Real Estate as an Alternative Investment

The goal of investors is to maximize their risk-adjusted return on their investments.  Traditionally, most investors do this by diversifying their investment portfolio across a range of investments that include stocks, bonds, and fixed return instruments such as CD’s and money market funds.   

Real estate is an asset class that should be an essential part of an investor’s investment mix.  Real estate investments offer outstanding returns at low risk over the long course of time, and its performance is not closely correlated with other asset classes.  Despite the turbulent times in the stock market over the last ten years, where the S&P 500 stock index produced a negative return through January 2009, residential real estate was up +4.6% per year over the same time period.  And by using the power of leverage, investment returns should be able to exceed 20% per year even with modest appreciation.

Real estate has been under-represented in investment portfolios because good property investment vehicles have not been easily available.  For many investors, their home has been their main real estate investment.  Others have branched out into Real Estate Investment Trusts (REITs), which have become increasingly popular over time.  REITs have offered good liquidity, and good overall returns, but tend to be volatile, with returns that may vary widely year-over-year.  Their other big drawback is since REIT dividend income is fully taxable at ordinary income tax rates; they are best suited for tax-advantaged accounts, such as 401(k) plans and IRAs.

Many large fortunes in real estate have been amassed by buying and holding properties to generate significant returns through cash flow and appreciation, and by taking advantage of their tax benefits, notably depreciation, long-term capital gains tax treatment, and the ability to defer tax liabilities through the use of 1031 tax-deferred exchanges.  Buying and holding properties offers some of the very highest returns, stability, and tax advantages available.  

Real estate can be owned in several forms, including commercial real estate and single family residences.  Commercial real estate, while offering compelling returns, generally requires significantly more investment capital than single family residential real estate and is more complex to acquire and manage.  Consequently single family homes represent an easier and lower risk path for first time investors.

While there are many successful investment models in real estate, they all share only one or both of the following fundamentals to build financial wealth: cash flow growth and equity build-up.  Most homeowners are familiar with equity build-up, which is driven by the appreciation of a home and/or paying down a mortgage balance over time.  Equity build-up increases one’s net worth in real estate assets.  

Cash flow relates to deriving rental income in excess of all of the cash obligations and costs incurred, including the servicing of mortgage debt.  To the extent that costs can be reduced and rents appreciate, cash flow will grow over time. 

Some of the best and most stable investment models combine both equity build-up and cash flow growth.  The pre-tax gains from cash flow growth and equity build-up are added together and projected out over a ten year period under a set of modest assumptions about property, rent, and expense appreciation.  The resultant total return on investment (ROI) is then expressed as a compound annual growth rate, or CAGR.  The ROI CAGR is the best single metric for judging the investment potential of an individual property and it can be used to compare real estate investment returns to other investment classes, such as equities (stocks). 

It is important to investment properties that combine appreciation and equity build-up with cash flow growth.  Properties must be selected with very strict and specific criteria relating to property appreciation potential, cash flow growth, and risk.  Investors should be able to always realize positive cash flow with a 20% down payment, even after expenses related to vacancy, repairs and maintenance, property management fees, taxes, insurance, and mortgage payments.  It is important for investors to choose structurally and cosmetically sound properties, obtain excellent tenants, and use a professional property manager.  

Investing in recent years has certainly not been easy.  Fortunately, real estate, especially single family properties, has been and is projected to provide some of the best risk-adjusted returns available to investors, and should be a central part of an investor’s portfolio diversification strategy.