An Attorney’s Guide to Real Estate Investing

“My Take” article from Housing News report by ATTOM Data Solutions

Real estate investments have become an attractive alternative to investing in traditional investments such as stocks, bonds and mutual funds. In fact, it has become a significant method to build wealth for generations. While purchasing a home is a worthwhile investment, adding real estate investments to a portfolio can add a powerful hedge and strong foundation as compared to the volatile stock market. In this article, we will explore several of the opportunities that real estate investment provides, along with the pitfalls to expect while investing.

Owning Rental Property

Rental properties have been around since the nation’s founding and have been a popular wealth generation tool for generations. With a rental property, the owner is usually responsible for paying the mortgage, taxes, insurance, and maintenance costs for the property. Typically, the investor will purchase a rental property with the hope that the amount of rent received will cover most, if not all, of the costs associated with owning the property.

This strategy requires patience, as there may not be enough in rental income to provide much profit until after the mortgage is paid off. Once the mortgage is paid off, however, most of the rent collected will become profit. This result is known as a “cash-flowing” property.

There is another benefit to owning rental property: appreciation. Owners receive all of the financial benefit that comes with the property’s appreciation in value, including any improvements to the property. On top of cash flow, this is the most significant benefit of owning a rental property. Based on the location of the property, appreciation rates may vary, but the value of the property can increase by double digits over a relatively short period, particularly in high profile regions such as Southern California. The neighborhood where the property is located will influence the type of tenants you will have, and your vacancy rate. By choosing the right neighborhood, you reduce the risk associated with high tenant turnover rates. Choose the wrong area, and you may be saddled with bad tenants, lower rent, and damage to your property.

There is also concern over the maintenance of the property. Many times, a rental property will need exterior and interior work after it is purchased. The difference between being a landlord and participating in other types of real estate investments is the amount of time you must spend renovating and maintaining it. You could hire a professional management company, but then, of course, you would have to deduct that expense from any potential profits gleaned from the property.

Fix-and-Flip Properties

This type of investment has become very popular because of a massive number of older homes hitting the market since the 2008 recession. Reality television shows have furthered the popularity of fix-and-flip investments. The fix-and-flip strategy is the opposite of buy and hold. It is similar to trading stocks, in that, an investor identifies an asset that could potentially make him or her a profit, purchases the asset, and “flips” it for a profit.

Most investors who employ this technique buy a home with the intention of holding it for a short period of time, usually six months to one year, and reselling it. The strategy can be challenging, in that the investor needs to identify properties that are significantly undervalued for their neighborhood while ensuring that the cost of repairs or renovation will not eat up too much of the potential profit.  The recent recession provided ample inventory and opportunity; however, many contend that opportunities in larger markets like California have become oversaturated.

The lower value must provide enough equity so that the investor can make improvements and still be able to sell it at market value and earn a profit. Another challenge is that the improvements to the property have to be appealing enough to compel prospective buyers to accept the market price. However, there is a risk that an investor will be unable to sell the property for whatever reason, saddling them with those expenses associated with the property, namely, the mortgage and maintenance.

The costs associated with purchasing this type of investment are also high. Many times, flippers will have to take out a short-term loan, typically with a much higher interest rate than a traditional mortgage, to outbid competitors. If the property doesn’t sell or they run into problems with the renovation, the investor may get stuck making those high mortgage payments for many months, or be forced to dump the property for a loss.

Real Estate Investment Groups

Real estate investment groups are a type of investment vehicle, similar to a mutual fund, which invests into rental properties in specific markets. This strategy is a good investment for those who like the idea of owning rental properties but don’t want the headache associated with collecting rents, maintaining the property, and filling vacancies.

Under this scenario, a management group will build or buy rental properties, typically apartment buildings and multi-family dwellings, and hold them in a rental portfolio. Individual investors are then asked to join the group with one or more properties that they own, but the management company will take care of the duties related to operating all of the properties held in the group. In exchange for overseeing the group of properties, the management company will receive a percentage of the total rents collected.

Typically, the investor still holds the lease for his or her property, while contributing a portion of the rent into a fund each month to cover the management fees and other expenses shared by the group. There are several variants of this type of real estate investing group depending on the type of property you own, the area where the property is located, and the kind of returns your property generates. Research is key to finding the right group for you.

Real Estate Limited Partnerships

A real estate limited partnership (RELP) is similar to an investment group in that it holds and maintains a rental property or a portfolio of rental properties. However, a RELP is an entity that is formed to hold these properties for only a specific number of years.

An experienced real estate property management company typically acts as the general partner. Individual investors are invited to provide capital in exchange for an ownership share of the limited partnership. The partners in the venture typically receive periodic income distribution based on the rental income that the group of properties generates.  Depending on the terms of the partnership, the properties are sold for a profit, the partners split the proceeds, and the RELP is dissolved.

