Here’s some good news for folks still waiting for the value of their homes to come back. In many parts of the country, the residential real estate recovery is continuing and, after years of pain, lots of people are seeing a nice boost in their property values. Prices in some areas are even looking frothy.
Real estate’s ups and downs in the past decade have spurred many investors to ask some hard questions about the role real estate plays in their overall investment mix. What percentage of my portfolio should be in real estate? What about real estate securities such as real estate investment trusts, or REITs? Do investment properties make sense in this market and for my circumstances?
How much you invest in real estate often depends on whether or not you own your home and how much equity you have built up if you do, says Greg McBride, CFA, Bankrate’s chief financial analyst. “For a lot of people, their home might represent a significant chunk of their portfolio. The risk may be that they are too heavily invested in real estate, not underrepresented,” he says. That said, for some people, real estate can be a good way to add diversification to your bond and equity portfolios.
REITs, which invest in properties and trade on exchanges like stocks, offer investors a liquid way to get into real estate (often reaping high dividends simultaneously). REITs specialize in all segments of the market, including commercial and residential properties in a range of locations. “If you hold a REIT mutual fund or ETF you get instant diversification,” McBride says.
Other people may want to take real estate investing a step further and purchase actual rental properties. “There’s certainly money to be made with that approach, but it’s not always easy,” warns McBride. Keep these pros and cons in mind when you’re considering increasing the role of real estate in your portfolio.
- Diversification. Investment real estate can provide solid portfolio diversification over the long run because you are holding a hard asset with the potential for high long-term appreciation, says Kristin McFarland, director of strategic partnerships at Darrow Wealth Management.
- Income. Rental income can provide a solid revenue stream. “We usually estimate a 2% annual return while you are holding the property,” says McFarland. “That’s a different kind of return than the stock market, but it can sustain you until you cash in on the long-term capital gain.”
- Inflation hedge. A property’s potential appreciation can help hedge against future inflation.
- Cash intensive. This is the biggest obstacle for most investors considering buying rental properties. You’ll need the down payment and closing costs as well as the monthly carrying costs. Then there are taxes, maintenance and insurance. Plus, you’ll need an emergency reserve for unexpected events such as a surprise assessment or large repair.
- Labor intensive. Being a landlord is hard work — often at odd hours — and therefore not for everyone. If you’re managing the property yourself, you’re on call 24/7.
- Illiquid. Your money will likely be tied up for years, especially if you need to wait out a market downturn before selling. Even in good markets, dealing with tenants and other issues can delay a sale.