Real estate can be an excellent investment, both for income and long-term growth. And when used correctly, real estate can produce strong returns.
When it comes to investing in real estate, you have two basic choices: Buy individual investment properties, or buy shares of a real estate investment trust, or REIT. Each can be a good choice, but there are pros and cons to each. Here's a primer on these two main types of real estate investing, so you can decide which is more appropriate for your investment objectives.
Investment properties can produce high returns, but the risks are substantial
The most obvious way to invest in real estate is to buy a rental property, such as a house, duplex, or small apartment building. And while this has the potential to be a lucrative investment, it's not for everyone.
Let's say you buy a house for $120,000, put 20% down on the purchase ($24,000), and obtain a 30-year mortgage at 4% interest. We'll say the house can rent for about $1,000 per month, which is a conservative assumption. When you subtract $458 for the mortgage and about $150 for taxes and insurance and you put 10% of the rent into a reserve fund for maintenance and repairs (believe me, don't skip this part), you can expect cash flow of a little more than $270 per month.
That represents an annual return of nearly 14% based on your $24,000 initial investment. And you'll be building equity in the property as times goes on, not to mention that the property's market value should rise over time. Assuming that about 2% of the mortgage is paid down over the course of the first year, and the property appreciates by 3%-4%, you could be looking at a 20% return on your investment during the first year. Not bad, right?
However, this assumes everything goes according to plan and that you're going to manage the property yourself. There could be several months where the property sits vacant, or you could get a bad tenant who costs you a bundle in legal fees to evict. The process of finding tenants, collecting rent, and dealing with any issues your tenant encounters can take up a lot of your time. If you don't want your investment to become a part-time job, expect to pay about 10% of your rental income for a property manager.
So while you can definitely make money with investment properties, make sure you consider the risks and time commitment required before you start shopping.
The right kind of REITs can manage risk and still produce high returns
Instead of buying properties, you can buy shares of a REIT, which invests in an assortment of properties, usually with a specific theme. For example, some REITs buy apartment buildings, some buy commercial properties, and some buy specialized properties like data centers or warehouses.
REITs are required to pay out 90% of their income to shareholders and can be great sources of passive income for investors. It's analogous to owning a property, except someone else does the work for you. Buying a REIT instead of an individual property helps to lower the risk you face as well. For example, if your rental property sits vacant, you'll not only earn 0% on your investment, but you'll also still have to pay the mortgage and other costs. On the other hand, if a REIT loses one of its tenants, it will barely be noticeable in the profits you make.
My personal preference is REITs that invest in commercial properties, simply because the nature of the business makes it a low-risk, high-reward investment. Not only do commercial tenants tend to sign long leases (15 years or more in many cases), but rent increases are also built right into the lease, and the tenants often cover the less predictable expenses like taxes, insurance, and maintenance. All the REIT has to do is find a tenant and collect a check.
Plus, some commercial REITs produce incredible returns. Leading retail REITs Realty Income and National Retail Properties have averaged annual returns of 17.1% and 14.1%, respectively, over the past 20 years. This kind of return is exceptionally high, especially coming from a relatively low-risk investment.
However, individual investment properties have the potential to produce even better returns, as I discussed earlier. You just need to ask yourself whether the extra return is worth the extra risk.
Real estate investments to avoid
Not all real estate investments are necessarily worth the risk, especially for those who are new at investing. Here are some real estate investments that are better left to the experts, and some that shouldn't be used at all.
- REITs that invest in mortgages, not properties. These use high leverage to deliver high returns, which leaves them susceptible to rising interest rates.
- Any investment properties located outside the United States.
- Investment properties you plan to rent out as a vacation rental, or on a short-term basis. Management expenses for these properties are generally higher than long-term rentals, and the legalities of short-term rentals can be complicated. It's easy to lose money with this type of property.
- Buying a permanent residence that's more than you need, simply because you consider it an investment
The bottom line
Even though owning rental property isn't for everyone, investing in real estate is -- or, at least, it should be. Real estate has a place in every investment portfolio, and it's just a matter of how much risk you're willing to take on and how much time you want to spend managing your investments. If the answer to those questions is "not much," REITs are probably the way to go. On the other hand, if you have the time and energy to deal with owning investment property, it can be an excellent way to build wealth.
Matthew Frankel owns shares of National Retail Properties, and Realty Income.. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.