I am often asked the question, “Is real estate a wise investment?”
My answer to this question is yes, I believe in investing in real estate (RE) as an asset class for the long term. But no, I am not a fan of investing in individual real estate properties as an investment.
I want to clarify; I am talking about buying real estate as an investment outside of or in addition to your home residence.
I know there are many people who may disagree with the opinions expressed here. Yes, there are exceptions to the general rule and if you know what you are doing, are an expert at speculative RE and fixing up homes and comfortable with the inherent risk of owning property you can be successful at using RE to increase your wealth. But I would say these people and situations are now the exception.
I always find it interesting that you hear so many stories about people that made tons of money in rental real estate, but rarely about the frequent disasters as people don’t talk about those as much. Just like you always hear about the amount of a gambler’s winnings but rarely the full amount of their losses.
One of the most important aspects of owning an individual investment property is understanding the numbers and viewing it as a business. If you are not sure what the Net Operating Income (NOI) is for the property you are considering, you should NOT buy it.
Here are the primary reasons why I do not recommend directly investing in real estate properties:
1) It is one of the few investments that can cost you significant money and time.
Owning property as an investment can include such costs as: interest on the loan, closing costs, cost of finding renters, cost for months without tenants, cost of additional insurance, cost of repairs and upkeep on an investment property and management fees just to name a few. Many people do not consider all the costs of owning a real estate property.
2) It is a leveraged investment which increases the risk.
Most people take out a loan to buy the investment whether it is a house, apartment building, or land. They are leveraging their initial investment and betting that the investment will be worth more. Leverage magnifies both gains and losses. (This is great on the upside, bad on the downside.) If the real estate market has dropped in value, you may not be able to sell the property for what you put in and you still have a cash outflow requirement every month.
3) It is not a diversified investment.
Most real estate is an investment in one property in one specific location. You are generally putting many of your eggs in this one basket which once again increases the risk. (Diversification is one of the most important tenants of investing. At my firm we are fans of low cost mutual funds and ETFs due to the inherent diversification of this type of security.)
4) It is a highly illiquid and non-marketable asset.
Depending on the real estate market it can take a long time to sell a home. Even during good markets, it usually takes more than two months to sell and close on a real estate property. Anyone who has owned a home during a buyer’s market, such as now can tell you their nightmare and frustration of having the house on the market for over a year (or years).
How about vacation homes?
Even with regards to vacation homes, if you want a vacation home to enjoy as your vacation home, do it, if that makes financial sense for you. I view that differently than just buying a second house purely as an investment. The enjoyment and pleasure you get by having a vacation home makes up for the risks and costs of the real estate. The main objective of a vacation home is to be used and enjoyed is different than a property bought primarily as an investment. (Often times it is much cheaper and more convenient to rent a vacation house for several weeks a year than to have the costs of owning a vacation home.)
REITs
If you believe in and want to invest in real estate, I AM a proponent for Real Estate Investment Trusts or REITs. REITs are a security that trades like a stock and invests directly in real estate by owning a portfolio of properties and/or mortgages. REITs allow you to own real estate as an investment in this asset class with the advantages of:
1) Having an expert picking the properties
2) Without the hassle, costs and obligation of maintaining an individual property
3) Not incurring the individual property risk due to lack of diversification (because many properties, mortgages, and/or locations may be owned by the REIT)
4) It being a marketable asset that can be quickly bought or sold through a major exchange.
5) A REIT by itself is a diversified investment
Conclusion
Although I do not recommend buying individual real estate properties as an investment, real estate as an asset class usually improves your portfolio diversification since it has a low correlation to the general market. Therefore, generally I do recommend committing a small portion of your portfolio to this class, not as a market call on this sector (especially now), but based on my belief in its ability to dampen the overall volatility of your portfolio in the long term.
Please note while we are not big fans of REITs right now, especially commercial property REITs, we should be in the future as the economy improves and supply lessens due to lower prices.