This investment strategy allows investors to participate in the real estate market without having any previous real estate investing or management experience. The downside is that since the properties are held for a specific period, the money you invest may be tied up for quite some time.

Real Estate Investment Trusts

A real estate investment trust (REIT) is similar to a RELP, except that the properties form a holding trust. The trust is converted to certificates, similar to a stock, which is then sold off to individual investors.

In a REIT, a corporation acquires a group of income-generating properties that it holds and manages. These properties may include medical buildings, office buildings, malls, or other high-capacity rental properties. The money raised from the certificate sales is used to finance the purchase of additional revenue-producing properties to be held by the trust.

The revenue generated from mortgages or rents on the REIT’s properties is distributed to the certificate holders on a regular basis and is a good strategy for real estate investors that want a steady rental income without the hassles of being intimately involved in the buying and management of physical properties.

Real Estate Mutual Funds

Real estate mutual funds invest in REITs and other real estate-related companies. Investing in real estate mutual funds allows individual investors to dabble in real estate without risking much capital. Mutual funds invest in a diversified group of real estate assets, therefore reducing risk and exposure to the investor. By using this approach, they allow individuals to participate in a broader range of real estate investments than provided by REITs.

With real estate mutual funds, novice investors can get involved in real estate after making an educated and informed decision. Mutual funds have a wealth of analytics and other data that can provide investors with all the tools they need to diversify their investment into those sectors of the industry that makes the most sense for their investment goals.

Why Real Estate is a Great Investment

Real estate has proven to be a great wealth-generating tool over the past several decades. Even after factoring in the housing crisis of 2008, private commercial real estate investing returned 8.4 percent annually over the decade of 2000 to 2010.

Real estate investing is also a great way to diversify a portfolio of stocks and bonds. Historically, real estate has low volatility compared to the stock market. While stocks can lose nearly all of their value, it is improbable the same will occur with physical real estate that you own.

Diversification of Your Asset Portfolio

Most people are invested in the stock market in one way or another, be it through work retirement programs or private investment. With real estate, an investor can hedge against a market downside by owning tangible assets, with low risk of severe devaluation.

Real estate has a negative correlation to the stock market. Meaning that when the stock market drops, real estate-related investment products are usually up. Although the Great Recession was somewhat of an anomaly, residential real estate prices continued to rise after 14 of the last 15 recessions.

Inflation Hedge

During expanding economic conditions like we are experiencing now, demand for housing rises. When demand rises, rents and values rise along with it. In this respect, the correlation between
GDP growth and real estate passes some of the inflationary pressure onto tenants, while generally retaining the purchasing power of the investor’s capital.

Leveraging Capital

Most real estate investing offers the power of leverage. Other investments, such as stocks or bonds, require the investor to pay the full value of the investment, whereas with real estate a buyer can leverage his or her credit and assets to finance the investment strategy.

Investors often obtain a second mortgage on a property they already own to place a down payment on another income-producing or flip property. No matter their plan for the investment property, they have leveraged a fraction of the assets they already own to purchase additional assets, without having to come up with the full price of the property out of pocket.

Flippers especially take advantage of this power of leverage. While most conventional mortgages require 20 percent down payment, many investors turn to alternative private lending to complete a transaction. With a private loan, an investor can leverage his or her existing assets, or the future value of the property to secure higher loan-to-value financing.

Real estate flippers especially like utilizing private lenders, where they can obtain quick financing based on the future value of the property after it is renovated, and their track record of making profitable decisions. This option offers them the flexibility to put up less cash and leverage more of the asset’s value against the potential to make a profit.

Drawbacks for Real Estate Investing

The most significant impediment to investing in real estate is illiquidity. Most real estate investing requires patience and a longer-term commitment to achieving a profit. Unlike stocks or bonds, which are traded daily, real estate takes time to liquidate and convert to cash.

Another drawback to real estate investing is the market itself. While economic upswings can have a positive effect on rents and property values, local or regional issues can result in a drop in value for specific neighborhoods. If an investor is over-leveraged by carrying too much mortgage debt on individual properties, he or she could become stuck, unable to sell the property if values drop significantly. Most investors realize this risk and balance their mortgage debt against current property values appropriately.

Final Verdict

Real estate investing makes good sense to balance out an investor’s portfolio of stocks and bonds, mutual funds, and physical commodities. While real estate investing is generally accepted as an “alternative investment,” it can help investors hedge against wild stock market swings, provide appreciation and a steady income stream, and improve balance to an investment portfolio of securities and other physical assets.