Real estate as an investment asset class. What are the merits, what are the pitfalls and how do you avoid them?
From the beginning of the century through the end of 2021, the FTSE NAREIT All Equity REITs Index gained 9.6% versus 7.7% for the S&P 500. It has been one of the best investment asset classes out there. Now, that’s not been as true since interest rates started climbing, but when this interest rate cycle is over, we can expect improved performance from real estate.
Now that’s important. What I gave you were statistics for the entire real estate environment, and it does vary by sector. Office properties may not be the best properties to be invested in in this post-covid environment. For those of you who are interested in investing in real estate, you have a choice between physical real estate and what are called REITs, real estate investment trusts.
Let’s talk briefly about the merits of real estate. Steady cash flow, appreciation, diversification, and it’s a great diversifier because often there’s a negative or very weak correlation between real estate and stocks and other investments. So that makes it a great diversifier. It’s tangible. You can’t print real estate. There are enormous tax benefits and we’re going to talk about them in great detail in some of the following posts. But most people know that you can deduct your mortgage interest, your property taxes, and as an investor even depreciation.
It’s a phenomenal inflation hedge in this period where we’re worried about inflation and that inflation hedge can be supercharged if you have a low interest mortgage because not only are you getting inflation value from the property, but inflation is devaluing the mortgage. So REITs, real estate investment trusts, are basically portfolios of real estate investments and that can be by sector. Commercial real estate, multi-family, storage units, you name it. They enjoy most but not all of the benefits of physical real estate and they’re a lot easier to manage. They must pay out 90% of their earnings by IRS rules.
REITs are professionally managed and that can be sweet and as I said, you can diversify sectors. Multi-family, industrial, retail. So the tax benefits of real estate at a high level, of course you’ve got your mortgage deduction. Now, if it’s a personal home, that’s limited. There are caps on the size of the mortgage, things like that, but not for investment properties. You can deduct the property taxes, you can deduct other ancillary expenses and that can be very useful.
Depreciation. Depreciation is the devaluation of a property through wear. There’s all sorts of depreciation schedules. The only thing with depreciation that’s a concern is when you sell depreciation. If the property’s gained value, you have to recapture that deduction and we’ll talk about how to manage that. There’s something called a 1031 exchange, a lot of requirements, property identification, where you’re going to put the money if you can’t find a property. Then last but not least, qualified opportunity zones. A way to absolutely wipe out large capital gains.
So we talk about real estate. Let’s talk about physical real estate. Physical real estate has more merits than REITs, but it also has challenges. One of the biggest merits I think for physical real estate is not only is it a great inflation hedge, but you’ve got a mortgage on it. If you’ve got a low enough mortgage, inflation at today’s rates are paying your mortgage in essence while your property is going up in value.
The thing that I think most investors miss with physical real estate is the investment when you factor in the value of your time does not return nearly as well as the bottom line in cash. If I put my time in at $100 an hour and I’m spending 100 hours a year on it, that’s another $10,000 worth of expenses that don’t show up on paper, but are very real if there were other things you could have done with your time and made money with that. Frankly, most investors, their time is worth more than $100 an hour.
You also have the risk due to lack of diversification. Unless you’ve got a number of properties, maybe even in a number of different parts of the country and in a number of different sectors, you have very highly concentrated risk. One of the risks that’s often overlooked is the legal risk. The lawsuit risk. Landlords, especially of residential property are frequently sued and it can be for silly stuff. There are a number of attorneys out there who work on contingency and don’t have enough to do, and will think nothing of filing a nuisance lawsuit. It’s almost green mail.
So you’ve got management, you’ve got loss at risk, you’ve got the benefit of inflation and finally, illiquidity. You can’t always get your cash as fast as you need it. You can’t always sell the property as easily as possible. So should real estate be in your portfolio? Absolutely. But let’s go in with our eyes wide open. This is the first of a series of five videos and I’m going to label these videos clearly. So you may or may not feel it’s relevant to you. If that’s the case, let’s not waste time. That’s why I’ve broken it up into five short videos. We’re going to talk about depreciation deferral, 1031 Exchange, qualified opportunity zones, Delaware statutory trusts. All sorts of sophisticated methods to manage the pitfalls of investing in real estate.
If you want more information or more further conversation on this topic, please call, email me. We’ll be happy to set aside time to talk about this topic. We wish you the best of investment success.