Real estate is one of the best asset classes to invest in. Financial advisors and portfolio managers won’t tell you this because they don’t earn percentage fees when you invest in real estate unless you are buying a real estate investment trust (REIT) fund or ETF. Obviously, if you speak to mortgage brokers and real estate agents they would tell you that buying properties is the way to go. Of course, they are biased as well since they earn commission fees when you buy homes.
Here’s an unbiased opinion – real estate investing is an amazing way to get ahead in your investment journey. Take it from someone who doesn’t earn money by telling you this and has a lot of experience in the real estate market. If done right, real estate investing could bring you a return on investment (ROI) higher than stocks, bonds, commodities, and other asset classes.
Below are some ways you, as a retail investor, could invest in real estate.
1. Physical Residential Real Estate Rental Properties
This is my preferred way of investing in real estate. All you need to do with this method is to check out houses for sale, do some investment calculations with a proper real estate model, and buy a property that makes financial sense. This method will be the focus of this article in the next section. Let’s look at some advantages and disadvantages of this type of real estate exposure in your investing portfolio.
Advantages of Investing in Residential Real Estate Rental Properties:
- Potential for positive cash flow every month.
- Significant return on equity (ROE) through a lot of leverage through a mortgage from the bank. Your net worth is likely to increase faster than most investors realize.
- You have full control over the asset.
- You can see the asset with your own eyes and it’s real and physical. It’s not just a number on a screen.
- Paydown of the mortgage over time, which further increases return.
- You can combine this method with real estate flipping – which is the process of buying an old house that needs renovations and reselling it.
Disadvantages of Investing in Residential Real Estate Rental Properties:
- Need a lot of capital to get started with buying a property.
- Might be hard to obtain a mortgage from the bank if you don’t have capital, have poor credit, or don’t earn a lot of money.
- Things in the house might break that you’re responsible for fixing, which could mean unexpected expenses.
- Have the potential to lose more than your initial capital during a big real estate market correction. A good example where this was the case for many real estate investors is the 2007-2008 real estate bubble and subsequent meltdown.
- Vacancy risk – if your property is vacant it’s not generating any cash flow. You might have a hard time finding tenants in certain geographical regions and locations.
- Tenant related issues – this could include missing rent payments, ruining appliances, walls, floors or other things in the home. They may also move out suddenly without telling you even if it’s against their agreement.
- Liquidity to transact with physical real estate is poor. This basically means that it takes a while to buy or sell real estate. It could take weeks or even months to buy or sell a house.
- Real estate transactions can be costly when buying and selling homes. This includes land transfer taxes, lawyer fees, an inspection, real estate agent costs, sometimes appraisal costs and other fees.
2. Your Home
The house or condo you live in or planning to buy at some point in the future is also a real estate investment. Just like buying a physical residential real estate property, you need to physically search for houses, figure out what makes financial sense and buy the right home for you.
Advantages of Owning Your Own Home:
- Everyone needs a place to call home. Might as well own the asset in which live.
- You won’t be “throwing away” rent money out of the window. Though there are other aspects to consider on this rent vs. purchasing real estate decision.
- No tenant associated risks since you’re the one that lives at the property.
- You have full control over the investment.
- Similarly to the rental property we mentioned above, you can see the asset with your own eyes and it’s real and physical. It’s not just a number on a screen.
- You could rent out parts of the home you live in and generate some cash flow. For example, if you rent a room or the basement of the house, that could generate some extra cash.
Disadvantages of Owning Your Own Home:
- In some cases it may make sense to rent instead. We’ll explore renting vs. buying a home in another article.
- You usually need a lot of capital for the initial down payment on a house.
- Interest expenses on the mortgage could be hefty.
- You will not have a positive cash flow from this type of investment.
- Again, similar to the first way of investing in real estate, it may be hard to obtain a mortgage if you don’t have capital, have poor credit, or don’t earn a lot of money.
- If something breaks in your house, you pay to get it fixed. You can’t call your landlord every time the furnace or washing machine gives you trouble; you, as the owner, have to deal with any necessary repairs.
3. Vacant Land
“They don’t make any more land” as the famous quote goes. And it’s true. A lot of the time, the land real estate where a house sits is more valuable than the structure itself. You would need to look for land for sale in a decent location where the land will become more valuable over time. It should be an area where people are migrating to and that’s becoming more popular over time. You could either wait for the land itself to increase in value and then sell it or build a house on the land you purchase.
Advantages of Investing in Vacant Land:
- Land is scarce since you physically cannot create more of it.
- Generally, you have the freedom to create what you want on that land. Could be used for many different purposes that could generate maximum value, assuming zoning laws are being followed.
- Usually, you have direct ownership of the land without debt. Therefore, there’s no anxiety related to any kind of mortgage payments.
- Don’t need to worry about maintenance the way you would for a rental property.
- It’s cheaper than developed land.
Disadvantages of Buying Land:
- No immediate cash flow potential.
- Still encounter property tax, which contributes to negative cash flow.
- May require a lot of capital, depending on the area where you buy the land.
- To build anything on the land will also generally cost a lot.
- Not many banks or institutions are willing to lend money to purchase and build on land, unless you’re in the business of building real estate properties.
- Since there’s no mortgage on the land, you won’t be able to have mortgage interest tax deductions.
