Real Estate Investment Tips
A recent Gallup poll found that more Americans (35 percent) believe real estate is a superior long-term investment compared to those who believe the stock market (27 percent) is superior.1 Everyone seems to know someone who made a fortune in real estate, whether it’s a relative who bought a $750,000 home 20 years ago for $50,000 or an HGTV celebrity who makes money flipping houses. Plus, real estate has the added benefit of being a tangible asset, something investors can touch and see. This is in contrast to a financial product such as a mutual fund, where it’s more difficult to make a connection with the underlying businesses.
This may be why many physicians are driven to make investments in real estate. But is this the best decision for you? Before you begin your journey toward becoming a real estate tycoon, consider the following.
Consideration #1 – Type of property
Real estate comes in many different forms, and the risks and benefits associated with each type can differ greatly.
Commercial properties typically come with longer lease terms (three to five years), offering the potential for more certainty in future cash flows. However, if the market heats up quickly, longer leases can be a drawback because rental price increases are typically agreed upon in advance and you may miss out.
In contrast, residential properties and short-term rentals have the benefit of rates that can increase with market trends; however, tenant turnover is typically much higher. Other factors such as the property’s location, seasonal weather, shifting demographics and events outside of your control (for example, an algae bloom near a costal property) can have a sizable impact on the vacancy and rental rates of your property.
Consideration #2 – What’s it worth?
“Location, location, location” is a well-known motto often repeated to stress the importance of this factor in any real estate deal. It is true that value is often dependent on the subjective taste of a buyer, so a property’s location and visual appeal can impact its price. Even two units in the exact same building can have significantly different values if one overlooks the golf course and the other overlooks the parking lot.
One strategy to help determine the value for an income-producing real estate investment is to use a formula known as the capitalization (or cap) rate. The cap rate is simply a property’s income (net all expenses) divided by its market price. The resulting ratio can be compared to similar properties to provide an idea of whether the property is properly valued. You can also rearrange this formula by taking the property’s operating income and dividing by the desired cap rate to obtain an estimated value of the property.
Financing also plays a major role in making real estate an attractive investment. You can borrow 80 to 90 percent of the capital needed to purchase a property, causing profits (and losses) to be magnified by a factor of 5-10x. This means that, when interest rates decline, a property becomes more profitable and can demand a higher selling price. The opposite occurs in a rising-rate environment. Because the higher debt expense cuts into profit margins, the investment will look less attractive to a new owner.
Unlike an investment in stocks or mutual funds, you may not know what your property is worth until it is time to sell. Some investors benefit from not seeing daily price fluctuations because it helps them remain patient and focused on the long-term outcome. The drawback is that it the lack of transparency can hide a very real risk – that your property’s value has decreased, potentially leaving you underwater with less value than the amount you owe on the loan.
Consideration #3 – Your responsibilities
Being a landlord can be hard work. Properties need to be constantly maintained and, over time, problems will inevitably arise. Commercial properties have different lease types, such as net, double-net and triple-net, which determine who is responsible for operational expenses. Between running a practice, seeing patients and overseeing staff, you likely have a lot on your plate. Physicians at the peak of their careers seldom have much time to spare. If you are already burning the candle at both ends, you may want to wait to invest in real estate until you have time to manage it all. Or consider taking on the extra expense of hiring a property manager if that makes sense for your particular situation.
Speaking of expenses, for residential properties, you should expect to cover property taxes, insurance costs and ongoing maintenance expenses. Utilities are often covered by the rental tenant, but this can depend on whether the building is set up with separate meters. If you choose to hire a property manager to maintain the rental units, you can expect to pay about 10 percent of your monthly rent for the service.
One of the biggest risks in owning rental property is the liability involved. If someone is injured on your property, you can be sued for your personal assets. A lawsuit at the peak of your career can be especially damaging to your family’s long-term financial security. There are two primary ways to protect yourself in this situation:
- Consult with your insurance agent to ensure you have proper liability coverage for your rental unit(s). Consider an umbrella policy for extra protection.
- Speak with an attorney to determine if it makes sense to transfer ownership of the property to an entity (such as an LLC) to separate it from your personal assets.
Consideration #4 – Your exit strategy
When entering into any investment strategy, it is crucial to plan for the end before you begin. Determine up front whether you plan on holding the property over the long term or if you plan to renovate and resell. Your exit strategy can influence many of the input variables, such as the type of financing you choose and the quality of your finishes.
Real estate has the potential to become a very illiquid investment, often due to factors beyond your control. It can take months, even years, to find a buyer and complete a real estate transaction. You many consider setting up a line of credit with your lender in advance so that, if necessary, you can quickly tap into the property’s equity without having to sell during a downturn.
Another option – REIT
If you consider the factors above and decide that direct real estate ownership is not the right decision, an alternative is to purchase a Real Estate Investment Trust (REIT). REITs provide exposure to real estate while maintaining liquidity. Each REIT consists of a portfolio of properties, ranging from cell towers and warehouses to shopping malls and apartment complexes.
Most REITs are traded on the stock exchange, making it possible to buy or sell them at any time. The income produced by the underlying properties is passed along to shareholders in quarterly distributions. It is important to note, however, that, unlike a mutual fund containing stocks, these distributions are often taxed as ordinary income rather than qualified dividends, which can have a significant impact, especially during your high-earning years. Be sure to consult with an advisor to make sure any potential REIT investments are in line with your long-term goals.
Also, be cautious of non-traded REITs, which are popular with brokerage firm advisors because of their high commissions. Because these funds are often very illiquid and complex, it can be difficult to understand exactly what you’re getting into.
The bottom line
Investing in real estate can offer distinct opportunities and serve as a diversifier when incorporated into a standard stock and bond portfolio. The use of leverage can magnify returns and provide the benefit of “forced savings” as the loan is paid down. However, real estate investments also come with a unique set of risks, including hidden costs, added responsibilities and difficulty liquidating in unexpected circumstances.
Many investors fail to account for the “sweat equity” they invest in managing and maintaining a property. In addition, an owner may be unaware of how volatile the market is because it is not possible to check the property’s price every day.
REIT funds can provide passive exposure and diversification within commercial real estate, but they lack the tangibility appeal that draws many investors to real estate in the first place.
A final word of caution
Be aware that real estate investors, especially those in jobs like yours that are known to be high-income professions, are often a target for fraudsters through “hard money” lending programs and Ponzi schemes. Be sure to conduct thorough due diligence on any investment presented to you that promises above-market returns. Also, steer clear of any real estate investment seminars with an aggressive sales pitch. If it sounds too good to be true, it probably is.
- Jones, Jeffrey M. “In U.S., Real Estate Still Leads Stocks as Best Investment.” Gallup.com, Gallup, 12 July 2020, news.gallup.com/poll/251696/real-estate-leads-stocks-best-investment.aspx