Real estate can be a good way to diversify your portfolio. There are several ways to access this market, depending on your capital and risk tolerance. Residential real estate can be capital intensive, but can also be potentially lucrative. Buying, selling and renting property can be big business, even at a relatively small level. Even retail investors can access the real estate market through portfolios and fund-based investments.
Have questions about whether residential real estate investments are a good option for your portfolio? Consider reaching out to a financial advisor.
Why Invest In Residential Real Estate?
Real estate is a famously volatile market. It entails a lot of risk, because volatility can mean plenty of downside. It also means the potential for outsized rewards. If you can find the right properties or assets, you can add a lot of value to your portfolio.
Real estate also diversifies your investing strategy. While the price of housing is related to securities (prices will generally fall during a recession, for example) the two remain distinctly different markets. By investing in property, you add an asset class that’s separate and apart from more market-based investments like bonds and equities.
When investing in residential real estate, consider two issues in particular:
- Remember your opportunity costs against traditional assets. If you’re looking to generate rental income, compare likely gains against what you could get from a Treasury or AAA corporate bond. If you’re looking to buy and sell homes, compare the market’s price increases against a simple S&P 500 index fund. While this isn’t the entire analysis, a good place to start is by asking how much a given real estate investment will net you compared to a traditional asset.
- Remember that real estate prices and returns vary widely depending on location. Broader indicators like national list prices won’t actually tell you much about your investment, because the profile of a property in (say) Trout Lake, Michigan is entirely different from one in Manhattan, New York. Make sure to review the local data for an investment, not just general market returns.
Your Own Home
If you own your own home, you’ve already invested in residential real estate.
There’s a lot to take into account when considering your home as an asset. The annual costs of owning a home are significant, and usually ignored when people calculate their property value returns. The same is true for interest on the mortgage. And after you move, you’ll still need someplace to live. Depending on your needs, this might eliminate any returns from your home sale.
That said, selling your primary home can be a significant tax and market windfall. If your home has appreciated significantly, you could make a lot of money by selling, especially if downsizing into a smaller, less expensive place is part of your strategy. As an individual, you also don’t pay taxes on the first $250,000 in profits off a primary residence sale (or $500,000 for a couple), making this one of the most tax-advantaged investments the IRS offers.
Second Homes
You can also buy, rent and sell a second home. This can get more complicated than managing a primary residence, but with higher risk comes the potential for higher reward. The IRS allows some tax deductions for a qualifying second home (such as mortgage interest) and these tend to be easier to finance than a dedicated investment property.
For a property to qualify as a second home, you must spend at least 14 days out of the year living there. Essentially, this has to be a place that you use, even if only occasionally.
Many people typically generate a return on their second homes by renting them out. This can offset the costs of owning your vacation property, and can even generate a profit depending on costs, location and demand. The IRS will tax your profits as ordinary income. You can even own multiple second homes, as long as you meet the minimum annual residency requirements on each, which can potentially generate considerable income in the long run.
However, as an investment, a second home is still extremely capital-intensive. You need enough spare cash to take out a second mortgage, meaning you’ll need the down payment at a minimum.
Dedicated Rental Properties
Owning dedicated rental properties is a different approach from a second home. With a dedicated rental, you do not spend any amount of time living on the property. You hold this asset solely for the purpose of renting it out. While rental properties can take many different forms, they almost all fall into either the long- or short-term category.
A long-term rental is an apartment or a rental house. Here, you are a landlord. You buy a property and rent it to a tenant. You collect rent (typically monthly); pay the costs of financing, maintenance and other necessary overhead; and keep whatever is left as income. Active investors can manage the property personally, handling tenants and maintenance issues on their own. More passive investors can hand the property off to a management company, which typically takes a percentage and then passes the remaining profits along.
A short-term rental is one that you rent for 30 days or less. This is an extremely important number. In almost all jurisdictions, tenants’ rights begin after 30 days. As a short-term rental, it is often advised to never consent to someone staying even one day longer than the jurisdiction’s tenants’ rights limit.
Short-term rentals are properties like cottages, vacation homes and Airbnb apartments. In this case, you rent to someone for a few days or a few weeks at a time. You pay the costs of maintenance, financing and other overhead, collect rental payments, and keep the difference as income. These properties are more volatile, because you need to keep finding new renters, but can be more lucrative and involve far fewer legal issues than tenancy.
The IRS taxes dedicated rental income as business income. You can write off the costs of running your business and will typically pay income taxes on any remaining income. As with a second home, dedicated rentals are an extremely capital-intensive business. You need enough money to buy a rental property, and financing costs are typically high for this kind of business mortgage.
REITs
A real estate investment trust, or REIT, is a fund-based investment built around real estate assets.
Like a mutual fund or an ETF, a REIT holds a portfolio of individual, underlying assets. As an investor, you buy a number of shares of this portfolio, and your returns are then based on the collective performance of these underlying assets. The exact nature of the portfolio is based on its organizing theme and investment strategy.
This can give you a number of different entry points into real estate. For example, you might invest in a mortgage-based REIT. In that case, the portfolio would hold mostly debt assets (mortgages), and the return would be based on the interest paid on those loans. Other portfolios might be organized around rentals. In that case, the fund might own and operate a number of rental properties, or might invest in a number of rental companies, and the returns would be based on the underlying rental incomes.
Depending on your results, REITs can be lucrative relative to the market at large. Some estimates put the average annual return for this sector at almost 12%, slightly higher than the S&P 500. More importantly for a retail investor, REITs are a capital-light way to invest in real estate. While most funds have a minimum requirement, the several thousand dollars it might cost to invest in a REIT is still a small fraction of the costs of buying real estate outright.
Flipping
House flipping is another real estate strategy that has grown in popularity. With flipping, you purchase a property, make improvements, and then hope to sell it for a profit. This practice is somewhat tax-advantaged since, while you cannot use the home sale exclusion, you might only pay capital gains taxes on your profits.
There are numerous risks associated with house flipping. You are essentially betting the value of an entire mortgage that you can sell this property quickly. Your costs are extremely high, since you are responsible for paying transaction fees, mortgage financing, and the capital costs of upgrading the property. All of this puts a lot of pressure on making a fast, high-value sale. Flipping is most often engaged in by contractors or real estate professionals.
Bottom Line
Investing in residential real estate can be very profitable, although this is often a capital-intensive sector. One of the biggest questions is whether you will use the property yourself. If so, you might consider a second home. If not, other options include dedicated rental and investment properties. For those who prefer not to get into physical real estate, real estate investment trusts present another opportunity.
Residential Real Estate Investment Tips
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- There are some essential tax and investment differences between a second home and an investment property. This can affect everything from how you pay taxes on your profits to how you finance your initial investment.
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