Real estate investment is one of the most consistent ways of building wealth and generate ongoing cashflow. For new investors, the number of ways investing in real estate can be overwhelming and making the right decision is heavily dependent on the individual’s circumstances and risk tolerance. We have narrowed down 3 real estate strategies as the best ways to invest in real estate for those starting on their journey.
The 3 easiest ways of getting into real estate
- Buying a rental property
- Real estate investment trusts listed on the stock exchanges (REITs)
- Real estate investment trusts Exchange Traded Funds (REIT ETFs)
These options have their own advantages and disadvantages in terms of liquidity, cashflow and capital growth opportunities. More importantly, the right choice is dependent on your investment horizon, tolerance for risk and volatility and degree of ongoing time commitments.
In addition to the options outlined above, there is also other real estate investment option such as:
- Real Estate private equity (or real asset funds)
- Real Estate debt
- Real Estate mutual funds
- Crowdsourced investment opportunities
We have discussed the other investment options in detail in the other posts on the site. These are more tailored investment options for those with specific income and capital growth requirements, and not all of the options are for everyone.
1. Buying Rental Property
Direct real estate investment means the investor owns and takes direct control in selecting, buying, selling and managing the property. This can range from residential apartments to retail or commercial assets. You can do the day-to-day management yourself or handed off to a third-party property manager.
The main limitation of buying a rental property just like investing in real estate private equity, is the large capital required upfront.
REITs and REIT ETF allow a gradual build up of position overtime but direct real estate investment requires all of the equity upfront. Even with high leverage in the capital stack, the banks will typically require at least 20% down and sufficient equity to cover the transaction costs.
Different to Listed Investments
The primary risks in investing in real estate directly is a concentrated asset and real estate market exposure. In effect all your eggs are in the same basket.
Some of the risks here include choosing the wrong tenant, and when the rent is not paid on time, it impacts the income of the investment.
Sticky Book Values and Low Volatility
Ostensibly real estate investments held directly are more stable compared to tradeable investments such as REITs or REIT ETFs.
Appraised value can be indicated from comparable transactions or based on the general direction of the market. But there are no forces aside from any mortgage requirements to mark to market.
The market can go up and down over the investment horizon but the gains and losses are realized at the time of sale. The only price that matters is the price when the asset is sold.
Low Management Costs
Aside from the unavoidable costs such as interest and taxes. Investors have a higher degree of control over additional expenses such as selecting the property manager, how the budget is managed and the timing of capital expenditures.
Holding real estate generally results in higher returns as there is no manager in the middle taking management fees on the asset.
The biggest drawdown in this instance is it is the most illiquid option out of all 3. Liquidity is only achieved when the property is sold and can only be realized once the property is sold, which can take a month from start to end.
Greater flexibility and Knowing The Area
In contrast to liquidity, direct asset investment is the most flexible out of all options as the investor is responsible for all stages of the investment process. This is an advantage for those who want to roll up their sleeves and get involved.
The biggest advantage individual investors have over professional real estate investors is that they know the local area and market much better. As they live and breathe the area, there will be a distinct informational advantage, which means there is a better chance of finding better deals.
Most professional real estate investors use an LLC or Limited Partnership Structure to hold in the property. Holding the real estate in a special purpose vehicle is a must have as it separates any future potential liability and protects the investor in the worst case scenarios. For example, if the asset is required to be tipped into bankruptcy without risking the investor’s other personal assets. At the cost of just hundreds to thousands of dollars, it can save many sleepless nights.
2. Invest in Listed REITs
We chose to include listed REITs as one of the best ways to invest in real estate because of its simplicity and allows anyone to have real estate exposure in the portfolio immediately.
Listed REITs provide indirect exposure to real estate. A real estate investment trust owns a real estate portfolio, and buying a REIT is like owning a fractional share of the underlying real estate. In a sense, it is paying for a manager to manage real estate assets where you can buy into and sell out in an instance.
Similarly, picking a REIT is like picking a stock, so it does require some involvement if you want to know what you own and how it is performing against the business plan.
The best part about owning real estate via a REIT is the flexibility it provides. REITs can provide access to a range of commercial real estate access and alternative real estate sectors.
REITs also provide diversified exposure to a portfolio of real estate assets, in contrast to direct real estate investment, where it is tough for individuals to achieve diversification. Owning a rental property means the investment portfolio is heavily concentrated in a single asset, and for most investors, it isn’t easy to own more than 1 or 2 assets.
The downside of investing in a REIT is that individuals do not have control over the portfolio’s day-to-day management or asset allocation. Buying into a REIT is buying into the REIT’s existing strategy and rely on the manager of the real estate investment trust’s expertise.
REITs Risk Profile
Owning a listed REIT will expose your self to stock market sentiment. The REIT shares will go up and down with the market, rightly or wrongly, and for those with patience, it can even provide great buying opportunities once in a while.
It is a given that owning real estate has a sense of taking some interest rate risk as a large portion of the capital stack comprises debt. The difference within a REIT exposure is that changes in interest rates expectation are reflected in the asset pricing almost immediately. The investment portfolio’s daily value is based on what everyone thinks it is worth rather than based on comparable transactions or valuations.
Paradoxically the value of the underlying assets is more stable than the daily trading price. There could be significant periods when the price deviates from value.
While not typically associated with low cost like index funds, REITs are also not high cost investments compared to real estate private equity. Entering and exiting positions reflect the brokerage cost, and there are no costs for the ongoing management in the portfolio.
All property and investment charges are contained within the REIT itself. Management costs benefit from economies of scale, which are typically under 1% of the asset under management.
Best Liquidity Out of All of the Options
REITs are the most liquid form of real estate investment.
The downside is that you do not have as much input in directing the day to day investment process as managing your own property. Real estate in the trust is managed by a team hired by the board of directors. Investors use their vote in selecting the board of directors.
Typical distributions from REITs are tax deferred. Capital gains are calculated similarly with investment properties.
3. Real Estate Investment Trust Exchange Traded Funds (REIT ETFs)
Last but not least is REIT ETFs. Picking REITs is like picking stocks but owning a REIT ETF is owning an index fund that tracks a portfolio of REITs and is an amalgamation of listed REIT approach to property investment. Simply REIT ETFs provide one of the best ways to invest in real estate with pure market beta exposure.
Investing in REIT ETFs is like a fund of fund strategy of investing in real estate, and it has the benefit of being the most diversified option out of all of the ways of investing in real estate.
This is the most passive investment option for investors looking to add real estate exposure in general but not looking for any sector or asset exposure.
An exchange traded fund owns a portfolio of REITs diversified across all sectors. Investors gain market returns and take on market risk.
The resulting return reflects the overall performance of the real estate asset performance. While returns can be lower than individual REITs, the offset is that they are accessible for those who are not familiar with investment and at a lower risk.
REIT ETFs allow investors broad real estate exposure without needing hands on management of the portfolio of assets.
3 Best Way to Invest In Real Estate Summary Table