🏠 Real Estate Investing: Hassle or Homerun?

In 2015, my wife and I moved to Austin, Texas sight unseen, and we’ve been living here ever since. We’ve seen the city evolve and change due to a booming local economy. To take advantage, we bought a rental property here and have experienced the ups and downs of direct real estate investing. This past week was a reminder to me of the often unseen/unreported costs of owning rental property. So with that inspiration, I decided to make this week’s issue of Founders + Funders a primer on real estate investing.

Like much of the country, Austin experienced an arctic blast of cold air this past week. Temperatures dropped into the teens and stayed below freezing for a few days in a row. Here in Texas, that’s rare and we aren’t built for it so when we get weather like this, there is always a palpable nervousness in the air as people prepare for busted pipes, power outages, and general chaos. Personally, I was acutely aware of the freezing temperatures as I stood outside in the wind and cold holding a hair dryer to the pipes coming out of the water heater of our rental unit to unfreeze the pipes. The experience was a not-so subtle reminder of some of the challenges of investing directly in physical real estate.

The Importance of Real Estate

Real estate is the largest asset on many American’s balance sheets. Home ownership is encouraged through policies like the mortgage interest deduction and subsidized lending programs. Many people have made serious money just by virtue of owning a home in an area that has become or stayed desirable. To give you a sense of the importance of real estate as a proportion of wealth, take a look at this data from the Federal Reserve.

Working with clients going through liquidity events, buying a home or investment property is often at the top of the list of potential cash uses. Additionally, real estate investing is often encouraged by the hordes of financial influencers on social media as well as roadside signs suggesting huge profits are in store if you follow their “program”. Real estate is indeed a big asset class that has minted many millionaires. So is property ownership the pathway to riches or ruin? Like most things, the truth is probably somewhere in the middle! Let’s take a look at the pros and cons of real estate investing, put it into context of an overall portfolio, and think about frameworks for decision making.

🤌 Pros of Real Estate Investing

Tax efficiency - Real estate investing has a lot of potential tax advantages. Mortgage interest and property taxes are deductible, subject to limits. Additionally, accelerated depreciation on investment properties can be used to defer taxes until you sell and it’s recaptured. When you sell, you can avoid capital gains on primary residence property sales if you qualify. Furthermore, capital gains can be deferred on certain commercial property investments if rolled over to another property (1031 exchange). 

Leverage - You can get a loan to buy a property with a fair amount of ease. This can have the effect of juicing your returns. However, it can backfire too! Leverage cuts both ways.

Improvements - You can work to improve the property value through your own sweat equity. 

🧐 Cons of Real Estate Investing

High transaction costs - When you sell your property, closing costs are typically around 6% of the total price, a high fee to pay relative to buying/selling stocks, mutual funds, or ETFs.

Illiquidity - Properties are highly illiquid because they are unique. It’s not uncommon for properties to sit on the market for months before a transaction occurs.

High effort - Owning and managing a property yourself is at least a part-time job. Do you really want to stand outside in the freezing cold on a Sunday night blow drying water heater pipes like I had to do? How much is that worth? You can always outsource the management but that comes with a cost and you still have to manage the management company. Finding a good property investment takes time and effort, not to mention the fact that you’ll be competing with other people who may invest in real estate full-time as a professional.

Difficult to diversify - Property is expensive. It’s pretty tough to build a diversified portfolio of properties unless you have a 8+ figure net worth. If some idiosyncratic risk is realized at your investment property, it could kill your returns.

🧩 Fitting real estate into your portfolio

First things first, you gotta live somewhere! Your primary residence isn’t really an investment, it’s more of a consumption good. It does bear some resemblance to an investment since real estate is often an appreciating asset, but you probably shouldn’t treat it with the same cold rationality that investing demands because there are a lot of psychic benefits you get from home ownership that can't really be quantified. However, even if you don’t treat it as an investment, it is still part of your balance sheet and should be considered real estate exposure for portfolio purposes.

So how big should real estate be in your portfolio? Googling the answer will get you as many opinions as web pages, but a good starting place is the proportional representation of real estate equity to total wealth at the macro level. From the Federal Reserve data, real estate makes up ~23% of the total net worth and ~28% of total assets of Americans. If your home is a larger percentage of your net worth, you may want to pause and consider other types of investments before buying that condo in Tahoe, or that rental property down the street.

💰 How to access real estate investments

You can invest in real estate in a number of ways. It doesn’t have to look like an HGTV show:

• Buy a property directly (see the above pros and cons)
• Invest in a private real estate fund (private REIT)
• Invest in a private real estate deal with other investors
• Invest in a publicly listed real estate investment trust (public REIT)
• Invest in a fund of publicly listed REITs

Investing in public REITs or REIT funds is the easiest and least expensive way to get some real estate exposure in your portfolio. If you invest in public REITs or public REIT funds, your real estate investment will be highly liquid (sellable in seconds with near zero transaction costs). Additionally, investing via a fund provides you with a level of diversification you are unlikely to be able to achieve buying individual properties or even individual REITs.

Looking at the returns of public REITs is a good proxy for return expectations since it’s a broad representation of real estate all over the country. Historically, REITs have performed similarly to the overall US stock market. Since the end of 1991, considered the inception of the modern REIT era, the Dow Jones U.S. Select REIT Index has delivered a 9.5% compound annual return while the Russell 3000 Index has delivered 10.0% annualized.

While the compounded returns are similar between REITs and other stocks, REITs are not perfectly correlated with stocks which means they have diversification benefits when added to a portfolio. Furthermore, REITs tend to deliver more of their returns through dividends than other stocks. Currently, the average trailing twelve month dividend yield on the ~180 REITs listed on US exchanges is near 7%, while the dividend yield on the Russell 3000 Index is around 1.5%.

💡 The bottom line

Investing in real estate can be great, if done with eyes wide open to the risks, costs, and in the context of a diversified portfolio. How you get your real estate exposure is up to you, but hopefully this article gives you some food for thought when considering the options.

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