If you are considering how much of your portfolio should be allocated to real estate, you probably have a lot of unanswered questions. Should you even invest in real estate? Should it be a core part of your portfolio? And should you invest in REITs or just buy real estate yourself?
In this guide, we’ll go over the main factors you need to consider to decide how much capital you should allocate to real estate and what the advantages are.
Should real estate be part of your investment portfolio?
If you are investing for the long term, you should definitely consider including real estate in your portfolio, and there are a few reasons why. On the one hand, it diversifies your holdings, and real estate tends to be a safer investment than stocks. Additionally, it can also provide you with cash flow, and it is a simple way to use some leverage without having the risks associated with margin.
Here are a few advantages of investing in real estate:
One of the main benefits of investing in real estate is that it allows you to leverage your money. When you buy a property, you can put down just 10% to 20%, which means that you can have control over an asset that is worth 10x to 5x your initial investment. Even if the returns on real estate are lower than stocks, no broker will ever lend you 10x to 5x the money you have, and margin loans usually only allow you to double your funds.
You can also use the cash flow generated by the property to pay your mortgage while gaining property equity. Real estate is the only asset class that allows you to leverage your money safely, which is a great advantage.
Another great advantage of including real estate in your portfolio is that it allows you to diversify your holdings. When the stock market crashes, stocks drop across industries and sectors, and the volatility will affect pretty much every stock and asset class. Real estate offers some downside protection in case the stock market crashes and the value of your portfolio collapses.
If you are investing in real estate to generate additional cash flow, you don’t have to worry about stock prices declining. In fact, throughout history, there have been a lot of periods when the stock market crashes and real estate value remains stable, and while there is no guarantee that this will happen in the future, it is a good indicator.
More control over your investment
Investing in real estate also gives you more control over your investment than in stocks. Its management and board of directors govern a company, and unless you have a large stake in the company and can influence the decisions made at the top, you end up being a passive investor.
If you invest in a property, you can control how it generates cash flow if you want to sell or renovate it, and therefore you have more oversight over your investment.
When you sell a stock and make a profit, you will have to pay capital gains tax, and the same principle applies to real estate. However, when it comes to real estate, there are a few ways that you can be exempt from paying capital gains tax.
One of the ways is Section 1031, which allows you to defer the capital gains tax on your property sale if you buy a similar property.
Real estate has historically been an excellent inflation hedge, and given the current levels of high inflation we are experiencing, it could be a way to hedge your portfolio against it. While some companies will struggle to increase their prices and could see their margins compress, which can affect their profitability, real estate, on average, tends to increase in value at a higher rate than inflation.
Real estate market overview
While real estate tends to be a great asset class to include in your portfolio, the current real estate market is showing some signs of slowing down. Over the past decade, and since the 2008 financial crisis, house prices have increased steadily, in part due to the low-interest rate environment, which made it easy for both investors and homeowners to finance and purchase their properties.
With the recent increase in interest rates, the housing market is experiencing a slowdown, with transactions declining, and as a direct consequence, house prices are also trending lower. We could see house prices continuing to decline in 2023 and 2024, depending on how the economy is doing and if interest rates will be higher.
If you are looking for ways to invest in real estate, it is essential to understand the negative correlation between interest rates and house prices. When interest rates are higher, mortgage payments are also higher, which makes it more difficult to finance and buy properties. Therefore house prices tend to decline when interest rates increase.
Real estate vs. REITs
You may also wonder if you should invest in individual properties or REITs, and there are a few differences that you should consider. On the one hand, the risk of investing in single properties is higher than investing in REITs.
REITs have a portfolio of properties, and therefore, they have a lot of advantages relative to single property investments. On the other hand, investing in REITs does not allow you to leverage your capital in the same way, which limits the amount of money you can make.
Global REITs have also outperformed the S&P 500 over the last nearly 30 years.
If you are the type of investor that likes to get to work and have more control and oversight over your investments, then investing in individual properties is the right thing for you. If, on the other hand, you want to have a more passive investing approach, REITs are a great alternative.
Real estate definitely has a place in an investment portfolio, and it is an asset class that should be considered when building your portfolio. Apart from REITs, investing in individual properties is not for everyone, and you should carefully consider how it will impact your returns and your portfolio overall.