There are many ways to build an investment portfolio. Of course, stocks and bonds are two of the more commonly chosen vehicles for beginner investors.
But alternative assets including artwork, collectibles, or crypto also garner significant interest. A drawback of alternative investments is that these assets can carry higher risk compared to the capital markets given their speculative nature.
One category of alternative investing that may be viewed as less risky than other areas while also providing lucrative returns is owning a rental property.
Although rental properties are a proven source of passive income, investors should understand the entire picture before blindly entering the real estate market. Let's break down some of the risk factors and costs associated with real estate and assess one option that may be a better choice for most investors.
Real estate investing can be tempting, but...
Cutting corners is not an option when it comes to building wealth. Even with passive income, you need to have adequate financial resources to access these options.
Buying a rental property is one of those ideas that seems alluring on the surface as some may see it as a low-effort source of passive income. However, people often ignore or miscalculate the challenges of real estate investing.
For starters, buying a rental property often requires significant capital. Furthermore, after your downpayment, more costs could be on the horizon. Why? As a landlord, you're responsible for drawing up a lease.
The most obvious risk you're taking is that tenants could damage your property. While tenants should be on the hook for such damage, they could easily try and wiggle out of reimbursing you. This could lead to taking tenants to small claims court, which will cost you some legal fees.
If the above scenario isn't appealing to you, hiring a property manager could be a backup option. This will also cost you money, which ultimately eats into your monthly rental collection fees.
Image source: Getty Images.
...sometimes it's better to go with the simple option
What you may not realize is that acquiring a rental property isn't necessary for investing in real estate. In fact, some of the best sources of real estate-focused passive income are from index funds.
The Vanguard Real Estate Index Fund (VNQ +0.07%) is a fund that invests almost exclusively in the real estate sector. Some of the fund's top holdings include real estate investment trusts (REITs) such as Realty Income, American Tower Corporation, and Simon Property Group.
This diversified basket of stocks provides investors with exposure to various aspects of real estate including retail, hotels, commercial office space, and data centers.
Is real estate a good investment?
Just like any other asset, there are pros and cons to investing in real estate. For beginners, I'd encourage more insulated methods such as investing in passive funds as opposed to outright acquiring a rental property.
One of the extra sweeteners of owning shares in the Vanguard Real Estate Index Fund is that it comes with a generous 4.1% dividend yield. In a way, you could view the dividend as similar to collecting a rent payment.
However, I see the Vanguard Real Estate Index Fund as much safer. Since the ETF is invested so heavily in REITs, which are required to pay out 90% of taxable income to investors each year, the dividend payment from the Vanguard Real Estate Index Fund is pretty reliable.
One thing to be aware of is that the Vanguard Real Estate Index Fund likely won't come with sizzling returns. The fund's average annual return since it was created in 2004 is approximately 7.5%. By comparison, the average annual return of the S&P 500 over the last 20 years is a slightly better 9%.
Nevertheless, I see the Vanguard Real Estate Index Fund as a better option than buying a rental property considering its lower risk, reliable dividend, and respectable long-term performance.
