Before You Jump Into Real Estate, Know the Risks
Finance

Before You Jump Into Real Estate, Know the Risks

 

Hispanic couple outside home with sold sign

Should I invest in real estate? With property values rising once again in many parts of the country, that’s a question many investors might be asking.

The short answer is that real estate can play an important role in an investment portfolio. As an asset class, it typically does not move in the same direction and at the same time as stocks and bonds, so it can provide valuable diversification.

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However, it’s important to understand its risks. Purchasing an investment property is a cash-intensive and time-consuming commitment, while investing in real estate equities puts you at the mercy of outside forces, like rising interest rates.

For most investors, putting between 5 and 6 percent of their portfolio in real estate assets, such as REITs, might be the most practical way to gain exposure to and diversification from real estate as an asset class.

If we’ve learned anything from the last real estate boom-and-bust cycle, however, as the real estate market heats up, offers to invest in property in one form or another become more frequent. Tempting as it may be to redirect a part of your nest egg to a “big opportunity,” investors should refrain from doing so without knowing all the risks and costs involved.

Direct Real Estate Ownership

One of the allures of real estate is that it’s tangible, unlike stocks and bonds. For investors who like the idea of being able to see their investment and those who prefer to be hands-on, direct real estate ownership might be an option to consider.

Direct real estate ownership comes in many flavors, from buying a rental property to purchasing a residential home with the goal of fixing and selling for a higher price. Both scenarios require substantial holdings costs.

Risks: This type of investment typically requires cash flow, and the returns do not happen overnight. The mortgage and taxes on a house do not disappear if you fail to rent it out for a period of time, or if it languishes on the market. “Most people think real estate goes up in value and you get rich,” says Leonard Baron, who has been involved in the real estate business as a landlord, property manager and investor, for more than two decades. “The reality is, many people subsidize real estate for years and years.”

Private Real Estate Deals

A private real estate deal entails investing in someone else’s property, whether it’s an undeveloped piece of land, a rental property, or financing a fix-and-flip operation. This might be appealing to those who like the tangible nature of real estate, but would prefer not to carry all the risk of sole ownership.

With this type of investment, the investor shares in the profit; if they are acting as a lender, they receive an interest payment for a set period of time and a balloon payment when the investment term ends. Such investment deals are typically more readily available to people who work in the real estate business, or simply run in those circles. The risks, however, can be substantial.

Risks: You are at the mercy of the savviness of the property developer or owner, Baron says. Before jumping in, make sure you know the person and his or her investment history well, as well as all the details of the deal. Do a deep dive on the developer or landowner’s track record, finances, and credit before investing, and consider using the services of a real estate attorney to draw up contracts and any other necessary paperwork.

REITs

For investors who don’t want the headaches and risks that come with owning investment properties, real estate investment trusts, or REITs, offer a hands-off approach.

A REIT is a publicly traded company that invests in real estate either through purchasing properties, or by buying pools of residential or commercial mortgages. Unlike most publicly traded companies, REITs are required to distribute 90 percent of their earnings to their shareholders, making them highly attractive to income-seeking investors. In a recent analysis of more than 350,000 investor portfolios, San Francisco investment firm SigFig found that investors over the age of 55 are nearly three times more likely to own REITs than investors age 35 or younger.

Risks: In a rising interest rate environment, the net asset value of a REIT could decline as its costs of borrowing rise, says Kathy Kristof, author of Investing 101. Investors should also be aware of the costs and tax implications typically associated with REITs.

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