Real Estate as an Asset Class
A look into why real estate should be in your portfolio
When we think of the concept of investing we almost always think immediately of the elusive world that is the stock market. Buying and selling notes based on economic trends and the positive ‘hunch’ your great uncle has on the longevity of a certain company has long been a cornerstone of the American approach to grow wealth. However, long term success from investing in the stock market requires significant patience, understanding, and usually reliance on someone else to handle your money and make appropriate decisions on your behalf. This ‘reliance’ is the reason many are reluctant to commit to a long term relationship with equities and the volatility inherent in getting to bed with the stock market. More and more, investors are looking at other ways to move their excess money to build wealth. These options are known as alternative investments, and more often than not at the top of the list falls real estate.
Unlike the stock market, real estate is secured by a physical asset and is historically an overwhelmingly stable investment. Just take a look at a comparison of returns between the two for the past 45+ years:
As you can see it is quite clear that overall real estate investments have outperformed the S&P 500 since pretty much the 80’s. Granted, there are many different ways you can invest in real estate, however, for the sake of this post (and basic understanding) we just want you to focus on overall investments in the real estate industry. We will get into more specific real estate investments and options in later posts.
In the majority of cases, an investment property will retain its value and most likely appreciate over time. This definitely depends on the location, but for NYC in general this is most definitely the case. When we boil it down let’s face it, people will always need a place to live. Therefore, real estate can be one of the safest ways to invest your money as the demand for your investment will always be there. Other than safety, there are many other factors that make real estate such an attractive investment and something you should consider adding to your investment portfolio. Here are a few:
Immediate/Consistent Cash Flow
Holding rent is key to real estate investing and is the most guaranteed way to gain immediate cash flow. Whether or not renovations are necessary, as long as you have quality tenants (we will elaborate on what this means in upcoming posts) in place you will be receiving rent checks in the mail. This is positive cash flow, and this is whats known as passive income – earnings derived from rental properties in which you are not actively involved. Now, the condition of your property will greatly dictate the amount of cash flow you receive. You may find an investment property with minimal issues and great tenants, in which case you find yourself with positive cash flow without much hassle and added work. However, more often than not, you will find yourself in a situation in which some renovations must be done to the property in order to make it more attractive to tenants. This is known as a value-added property. Although these renovations require expenses to be paid out of your pocket, if done the right way in the long term these types of properties have the most potential and could become a gold mine for you. A little work to make a property more attractive goes a long way in growing your wealth and gaining a consistent stream of passive income – isn’t this why we invest?
Long-term appreciation/equity grow over time
Long-term real estate investments also build equity over time. In the section above we mentioned cash flow through monthly rental payments from your tenants. These monthly payments will also go towards your mortgage payments for the property. Essentially your tenants are paying off the mortgage and thus your investment for you.
Also, in most markets real estate appreciates over time. This is especially true in New York City. According to Forbes, the median home value of apartments throughout the city this year is $994,189, compared to $605,859 back in 2004. That is an average annual appreciation rate of 4.22% since 2000. Although it is expensive, with the proper financing that fits your needs investing in real estate can significantly increase your wealth – as it has for so many over the past decade.
Real Estate has low correlation to other assets
Historically, real estate and other assets such as bonds and equities do not have a casual relationship. Real estate moves differently and thus has an overall low correlation to stocks and bonds. This characteristic alone makes real estate a great investment as it will greatly diversify your portfolio and offset the volatility associated with typical investment vehicles. Also, diversifying within equities is difficult. Investing in real estate can cushion your portfolio and protect you against economic downturns that affect stocks in a negative way.
Protects against inflation
This is related to the long-term appreciation section above. Real estate is one of the few investments that reacts proportionately to inflation. As inflation occurs and the cost of living increases, housing values and rent prices also go up. Therefore, year after year you as a landlord/investor have the ability to increase your rents and thus make a larger passive income. Although there are always expenses associated with properties and along with inflation goes the increase of taxes and insurance, this proportional relationship will yield you a higher return then if inflation was non-existent.
There are tax advantages associated with investing in real estate
There are many tax benefits when investing in real estate. One of the more significant tax shelters comes from the depreciation of property. Because the cost of real estate is so large and often purchased with debt, real estate investing uniquely benefits from depreciation. Here is how:
Scenario 1 (w/o depreciation expense):
$5,000 taxable rental income x 25% federal income tax = $1,250 owed
Scenario 2 (w/ depreciation expense):
$5,000 income – $3,000 depreciation expense = $2,000 taxable income
$2,000 x 25% federal tax rate = $500 owed
Tax Savings = $1,250-$500 = $750
This savings is known as a tax shelter and is unique to real estate. It is also important to keep in mind that the IRS will require you to pay taxes on your rental property if you decide to sell it. In this case you would recapture the depreciation and have to pay, which is significant incentive to hold on to your investment property for the long term as real estate is an illiquid asset after all. There are also other tax strategies you could use when selling such as the 1031 exchange which can shelter you from capital gains tax, but we will get into in a different post.
Investors have the ability to leverage their capital
This is a huge difference between stocks and real estate. If an investor wanted to buy $150,000 in stocks, they would need $150,000 in cash in order to follow through with the investment. With real estate, however, an investor can buy a piece of real estate valued at $150,000 for only a certain percentage of that value, say $25,000, in cash and acquire a loan for the remaining $125,000. Many investors can secure multiple mortgages and grow their portfolios with only a certain percentage down on each property. Conventional financing allows investors to maximize their investment opportunities and leverage their cash on hand. #realestateperks.
You get out of real estate what you put in
The beauty of real estate and one of the top reasons why investors get into it is because the time commitment is flexible and 100% on you. Depending on how intensely you want to invest you can be a “fix-and-flip” investor essentially acting as the property manager and making investing your full-time job, or you can simply use one investment property as a source of passive income that accumulates over the years. The degree of commitment is all on you, which sometimes this control (including control of risk) of our investments is all we can ask for.
As you can see there are a plethora of reasons why investing in real estate is something everyone should consider. And the ones mentioned above are simply grazing the surface of benefits associated with real estate. Whether making it your full-time job or simply looking for a side investment, there are investment opportunities of all types in this industry. If you want to put your hard-earned money to work and watch it grow, investing in real estate is the way to go and something everyone should at least consider.
With that, I will leave you with some wise words of wisdom from a man much smarter than us.
“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.” – Franklin Delano Roosevelt