Investing in your Real Estate Can Diversify Portfolio and Add Income

Key Takeaways:
  • Real estate can serve as a useful tool for portfolio diversification and potential income generation.
  • Investors can explore options like ETFs, REITs and private REITs based on their goals, risk tolerance and liquidity needs.
  • Tax considerations play an important role in evaluating and managing real estate investments.

 

For investors entering their distribution years – the time of life when the retirement portfolios they have built start paying off – investing in real estate can yield strong returns and steady income. But the thought of owning rental property and being a landlord does not appeal to many investors.

Real estate investment need not put you in a position to manage your own properties and pay for repairs. There are many ways to add passive real estate investments to your portfolio and provide monthly income in retirement.

While real estate values may be changeable in the short term and are sensitive to interest rates, over the long term they tend to rise steadily. As an investment, real estate can bring steady growth to your portfolio that is less vulnerable to the fluctuations of the stock market than other investments.

Real Estate Investment & Asset Allocation

The performance of real estate investments is not necessarily correlated with the stock market, and that’s one of the factors that makes real estate an attractive addition to most portfolios. It provides diversification, along with a buffer against the winds of the stock market. When the market is down, a real estate investor still gets that monthly dividend check.

To maintain a healthy level of asset allocation, we typically recommend that investors hold their real estate investments to approximately 5% to 10% of their portfolios.

Additionally, investors should consider their time horizon. A buy-and-hold strategy for at least five to 10 years with real estate is recommended, particularly if the steady dividends will be an important piece of your income.

The most common real estate investment options for individual investors include:

Exchange-Traded Funds (ETFs)

For investors who are inexperienced in managing parts of their portfolio online, buying a real estate investment through an ETF can be a good way to dip a toe in the water. Many types of real estate investments are available in ETFs, including commercial, residential, warehouse and multifamily properties. Moreover, many of these funds include properties outside the U.S. that may be appreciating quickly.

These types of ETF investments offer easy liquidity, so you can generally buy and sell whenever you are ready. They typically have no minimum investment requirements, other than the share price of the particular fund you decide to purchase. (Fractional shares are not available.) This enables you to make a small initial investment to see how it performs for a while, then decide whether you want to make a more significant investment.

There are few disadvantages to real estate ETFs. However, investors should be prepared for a higher degree of volatility due to the liquidity.

Real Estate Investment Trusts (REITs)

A REIT is trust company that raises capital through an initial public offering, which is then used to buy, develop, manage and sell real estate assets. The trust then sells units of investment, and each investor essentially buys a portion of a managed pool of real estate. As an investment, a REIT is similar to a mutual fund, except it is made up of real estate assets rather than equity shares.

The pool of assets contained in a REIT generates income through renting, leasing and selling property and distributes it directly to the REIT holder regularly, i.e., monthly or quarterly.

As with mutual funds, there are many different types of REITs, including:

  • Equity REIT: This is the most common type of REIT. This entity buys, owns and manages income-producing real estate. Revenues come primarily through rents and not from reselling the portfolio properties.
  • Mortgage REIT: Also known as an mREIT, this entity lends money to real estate owners and operators. The lending may be either directly through mortgages and loans or indirectly through the acquisition of mortgage-backed securities. Earnings come primarily from the net interest margin — the spread between the interest they earn on mortgage loans and the cost of funding these loans.
  • Hybrid REIT: This type of enterprise holds both physical rental property and mortgage loans in its portfolio.

The benefits of investing in REITs include broad diversification in the real estate portion of your portfolio. They require no management on your part, and they typically pay a dividend stream that provides steady income.

Like ETFs, REITs involve no ownership of physical property, so the investor does not pay for property taxes, insurance, utilities and other property-related costs. Also like ETFs, REITs typically do not have investment minimums. However, if you are looking for a certain income stream, the investment will have to be at a level that will generate your desired dividends.

Private REITS

A private REIT buys and leases real estate, collecting rent on the properties and then distributing that income as dividends to shareholders, similar to a standard REIT.

However, a private REIT is a type of real estate investment trust that is exempt from SEC registration, is not subject to most SEC regulatory requirements and is not listed on a major exchange.

Generally, you have to be a qualified or accredited investor to buy private REITs, and they are often sold to institutional investors.

Typically, there are requirements for minimum initial investments, anywhere from $5,000 to $100,000.

Private REITs are less liquid than standard REITs or ETFs, and an investor may have to wait to get into a specific private REIT. There can be a wait on the other end, too, delaying an investor from selling their interest if the fund company is oversubscribed. For the good of the investment, the fund company can limit the amount of money leaving the REIT at any one time. This rarely happens, but it does mean that the private REIT is not as liquid as other investment options.

The benefit of minimized liquidity, however, is a lower level of volatility.

Investment in a private REIT is more nuanced and usually accomplished through working with a financial advisor who understands the rules and can determine if it is the right fit for an investor’s portfolio.

Tax Ramifications of Real Estate Investment

One significant tax benefit of holding real estate investments is that only 80% (not 100%) of the dividend income is subject to federal income tax, under Sec. 199a of the Internal Revenue Code. (It’s important to note that this provision of the Tax Cuts and Jobs Act of 2017 is scheduled to expire at the end of 2025.)

Individuals who currently own and manage rental properties should not overlook tax-advantaged methods of disposing of their existing properties and reinvesting in real estate funds.

One client owned six residential rental properties in Kansas, but she no longer wanted to manage them day to day. She sold all of the rental properties and rolled the proceeds into a 1031 like-kind exchange, putting all of the money into a REIT, which became the exchanged property. As a result:

  • She deferred federal income tax on the sales of the properties for her lifetime, and when she dies, her children will get stepped-up basis and will owe no capital gain taxes.
  • She receives income every month from the REIT.
  • She no longer has to worry about managing the properties.
Questions?

Real estate is an investment, offering less volatility than the stock market and may provide gains over time, as well as the potential for current dividend income.

If you would like to discuss real estate investments as part of your portfolio, contact an Adams Brown Wealth Consultant.