Real Estate Risks and Rewards

If you’re reading this, you probably already know real estate is a good investment.

What you might not know is why—and that’s OK. After all, the way most Americans think about real estate is in the context of their own home: primarily as shelter, with the potential to build equity over time. A win-win. This rationale explains why nearly two-thirds of U.S. homes are owner-occupied.^[1]

Yet few people follow this line of thinking to its next logical step: owning real estate solely for investment purposes. Less than 7% of the U.S. population owns rental property, according to IRS data^[2] Sure, affording even a single home, let alone multiple homes, in this current housing market is no easy task.^[3] However, even real estate investment strategies with low barriers to entry appear to be an afterthought for most investors. Just 3% of Americans invest directly in the stock of publicly traded real estate holding companies known as REITs.^[4]

It’s hard to say exactly why so many investors limit their direct real estate exposure to a single property. It could be misconceptions about the investment options available to them or simply a lack of knowledge about what real estate investing entails.

If you find yourself wanting to broaden your portfolio but are still unsure if/why you should invest in real estate, you’ve come to the right place. In this post, we’ll go over some of the basics of real estate investing so you can decide if real estate is right for you.

Some topics we’ll discuss:

• What are the benefits of investing in real estate?
• Is real estate a good investment now?
• What risks are involved?
• What’s the best way to identify a good real estate investment?
• What are the different ways to invest in real estate?

What are the benefits of investing in real estate?

What can real estate add to an investment portfolio? There are many benefits. Let’s start with the ways you can make money from real estate.

Multiple return streams
Real estate can provide two different types of returns: income and appreciation. Income comes in the form of rent collected from tenants each month. Appreciation comes from an increase in the value of the property over time. While the prices of homes^[5] and commercial real estate^[6] can both fluctuate from year to year, they have both consistently risen in the long run.^[7]

Stability
That brings us to the second benefit of owning real estate: stability. Real estate typically provides better returns than bonds, and it has historically been a far less volatile investment than stocks.^[8] A number of factors contribute to this stability.

Leases frequently allow for rent increases. This income can offset declines in property values or rising costs. Additionally, stability arises from the fact that real estate prices are not directly tied to stock market movements.^[9] Real estate is not bought and sold as easily as stocks or bonds—a characteristic known as illiquidity. Since real estate is less liquid, it is also less affected by the volatility that can drive wild swings in prices for other types of assets. Such stability makes real estate relatively immune to the herd mentality that drives boom and bust cycles common to corporate equities.

The benefits of investing in real estate are enjoyed most by those who own properties directly or through a private fund, ^[10] as “unlisted” real estate investments (those not listed on an exchange) are immune to the market swings that affect stock prices. Publicly traded REITs, as a whole, have also outperformed the broader S&P 500 Index over most time periods.^[11]

Inflation hedge
Stocks and bonds both tend to respond negatively to inflation.^[12] Real estate returns, however, may actually increase with rising prices.^[13] That is not to say real estate is fully insulated from the effects of inflation. Higher material and labor costs can impact development and renovation budgets. Likewise, rising interest rates can make new transactions harder to finance. Yet, as discussed above, these costs can usually be passed on to tenants through higher rents (as long as GDP and wage continue to rise).^[14] Both residential real estate and some long-term commercial leases include provisions for rents to escalate in line with inflation.^[15]

Diversification^[16]
Real estate is an excellent portfolio diversifier that can fill the roles of both stocks and bonds, which make up the bulk of most investment portfolios. ^[17] The latter provides a steady baseline income while the former is tasked with generating the bulk of capital appreciation over the long term. That is to say, when bond yields are low, as they have been for more than a decade, steady real estate cash flows can provide a well-needed boost to lagging fixed income yields, ^[18] as monthly rent collections can produce consistent payouts similar to a bond yield. Likewise, real estate values are not dictated by stock market movements. This makes real estate a defensive component for any portfolio.

