If there's one question we hear all the time from new investors, it's this one: "Is real estate a good investment?" These investors want to know whether it's really possible to make money in real estate or they should just stick to playing the stock market. We've done our best to answer this question below. Read each section to get a better idea of whether real estate investing is the right choice for growing your portfolio.
What are the different ways to invest in real estate?
Before we get into the specific benefits of investing in real estate, it's important to clarify that there's more to real estate investing than just becoming a landlord and collecting rental income. In practice, there are six different ways you can add real estate assets to your portfolio:
- Buy-and-hold strategy: This is the classic real estate investing strategy in which you buy an investment property, find a tenant, and collect regular rental income.
- Short-term rental strategy: A short-term rental strategy is similar to a buy-and-hold strategy, except that rather than finding a long-term tenant, you only rent out your investment property for a short time. Often, investors will use platforms like Airbnb or VBRO to market their properties.
- Fix-and-flip strategy: Also known as "flipping houses," a fix-and-flip strategy involves buying a residential property that's undervalued for the market, fixing it up, and then selling it for a profit.
- Real estate wholesaling strategy: A wholesaling strategy also involves buying a property that's undervalued for the real estate market. But in this case, rather than fixing it up first, you turn around and sell it very quickly to an end buyer at a higher margin.
- Real estate investment trusts (REITs): If you like playing the stock market, you might be interested in investing in a REIT. REITs are publicly traded companies that either own and operate or finance real estate. Investors can buy shares of these companies and receive dividends in return. Alternatively, you could also invest in a real estate investment fund, such as a mutual fund, or a real estate exchange-traded fund (ETF).
- Crowdfunding: Similar to REIT investing, crowdfunding is a good way to generate passive income. In this case, an experienced real estate professional will usually identify a good investment opportunity but won't have the income to fund it. Instead, they will use a platform to pool funds from interested investors who will then receive a share of any profits in exchange for their capital.
What are the pros and cons of investing in real estate?
Like any major investment, before you get started investing in real estate, it's important to consider the pros and cons. We've listed a few of them below so that you have a better idea of what to expect if you decide investing in the housing market is right for you.
To start, if you decide to add real estate to your investment portfolio, there are multiple ways you can see a profit. As mentioned above, if your goal is to generate regular cash flow, you can go with a buy-and-hold strategy. In that case, you'd also have the opportunity to benefit from long-term appreciation. Meanwhile, if you'd prefer a lump-sum payout, you could go with a fix-and-flip strategy or a wholesaling strategy. And if your goal is to add more passive income, you could choose REIT investing or crowdfunding.
Additionally, there's a tax benefit to real estate investing. For example, you could use depreciation to significantly lower the tax rates on any long-term profits, or you could use a 1031 exchange to defer any capital gains from selling your rental property. While you need to talk with a tax professional to make sure you take advantage of all the tax benefits available to you, it's important to know they exist.
Lastly, real estate lets you build equity, which you can eventually use as leverage to expand your investment portfolio. For instance, a real estate investor often will open a home equity line of credit (HELOC) on one of their investment properties to fund the down payment for a new purchase.
The biggest downside is that the initial investment for investing in real estate is usually larger than it might be for another investment option, particularly if you want to use either a buy-and-hold strategy or a fix-and-flip strategy. Put simply, when you're getting a mortgage to cover the purchase price, you need to be prepared to pay for the down payment and closing costs, as well as have sufficient cash reserves in the bank.
Also, many forms of real estate investing are a lot of work. While crowdfunding and REIT investing both allow you to generate passive income, other forms of real estate investing require a lot of effort. With a fix-and-flip strategy, for example, you'll have to put a lot of sweat equity into improving the home before you can raise the property value enough to sell it for a profit.
What is the long-term growth rate of real estate investments?
In truth, it's hard to make an apples-to-apples comparison when you're looking at different asset classes. In this instance, equities tend to appreciate much faster than real estate. However, they don't offer the same opportunities for leveraging, so it's hard to get an accurate read on which investment option is ultimately more valuable.
Despite that, in a paper entitled "The Rate of Return on Everything, 1870-2015," researchers from the Federal Reserve Bank of San Francisco looked at the average rate of return for each major asset class in 16 global economies. Their research dates back all the way to 1870. However, for the purposes of keeping the data manageable, we decided to just look at the rates of returns in the United States from 1980 to 2015.
Here is what they found:
- Bills: 1.71
- Bonds: 5.71
- Equities: 9.09
- Real estate: 5.66