Many investors like to diversify their stock portfolio with real estate. Real estate is property that can include land, buildings, natural vegetation and animals, and water and minerals on the property. Real estate can be used as a hedge against inflation as it often reacts proportionally to inflation—as inflation increases, so does the value of the real estate.
The biggest benefit to diversifying your assets with real estate is the correlation between real estate prices and market and economic conditions. Generally real estate prices tread along with inflation. However, with this type of investment, you have to watch how leveraged the real estate market becomes. Home prices soared in early 2006, but with subprime lending practices, the bubble eventually burst, causing prices to fall dramatically, leaving many owners with negative equity.
Most investors do not include their primary home in their investable assets. For example, if you have $1 million in a portfolio of stocks, you may also have a home worth more than $300,000, making your net investment $1.3 million. If you were to add an investment property, your entire portfolio could be $1.5 million or more with a third of your assets exposed to real estate.
Investors can be active participants or passive participants in their investment through a variety of ways to invest, including residential or commercial real estate, unimproved land, real estate investment trusts, mutual funds or exchange-traded funds, and limited partnerships. Let’s take a look at the two most common: owning investment property and owning shares of a real estate investment trust.
As any landlord will tell you, investing in residential real estate is a full-time job. You have to be on call for problems and repairs, maintain the property, collect rent and evict tenants who do not pay, etc. Although you may someday sell your residential real estate at a profit, the greater part of your return will likely come from rental income. However, if you can earn 4% to 5% on your rental versus 4% to 5% on a dividend-paying stock, most people would prefer to own the stock and not deal with tenants calling you in the middle of the night because the heater is broken.
Owning residential or commercial real estate also opens you up to more liability as you can be held responsible for injuries that happen on your property. We often recommend that investors create a limited liability company (LLC) to own the property to establish a level of personal liability protection from tenant claims. Ideally, this will help protect your personal assets. The LLC is a pass through entity, so all profits and losses will pass through to the owner.
Real estate Investment trusts (REITs) allow you to invest in real estate without a significant capital requirement and further diversify your real estate investment by purchasing multiple assets. REITs are passive investments that return up to 90% of earnings to shareholders through dividend payments. REITs also trade on stock exchanges, so shares are much more liquid than owning a physical asset. If you needed to sell the investment, residential or commercial property could take months or years to sell, while REITs could be sold nearly immediately. REITs are also interest rate sensitive because as the cost of borrowing increases, the cost of their capital increases and squeezes profits.
Real estate can diversify a stock portfolio, but like every investment, real estate investing has inherent risks that must be monitored. Real estate adds additional work to maintain your portfolio, but the rewards can be worth it.
If you have questions on how real estate investments may fit in your overall portfolio, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
