional asset classes. However, if handled properly, real estate can provide phenomenal opportunities for investors. The potential for capital appreciation, along with enhanced yields (rental or dividend income) make real estate an intriguing opportunity. Consult your investment advisor to gain a complete understanding of how real estate fits in your portfolio.

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