- Permits, zoning, and legal approvals are some concerns you’ll need to consider. How many lots, what type of properties and other restrictions will apply when developing on land.
4. Real Estate Investment Trusts (REITs)
REITs are securities that own, manage and usually rent out all kinds of real estate. Some REITs focus on residential housing, others on commercial and industrial properties. Public REITs are like stocks that you can be purchased on stock market exchanges. Some large ones on the Toronto Stock Exchange (abbreviated TSE or TSX) include H&R Real Estate Investment Trust (HR-UN) and Riocan Real Estate Investment Trust (REI-UN). In the US, some big names include American Tower Corp (AMT) and Simon Property Group Inc (SPG). This is not the best way to grow your net worth through real estate, but let’s look at some advantages and disadvantages of investing in this investment vehicle.
Advantages of Investing in REITs:
- You don’t need a lot of money to get started with this kind of investing.
- The only amount you could lose is your initial investment.
- Liquidity – you can buy and sell these investments within seconds. Whereas, actual real estate properties could take weeks or months to sell or buy.
- As an investor, you receive regular monthly or quarterly dividends from these investments, since REITs are required to pay out at least 90% of their earnings to investors. The dividend yields on REITs are very attractive and can range from about 3% to over 10%.
Disadvantages of Investing in REITs:
- You can’t utilize the massive leverage advantages of getting a large loan (mortgage) from the bank when buying a house or property.
- REIT prices fluctuate on a daily basis. Therefore, your investment is subject to a lot of volatility.
- There is a security specific risk if you don’t diversify and only buy one REIT security. An example of this risk includes the bankruptcy of a specific REIT you invested in or even just a lawsuit that the company lost, which may cause the price of the shares to crash.
- Every time you buy or sell REITs, you’re subject to trading costs.
5. Exchange Traded Funds (ETFs) with Real Estate Exposure Through REITs
An Exchange Traded Fund (ETF) is a basket of securities that is wrapped in a fund. This investment vehicle trades on a stock exchange similarly to stocks. REIT ETFs are just real estate funds that hold a basket of REIT securities. Some of the bigger once on the Toronto Stock Exchange (abbreviated TSE or TSX) are BMO Equal Weight REITs ETF (ZRE) and iShares S&P/TSX Capped REIT Index ETF (XRE). In the US, some big names include Vanguard Real Estate Index Fund (VNQ) and Schwab US REIT ETF (SCHH).
Advantages of Investing in REIT ETFs:
- Instant diversification of a basket of REITs through ETFs that hold them.
- Low transaction costs when buying and selling ETFs.
- Most ETFs are very liquid and it can be easy to buy and sell these funds throughout the business day.
- This type of fund has a relatively low annual expense ratio or fee than most other types of funds, such as mutual funds and hedge funds.
- ETFs are very transparent with their underlying holdings since they are required to report their holdings on a daily basis.
- You can short sell ETFs, the same way as stocks.
- You can buy ETFs on margin, just like stocks.
Disadvantages of Investing in REIT ETFs:
- Similar to individual REITs, ETF prices fluctuate on a daily basis. Therefore, your investment is subject to a lot of volatility.
- Every time you buy or sell ETFs, you’re subject to trading costs.
- ETFs may experience tracking error, which is return deviation from the index passive ETFs are meant to track. This means that the ETF may not track the performance of the underlying index properly.
6. Mutual Funds with Real Estate Exposure
Just like an ETF, a mutual fund is a basket of securities that is wrapped in a fund. However, mutual funds do not trade on stock exchanges and can only be bought and sold at their net asset value (NAV) after markets close (4 PM EST on NYSE for example). The fee structure and taxation is also different between ETFs and mutual funds. Real estate mutual funds are mutual funds that hold a basket of securities related to real estate. These could include REITs, home builders, and other real estate companies. Some of the more popular ones are Vanguard Real Estate Index Investor (VGSIX) and DFA Real Estate Securities I (DFREX).
Advantages of Investing in Mutual Funds with Real Estate Exposure:
- Same as ETFs, there’s the benefit of instant diversification of a basket of real estate securities and REITs in a real estate mutual fund.
- Unlike ETFs, mutual funds allow the investor to reinvest their dividends into the underlying mutual fund automatically without incurring transaction fees.
Disadvantages of Investing in Mutual Funds with Real Estate Exposure:
- Usually have higher fees than other funds, such as ETFs.
- Mutual Funds are less transparent than ETFs since mutual funds are only required to report their holdings on a quarterly basis.
- Mutual fund prices or net asset values (NAVs) change at the end of every day. Therefore, your investment is subject to a lot of volatility.
- You can only buy or sell mutual funds at the end of the day. Unlike ETFs that trade throughout the day.
- You cannot short sell mutual funds.
- A lot of the time mutual funds have investment minimums that are not accessible to all investors.
The Bottom Line
All of these methods of investing in real estate are subject to market forces as well. These can be advantages or disadvantages depending on which way the market is headed; any real estate investment has the potential to increase or decrease in value over time.
This is not an all-inclusive list of ways of investing in real estate but is meant to highlight some of the most popular ones. Other methods of real estate investing may include commercial real estate investing, industrial buildings, house flipping, rent-to-own, cottages, temporary renting through Airbnb, investing in home construction companies, and many more. For the purposes of this article, I wanted to keep it relatively simple.