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Tax advantages
Investing in real estate also comes with a variety of tax advantages for U.S. taxpayers.^[1] One is depreciation, which allows an investor to write off a portion of their investment property’s value every year. Investors can also deduct property taxes, insurance, mortgage interest, and maintenance costs from their annual tax bill.

Income generated from a rental property is not classified as earned income, meaning real estate investors do not have to pay payroll taxes. Also, as with stocks, gains realized when an investor sells a piece of real estate they’ve owned for at least a year are treated as capital gains. These are taxed at a rate lower than ordinary income. In real estate, however, multiple programs are available to defer or defray the tax hit. These are just a few of the most prominent tax incentives for investing in real estate. There are others, depending on the vehicle you invest in and your personal tax situation.

Is real estate a good investment now?
Given the gloomy headlines about some property types, such as malls^[2] and offices,^[3] you might be wondering: is real estate a good investment right now? The answer is yes, but not all real estate is created equal.
As the old saying goes, the key to real estate is: location, location, location. It’s a cliche, but there’s a lot of truth to it. To put a finer point on it, real estate investing often comes down to asset selection, finding the right property in the right spot. A last-mile logistics center in a booming metro area is probably going to perform well. A 1980s vintage mall in the suburbs? Not so much.
Identifying the property at the far ends of the quality spectrum is easy. Choosing between two similar apartment buildings or hotels in equivalent cities is more challenging. These situations require a deep knowledge of market trends and a keen eye for property details. Choose poorly and you could find yourself in a constant cycle of throwing good money after bad.

The other key element to sound real estate investment is price, not only the price of acquiring a property but also the costs of executing a business plan. This means factoring in elements like cost of capital—the returns you must generate to cover financing costs—and the credit quality of your tenants. This is where the illiquidity of real estate can work against investors. Unlike the stock market, where bad investments can be offloaded relatively quickly, exiting a poorly executed real estate investment can be time consuming and expensive. An experienced investment manager and a reliable property manager can help ensure your asset’s business plan stays on track, both from a timing and cost perspective.

What risks are involved?
It’s important to acknowledge the risks involved in real estate investing. There are some that are shared by all manner of real estate investments and others that are specific to certain sectors and strategies.

Risk spectrum
Broadly speaking, real estate investments are grouped into one of four strategies, each of which carries its own risk weight.

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The least risky are Core investments, which are high quality, highly leased properties that need little to no capital improvements. Then there is Core-Plus, which includes similarly high quality assets that need modest improvements. Value-Add strategies, as the name suggests, involve significant investment to improve a property’s cash flow by increasing occupancy, growing rents, or by boosting overall market value. Finally, Opportunistic strategies are the most risk intensive, as they generally include an element of speculation, such as building a new property from the ground-up, or repositioning an asset from one use case to another. The greater the risk, the greater the expected return on a successful investment.

Credit risk
Most real estate investments involve a substantial amount of debt.^[1] This is often referred to as leverage because you are using borrowed money to increase the buying power of your equity. Think of leverage vis-a-vis purchasing a home, which typically requires a 20% down payment. The other 80% of the purchase prices is usually covered by a mortgage. This 80% is debt. Debt can work to your advantage, giving you access to five times more purchasing power than you could afford on your own. Too much debt, however, can make it difficult to cover your mortgage payment.

This same principle applies to commercial real estate. However you choose to invest in real estate: directly, through a REIT, through a private fund, or via a different structure, it is important to make sure debt levels are prudent.

Relying too much on debt can also leave you more exposed to changes in market pricing. If your property value falls below the debt you owe on it, this is called being “underwater.” Being underwater makes it difficult to either refinance your property or sell it for a profit. Depending on how your investment was underwritten, this can also make it more difficult to achieve the rent collections you projected, because the market is valuing your property less now than when you bought it.

When examining debts, it’s also crucial to consider the type of debt you’re taking on while ensuring your leases are structured accordingly. For example, if you borrow floating-rate debt, which increases in line with inflation, you want to ensure the cash flow from your properties is adjusted accordingly. For apartments with frequent turnover, this is fairly straightforward. For office tenants with 10-year leases, an inflation-resistant lease structure is not always a given.

