There are many ways for people to invest in real estate, such as fixing and flipping properties and building houses to spec and selling them at a profit. However, from a long-term perspective, the best ways to invest in real estate are buying rental properties and investing in real estate investment trusts. Both can be excellent ways to build wealth, and both have their pros and cons.
Here's a rundown of these two approaches to investing in real estate and how to determine which is right for you.
Buying properties puts you in control -- but it can bring headaches
The most obvious method of investing in real estate for the long term is simply buying a property, renting it out, and holding it for the long run.
This method has many benefits. First, it puts you in control of your investment. You decide how much you pay for the property, the rent you charge, and the tenants you allow to live there.
This method can also be rather lucrative, at least on paper. As a simplified example, let's say you spend $100,000 to buy a house that you can rent for roughly $1,000 per month. A good rule of thumb is to estimate the rent potential at 1% of the property's value -- not a perfect estimate but a decent starting point. Furthermore, we'll say you put 25% down on the home ($25,000) and obtain a 30-year mortgage at 4.25% interest. To keep our numbers simple, let's say the sellers paid the closing costs as part of the deal.
So your property is bringing in $1,000 per month. Let's look at your cash flow, bearing in mind these costs might be higher or lower depending on the property and its location:
|Mortgage (principal + interest)||-$369|
Your theoretical cash flow from the property is $348 per month, or a 16.7% annualized rate of return based on your original $25,000 investment. You're also building equity in the house: During the first year, you'll pay off $1,265 of the outstanding mortgage balance. Further, home prices tend to appreciate over time; to be conservative, we'll assume average annual growth of 2%, or $2,000 in the first year.
In all, this adds up to a total one-year return of $7,441, or 29.8% on your original $25,000 investment. Sounds pretty good, right?
However, no investment that could return nearly 30% per year comes without risk. For starters, there is the risk that the property will sit vacant for several months at a time, earning a negative return (you still have to pay the bills). You could also be forced to evict a tenant, which is neither easy nor free. Or you could run into some expensive unexpected maintenance problems, such as replacing the house's HVAC unit. In reality, you're unlikely to achieve an idealized return like this on a consistent basis.
On top of that, owning and managing rental properties involves a substantial time commitment. If you don't want to worry about the day-to-day operations or finding tenants, prepare to pay about 10% of the rent to a property management company.
Consider high-quality REITs for a more passive approach
The takeaway from the discussion above is that investing in actual rental properties isn't for everyone. Fortunately, there's an easy way to invest in real estate without ever owning a property.
Real estate investment trusts, or REITs, are essentially companies that pool investors' money to purchase, develop, and/or manage a portfolio of properties. There are REITs that specialize in several types of properties -- apartment buildings, student housing developments, retail properties, offices, industrial properties, healthcare facilities, and storage buildings -- as well as some with an even narrower specialty.
There are several advantages to REIT investing, as opposed to buying individual properties. For starters, the vacancy and maintenance-related risk is more predictable. As an example, leading apartment REIT Equity Residential (NYSE:EQR) owns 109,225 rentable units. If an individual apartment sits vacant, investors won't feel the effect. The same can be said if a few units need costly maintenance, or if a tenant must be evicted.
Further, REITs are professionally managed by experts, and because of their size, they can manage their own properties more efficiently than individuals or smaller property management companies.
In terms of return potential, while you could (theoretically) make more money with your own investment properties, some REITs have been quite lucrative for their investors. For example, popular retail REIT Realty Income (NYSE:O) has averaged a 17.4% annual return since 1994, and it has increased its dividend 70 quarters in a row. In fact, most of the major property-owning REITs have averaged double-digit returns over the long run.
But REIT investing isn't without risk either. While REIT income is generally more predictable than income from individual properties, it's not guaranteed. Most REITs borrow money to finance their purchases, just like most people do when buying property; if interest rates increase, it could make borrowing more expensive, cutting into profitability.
In addition, weakness in a particular kind of real estate could wreak havoc on REITs that specialize in that type of property. If the retail sector were hit with a wave of bankruptcies, profits and property values could plummet at Realty Income and its peers. I don't think that's likely by any means, but it's a risk you should consider.
Which is right for you?
Basically, the decision comes down to two major factors: how active a role you want to play in your investments and how much risk you're willing to accept. If you're willing to dedicate the time and effort required to evaluate investment properties, negotiate a favorable deal, find tenants, and manage the properties (or pay someone else to do so), and if you don't mind taking on the additional risks involved, buying rental properties can be quite lucrative.
On the other hand, if you prefer to trust your money to the experts and don't want to worry about matters such as finding tenants and dealing with evictions, investing in REITs could give you peace of mind while also delivering strong, wealth-building returns.
Matthew Frankel owns shares of 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.