Investing in Real Estate

Real estate as an investment can be very profitable. It has its challenges, especially if you are buying property and managing it yourself. But done properly, real estate can provide cash flow, diversification and other benefits to your investment portfolio.

Fundamentally, investing in real estate is basically buying an asset, leasing the asset to others and collecting rents for the use of your asset. Whether you buy properties directly, invest in a syndicated partnership or purchase a real estate security, this is how you are going to make a return on your investment.

Owning a rental property is at the highly complex but highly rewarding end of the real estate spectrum. Buying real estate directly is a relatively complex transaction and managing the properties can become a full time occupation on its own. A single property, or even a few in the same community, is not diversified either by type (e.g.: office, residential, commercial) or by location. It’s also very illiquid – hard to sell or get your money out of it. Also, more than your investment is at risk. If there’s a fire or lawsuit, you can lose more than the money you’ve put into the property. Still, there are distinct advantages to doing it this way. The income is all yours, as is any appreciation, and there are tax advantages to owning real property, too.

The easiest way to own real estate is to purchase real estate securities, or REITs (Real Estate Investment Trusts). Or, easier still, buy a mutual fund that invests in REITs. REITs will provide the most diversification, often with multiple property types and can be globally diversified. While you gain liquidity, ease and diversification, you give up the tax benefits and add some non-deductible costs.

There are plenty of options in the middle ground between owning the property yourself and just buying an index mutual fund. One such option is through partnership arrangements. Real estate partnerships are syndicated investments where one group creates a company specifically to invest in a given property (occasionally multiple properties). The syndicator collects funds from investors, rents from tenants and handles all the management chores, and typically gets paid handsomely for the service. But returns to investors can be decent as well, and one advantage of a Limited Liability Company (LLC) or Limited Partnership (LP) structure is that only your initial commitment is at risk.

Partnerships should be carefully analyzed before joining. They often have very high minimum investments ($100,000 or more), are hard to get out of and rarely diversified. The partnership structure also lends itself to severe conflicts of interest in which the syndicator also frequently provides many of the underlying services (like property management, brokerage, administration, etc.) through other shell companies. This encourages overpaying for these services, costing you money.

Another relatively new entrant in the real estate investing world is crowdfunded investments like RealtyShares. Crowd funding takes the high minimums of partnership structures and breaks it down into smaller shares. You typically (or at least should) gain the benefit of the limited liability protection of the partnership, but pay an extra fee in order to access the investment at a smaller size. Crowdfunding can also provide access to shorter-term real estate investments, for example lending money to house flippers or developers for short-term, high risk loans.

There is one particular flavor of real estate investment that should be avoided at all costs: the non-traded REIT. These are so bad that even the brokerage industry’s lapdog self-regulator, FINRA, has had to warn investors about them. The high costs, high commissions and lousy returns are a terrible deal for investors, but brokers are well paid to sell them so they just won’t go away. More on this subject next month.

Real estate can be an important investment portfolio diversifier. Returns are typically comparable to stocks, but often occur at different times (low correlation), providing a substantial diversification benefit. But you don’t have to overpay for that diversification. One exchanged traded fund (ETF) tracking (listed) REIT shares costs 0.12 percent per year with no up-front commissions (and you don’t have to do the plumbing, either).

This column is prepared by Rick Brooks, CFA®, CFP®.  Brooks is Director/Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in financial planning and investment management for people preparing for retirement. Brooks can be reached at (858) 755-5166, or by email at rbrooks@bfadvisors.com. Brooks and his family live in Mission Hills.

Category: Business, Education, Real Estate