2022-2023 have been very eventful years thus far marking a lot of peaks and troughs – record high inflation peaking at 8.5-9%, rising interest rates (5.25-5.50% fed funds target rate a of the time of this article), low unemployment of 3.7%, and a stock market decline of 25% since the beginning of 2022 with a volatile but strong rebound to follow.
For those whose savings or retirement have been placed in the stock market, the stock market tumble has been painful to watch and experience raising the question – how does one mitigate that risk and avoid a painful repeat in the future? How does one protect their retirement assets? How does one create an additional income stream to hedge against an unexpected lay off?
Real estate offers a solution that presents not only an opportunity to diversify one’s investment but also carries other benefits. As with any investment, real estate has its risks and disadvantages too. In today’s article we look to present a balanced view of that.
Pros:
1. Cash Flow: Real estate investments, whether active or passive, if managed properly, can create an additional income stream that you can re-invest in other cash flow producing assets, cover unexpected/additional living expenses, or save towards retirement. In addition, as in most cases leases are set on an annual basis, one can reset (increase) rent rates every 12 months to better adjust against the rising operating costs, including insurance and taxes and any other inflationary impact.
2. Appreciation: A picture says a thousand words. While there tends to be some price softening during recessions, in the long run real estate values continue to increase. Thus, for long term buy and hold investors, real estate creates both a strong retirement vehicle and a way to build generational wealth.
3. Diversification: Real estate presents a good diversification strategy away from the stock market. Even within real estate there are multiple asset classes (residential, multifamily, self-storage, etc.) with cyclical and countercyclical assets and some being more recession resistant than others.
4. Tax Deferral And/ Or Tax Reduction Benefits: A less known benefit of real estate is the ability to defer taxes (via depreciation and 1031 exchange) or reduce taxes (via achieving a real estate professional status “REPS”). However, the bottom line is that for tax reporting purposes: (i) depreciation can lower your passive taxable income; (ii) 1031 exchange gives you the ability to defer capital gains taxes indefinitely by exchanging the property you intend to sell for a like kind property; and (iii) by spending 750 hours or more and more than 50% of your time on real estate, you could qualify for REPS and benefit from a lower income tax rate.
5. Leverage: In simple words that means leveraging (utilizing) other people’s money (e.g. bank loan) to buy the asset, thereby increasing the return on your capital. You can then use the additional capital to purchase more cash flow producing assets. You can also refinance property after some time and invest the cash out refi tax-free income in more assets.
6. Inflation Hedge: As shown in the St Louis Fed graph above, real estate values rise over time. This presents a great hedge against inflation, which tends to erode the purchasing power of cash sitting in the bank. In addition, debt at a rate lower than inflation becomes an asset during a period of rising inflation (in essence you pay a negative interest rate on your loan). Thus, you benefit on both ends.
Cons:
1. Liquidity: Unlike marketable securities, you cannot liquidate real estate in a whim. It generally takes 45-90 days to close on a property, depending on the asset type and size. In addition, if you invest as a limited partner, most syndications have a hold period of 3-7 years, thereby limiting one’s ability to sell their ownership share. For these reasons, real estate is deemed to be a less liquid asset.
2. Starting capital: Real estate generally has a high entry ticket, as in most cases a 20-25% down payment is required to purchase an asset. Most people do not have that amount of excess capital laying around. However, there are ways to get started via own capital, crowdfunding platforms or REITs, partnering with others, or creative financing.
3. Location: The property you purchase might not be in your back yard. In addition, if not properly diligenced, it may end up being in a bad market or bad neighborhood. A change in regulation (e.g. imposing rent control) can also adversely impact your business (ability to raise rents as planned). You can do a lot of things to improve the physical condition of a property but you cannot change the market. Therefore, it is important to perform that market, submarket, and location diligence upfront.
4. Long Term Horizon/Time: In accounting terms, real estate is deemed to be a fixed/long term asset. As such, and as the name implies, it is not a get rich quick scheme vehicle. As shown in the St. Louis Fed chart above, real estate values do rise over time but it does go through cycles. As such, it does take time…and patience rewards those with a long term approach.
5. Poor Execution: This applies to any business but as the saying goes, the devil is in the details and execution. Poor execution can lead to negative cash flow, thereby turning the cash cow asset into a dog/a poor investment that not only is costing you money every month but also erodes in value. Proper planning, investment valuation, and partnering with the right team can help mitigate this risk.
6. Overleverage: Putting in too much debt on a property can be risky, especially during a downturn when cash flow might get tight. In a scenario where your cash flow is thinner and you do not have sufficient cushion to weather the storm, unless you have excess liquidity set aside, you may face challenges servicing the high amount of debt (especially if you locked in a high interest rate or have a floating rate in a rising interest rate environment), forcing you to sell the property at a loss or lose it to the lender via foreclosure. Obtaining the right financing structure and not overleveraging can help mitigate this risk.
We hope today’s quick snippet presented some food for thought and opened other ideas for you to consider as you look for ways to diversify your portfolio, manage and mitigate the risks outlined above, build wealth, and leave a legacy for your loved ones.
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.