Tenant risk
Tenants are a risk category unto themselves. A key consideration for any income-generating property is the creditworthiness of the tenant. In other words, how likely are they to make timely payments and fulfill their contractual obligations? This is an advantage for many office and industrial properties. Companies, especially publicly traded ones, tend to have more thorough financial statements than individual renters. They are also more likely to be vetted by credit rating agencies. A guarantee from a parent company can also assuage tenant concerns.

Yet, even seemingly rock-solid tenants can run into unexpected problems that prevent them from being able to satisfy their rent payments. Therefore, default risk should be factored into every real estate investment plan. A diverse mix of tenants could help mitigate default risk. While shocks and market trends might prevent an individual company from paying its rent in a given month, a mix of tenants is less likely to default all in the same month. The greater and more varied your tenant base, the better insulated your investment will be from volatility. Compare this to a single-family rental property, where there is just one tenant; if that tenant stops paying, your cash flow falls to zero.

Vacancy risk
Different circumstances can introduce vacancy risk to a real estate investment. A property could be left unoccupied simply because the former tenant no longer wants or needs the space. This is evident in malls across the U.S., where retailers are downsizing their footprints due to increases in online shopping. Similarly, some office tenants are rethinking their real estate plans as more employees embrace working remotely. One way to avoid vacancy risk is by updating your property periodically, renovating lobbies, adding new amenities, etc., to help the property remain attractive to tenants.

Development risk
Development (or redevelopment) risk is among the biggest risks in real estate because of its speculative nature. The assumption is that building a certain type of property or adding something to an existing one will result in tenants’ willingness to pay some kind of premium rent, or at least enough to justify your costs. Certain property types, such as data centers and research laboratories, are very expensive to develop and outfit. Strong demand tends to make these projects feasible, but there’s still risk to developing any asset.

Unknown risks
External factors such as natural disasters that damage a building, and/or its surrounding neighborhood and infrastructure could impact a property’s value in an unexpected way. Unknown risks also include policy risks, changes to local, state, or federal law that undermine investment plans. Rent-control laws that cap rent increases on residential properties are a prime example.

There are risks at every stage of the real estate investment cycle. There are also ways to mitigate those risks, which is why working with an experienced real estate investment manager is so important, especially for investors just learning the ropes.

What’s the best way to identify a good real estate investment?
There are some tried and true methods for assessing the quality of a real estate investment. One is the capitalization rate, the net operating income of a property for a year divided by its market value. This can indicate if a seller’s asking price is on par with the value of similar properties.A more sophisticated way of assessing performance is the internal rate of return, or IRR, which measures a property’s average annual performance over a given period of time. ^[2] IRR factors in monthly rent collection, the lump sum received at the time of sale, and incorporates other metrics, like the change in the value of money. It can be used retrospectively or to forecast the outcome of an investment.

What are the different ways to invest in real estate?
Overall, there are many benefits, a few notable risks, and a multitude of ways to invest in real estate. It can be daunting for newcomers, but it does not have to be. There are easy ways to get involved.

Investing in REITs can be a good introduction. For accredited investors—those with at least $1 million of assets, not counting their primary home, or those who have an annual income of $200,000 individually or $300,000 as a married couple—private funds are a way to get direct exposure to real estate with the expertise of an experienced manager. Private funds can provide individual investors access to high quality properties and sophisticated investment strategies without the volatility that comes with being listed on a stock exchange.

Conclusion
However you go about it, investing in real estate contributes a lot to an investment portfolio. Real estate offers potentially steady cash flow and the opportunity for equity appreciation over time. It adds diversification that can protect you against market volatility, and it provides significant tax advantages. There are also significant risks tied to investing in real estate that, like any investment, can lead to losses if they are not properly mitigated. Experienced investment managers who know how to navigate real estate investment risks are typically able to turn these higher risks into higher returns.

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