Some Thoughts on Investing in Real Estate

A reader asks:

I’m a doctor and a lot of my colleagues are getting into real estate. There’s a group that invests in local deals in our area and all I have to do is write a check (no property management, upkeep, dealing with tenants, etc.). What are your thoughts on investing in real estate?

Maybe it’s a sign of the times and where we are in the economic cycle but I’m hearing more and more people talk about investing in real estate again. This would have been unfathomable back in the 2008-2012-ish time frame.

Before getting into my thoughts on investing in real estate, I would start out with some fairly simple questions:

  • Are you maxing out your 401(k) or SEP-IRA?
  • Are you maxing out an IRA (backdoor Roth could also be a decent option for a high-earning doctor)?
  • Have you paid off high-interest rate debt?
  • Are you funding a 529 plan for your children?
  • Are you making contributions to a taxable investment account?
  • Do you have enough money in a liquid savings account to cover variable expenses?

If your answer is no to any of these questions then putting money into real estate or any other alternative investment structure is probably not a great idea. This isn’t true for everyone but it is for most savers and especially those who are looking to venture into other areas of the investing universe without a ton of background in the space.

With that caveat, it makes sense to look at the characteristics of real estate investing to get an idea of what you’re getting into. I’m no expert but as with any investment, there needs to be a legitimate due diligence process and philosophy involved for things to work out. I would want to have answers to the following questions before taking the plunge into any real estate deals:

Why are you investing? Some real estate investors are interested in cash flow or income. Others are in it for price appreciation. The reasoning behind any investment is a simple, yet often overlooked first step. Over the long-term, real estate more or less keeps up with inflation, on average. If you’re banking on price appreciation — through either the use of leverage or the local real estate dynamics — you have to be realistic about how difficult it can be to time these cycles.

How will you invest? There are a number of different avenues to explore in real estate. You could buy and manage your own properties, get into syndicated deals, sign up for a crowdfunded deal, or invest in publicly traded real estate investment trusts (REITs). Anything more complicated than REITs will require more time and effort as well as less diversification and liquidity. There are also different tax ramifications for each structure.

What are the risks? The biggest risk in private real estate deals is the problem with diversification, or rather a lack thereof. You’re basically putting all of your faith in a single region, city, area, neighborhood and local economy. It takes a decent sized portfolio to build up enough properties to be considered diversified and even then the risks are much greater than investing in a simple low-cost REIT ETF. For most people, their own home is already their biggest asset so owning more real estate could actually make it even harder to diversify because it will make up such a huge piece of your portfolio (depending on your net worth of course).

The other risks are project specific. Do you understand what it takes to be a landlord? Are you comfortable hiring a management company to tend to your properties and tenants and paying them a cut?

How does this investment fit with the rest of your portfolio? You could make the argument that investing in real estate will diversify a portfolio of publicly traded stocks and bonds by providing income and exposure to an uncorrelated asset class. But those correlation benefits must be weighed against the fact that you’ll likely buy local where you also own a home and work. Betting too heavily on your local economy could be an avoidable and unnecessary risk factor.

What’s your edge? This is the most important consideration in this exercise. Investors in any asset class or strategy should always have an answer to this question. Do you have experience in the space or will you outsource most of the knowledge and management to experts? How will you vet and gain access to deals? If you do choose to outsource, what are your criteria for selection? What do you know about the real estate space that others in your area may not?

Are you looking to pick up properties on the cheap? Buy in desirable locations? Find properties with stable cash flows?

I’ve asked a lot of questions here but haven’t provided a lot of answers for a reason. Investing in real estate isn’t for everyone. If you do it as a hobby you will most likely fail because there are professionals who know far more than you do.

Real estate can be something of a prestige investment class because it gives people something to talk about. A portfolio of low-cost mutual funds or ETFs isn’t nearly as stimulating in conversation. But for the majority of people, it doesn’t have nearly the same risks.

I have no problem with investing outside of publicly traded securities.

But you should have a good reason for it beyond, “that’s what my colleagues are doing.”

Further Reading:
Pros & Cons of a 30 Year Fixed Rate Mortgage