Want to diversify your portfolio? Looking to hedge the next equity bear market?
“The industry sectors and the S&P 500 index show a nearly 90% correlation when we look out five years. However, real estate stands uncorrelated from the pack.” In all the U.S. equity bear markets of the past 60 years, the only asset class to perform as well as bonds has been residential real estate. And from 2000 to 2016, real estate outperformed the stock market by approximately 100%.
So why don’t more people invest outside traditional stocks and bonds? Lack of information.
In this article, we talk to famed American businessman Than Merrill and others to determine the best way to add real estate to your portfolio…
Investors considering expanding their exposure to real estate have two primary options:
- Purchase ‘brick-and-mortar’ investment properties (cash flow real estate), and collect rental income.
- Buy shares of real estate investment trusts, or REITs (actively managed real estate investment portfolios, traded on exchanges), and collect income through dividends.
According to Merrill, the key to a diversified retirement portfolio — and retiring comfortably — is investing in rental properties and a diverse selection of REITs.
Cash Flow Real Estate
A rental property, a type of a buy-and-hold asset, delivers positive cash flow from day one. As the property owner (the investor), you receive monthly payments from the occupant (rent-paying tenant) of the property.
Cash flow properties provide attractive and stable income.
You earn income from day one, plus a lifetime stream of monthly rental payments.
And while dividends from REITs fluctuate with the market (i.e., volatility), income returns from brick-and-mortar real estate investments remain stable and have historically grown.
- When you purchase the property outright — as you can in Detroit, with prices under $60,000 — you can use all the income to generate wealth.
- If you finance the property, most of the rent you receive will likely go toward the mortgage until it’s paid off, but you’ll be building equity with little to no money out of your own pocket.
Brick-and-mortar real estate allows the investor to maintain control.
When considering your options, you can see, touch and smell each property before purchasing it. You can also research the local rental market and examine data on how similar properties have recently fared. In addition:
- If you work with the right property investment company, the home you purchase will already be occupied by pre-screened, rent-paying tenants.
- If you hire a skilled and experienced property management company to handle the day-to-day landlording affairs, you’ll earn your income passively — hands off and stress free.
Additionally, you always have something physical to fall back on.
Even if the economy tanks, and your property loses value, you still have a tangible asset. And as long as you have tenants, you have a monthly income stream.
Direct investment in real estate offers a high tangible asset value, with appreciation.
Since 1776, U.S. real estate has doubled in value every 20 years.
If you renovate your property, you can increase:
- The value of the property.
- The rent you charge your tenants, and the income you receive from these payments.
- The profit you make if/when you choose to sell the property.
Rental investments regularly bring returns (ROI) far higher than those achieved by most REITs. In Detroit, for example, ROIs are commonly in the double digits, often upward of 20%.
Physical investment properties allow investors to defer taxes, as well.
- Each year for 27.5 years, you can depreciate part of the value of the property as a tax deduction.
- Also, by using the 1031 exchange, you can sell your property and, as long as you ‘replace’ it with a ‘like-kind’ property, you can defer tax payments. In theory, you can continue deferring capital gains on each property until death, potentially avoiding taxes altogether.
Of course, a diversified retirement portfolio must consist of more than rental properties. “And, as far as I am concerned, nothing compliments a rental portfolio quite like real estate investment trusts (REITs),” says Merrill.
REITs, or collections of real estate-related assets, are traded like stocks on major exchanges such as the New York Stock Exchange. Typically comprised of residential, commercial, industrial and/or agricultural real estate investments, they may also include storage units, mortgages and malls.
“The primary problems with REITs is that they offer a less attractive rate of return while doing nothing to temper stock market volatility,” says Ajay Gupta, CEO of Gupta Wealth Management. “But for some clients, the liquidity factor is a reasonable tradeoff for taking on additional risk.”
Indeed, unlike brick-and-mortar investments, which can sometimes take time and money to move, shares of REITs can be sold quickly for cash.
REITs can also be a reasonable choice for real estate investors who do not have the capital for direct investment, even in Detroit.
While you can invest directly in a variety of rental properties in multiple markets, REITs make real estate diversification easier — you can either invest in a diverse selection of REITs or select a specific REIT that is in itself diversified (e.g., by property type or geographic location).
There are also REITs that pay dividends, so though earnings do not result in direct cash flow, they do earn income in your portfolio.
Since rents and values tend to increase when prices do, REITs can protect against inflation, too. In fact, as measured by the Consumer Price Index, REIT dividends have outpaced inflation in all but two of the last 20 years.
As with all investment types, REITs do come with risks (e.g., you’re not involved in the investment selections); nevertheless, says Merrill, they “are a great way to hedge against the inflation that is likely to occur between now and the time you do in fact retire.”
Rental properties, meanwhile offer savvy investors “a great opportunity to not only compliment their diversified retirement portfolio, but pad their retirement coffers with one of the best cash flowing investment opportunities out there.”
At Pioneer Homes, that’s our focus: finding you the right rental property, in the right place, at the right price…
[Schedule a free consultation with our Director of Investments today.]