The Diversified Blog

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Risks of Owning Real Estate

Is Real Estate Investing Right for Me? 

 

The hot real estate market in Boulder and Denver has generated a lot of interest from investors who wonder whether they should get in on the real estate action instead of investing in the stock market. I don’t blame people for wondering. Through both the popular press and word of mouth, success stories abound, suggesting that an investment in real estate may offer a more reliable ride to easy street. 

 

Is the hearsay worth heeding? I’ll explain more in a moment, but here’s the bottom line: There is solid academic evidence suggesting that the real estate market often marches out of step with stock and bond markets, and that it has its own risk/return story to tell. That means that a sensible (typically, small) allocation to real estate may make sense within a well-crafted, globally diversified portfolio. 

 

But, as with any investment, there are rational and speculative ways to go about incorporating real estate into your portfolio. Let’s look at the differences. 

 

A Tale of Risks and Expected Returns

First, let’s debunk that myth that real estate is less risky than the stock market. Whether you’re investing in real estate, stocks or bonds, remember this #1 rule of investing: Risk and expected return are almost always related. There are rarely, if ever, dependable opportunities to earn greater rewards without accepting greater risks.

 

Some of the risks to be aware of in real estate investing include volatility, concentration and leveraging. 

 

Volatility Risks  

If you’re invested in a piece of property or similar venture, it may feel less risky than the stock market because you won’t see its value continuously fluctuating the way you do with a stock or stock fund. That’s your investment’s volatility, or how much and how often its value moves up, down. 

 

You can Google “Apple” and watch the share value fluctuating right in front of you. You can’t do anything like that with a piece of property, so it may feel as if you’re on more solid ground. In reality, the value is still frequently fluctuating with every new bit of news, and chances are it’s fluctuating more wildly than if you had invested the same chunk of change in a 50/50 portfolio of structured stock and bond funds.

 

Concentrated Risks  

When we help clients invest in real estate, we want to help them maximize available returns from that market while minimizing the risks involved. 

 

One of the biggest risks to eliminate is the risk of owning too few properties. Individual properties can be mismanaged or burn to the ground. Renters can default. Neighborhoods decline. Local governments claim eminent domain … there’s almost no end to the misfortunes that can wipe out the worth of concentrated property investments. 

 

Fortunately, this form of risk is also one of the easiest to eliminate with a simple and obvious solution: Instead of trying to get lucky on a concentrated real-estate bet, invest in well-structured Real Estate Investment Trust (REIT) funds that capture entire domestic or global real estate markets.

 

Leveraging Risks

Historically, long-term real estate returns have been good (although highly volatile from one year to the next). One big reason for this is leverage. If you put 25% down, you’ve got renters covering your mortgage and your expenses are modest, it all looks pretty good. Your 25% down controls 100% of the value of the property. If the property appreciates at 3% per year and you’re breaking even on cash flow, your annual return is 12%.

 

What could go wrong? Unfortunately, leveraging works both ways. Say for example the property goes down by 2% a year for 4 years and then you need to sell it. Typical transactions costs are 6% for selling. Therefore you are down 14% on the full value of your of the property. You have lost 14%/25% – or more than half of your investment (down payment). This is a real risk.

 

In short, if you’ve underestimated your maintenance costs, Boulder Creek floods the first floor, oil-dependent Denver goes into recession, or your adjustable rate mortgage skyrockets (I’ve seen all of these things happen), your leveraged risk exacerbates the risk of being overly concentrated and creates a perfect storm that can wipe out your retirement income faster than you can say “Go, Broncos.” 

 

PS: Taxes 

By the way, all of this is before we even talk about the time and energy required to properly manage the taxes involved in direct real estate investing. Suffice it to say, you’ll want to have a good accountant to assist you on that. 

 

Investing on Easy Street

If you would like to speculate in local real estate – i.e., if you have money with which you can afford to win big OR lose entirely – I wish you well, but this post is probably not for you. If you would like to invest in the real estate market, seeking to efficiently capture its expected returns while managing the very real risks involved, consider a modest allocation to a well-diversified, thoughtfully structured REIT fund or funds covering U.S. and/or global real estate markets. Look for funds that are relatively low cost and widely diversified across types of holdings as well as geographic locations. 

 

Need more help? Give us a call.  

 

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail This email address is being protected from spambots. You need JavaScript enabled to view it. .

 

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

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