Investing in real estate: pros and cons to consider before buying property

Real estate investing can be a lucrative way to build wealth and diversify your investment portfolio. Our family actually dipped our toes into this last year (probably the worst possible time to start).

In this article, we will explore the various ways you can invest in real estate, from owning rental property to investing in REIT companies and real estate mutual funds.

Is Investing in Real Estate a Good Idea?

There are a ton of reasons to invest in real estate. It has the potential to provide stable cash flow, capital appreciation (the cost of houses keeps going up), and tax benefits. Additionally, real estate can provide a hedge against inflation and market volatility.

Real Estate Tax Benefits

One example of how real estate provides tax benefits is through depreciation. When you own a rental property, you can deduct a portion of the property's value as a depreciation expense each year on your tax return. Depreciation is a non-cash expense that allows you to reduce your taxable rental income, and as a result, lower your overall tax liability.

Let's look at an example:

Pretend you own a rental property that you purchased for $200,000. You can depreciate the value of the building over a period of 27.5 years, which means you can deduct $7,273 ($200,000 / 27.5) from your taxable income each year for depreciation. Assuming a 30% tax rate, that's a tax savings of $2,182 per year.

In addition to depreciation, there are other tax benefits to real estate investing such as deductions for mortgage interest, property taxes, repairs and maintenance, and even travel expenses related to managing your rental property. If you have an accountant they can walk you through all of these details and how to ensure all of these deductions make it onto your taxes.

How Can Real Estate Help Hedge Against Inflation?

Inflation is the general increase in prices of goods and services over time, which reduces the purchasing power of your money. When inflation occurs (like it has been since 2022), the cost of living rises, and your money's value decreases. This can be challenging for investors who hold cash or bonds because the value of their money diminishes over time.

However, real estate investments can help you hedge against inflation. Real estate is a tangible asset that can hold its value even in times of inflation. As the general price level rises, so do the rental income and property values. As a result, real estate investors can benefit from increased cash flow and appreciation (the value going up) of their assets.

Real estate investments can also be leveraged with debt, which can further enhance your returns in a low-interest-rate environment. If you borrow money to buy a property, your fixed interest rate stays the same, but the rental income and property values may increase due to inflation. This means that the real value of your debt decreases over time, making it easier to pay off with the rental income you receive.

Let's look at an example:

Pretend you're considering buying a rental property for $200,000 in a market where the inflation rate is 3% per year. Assume you put down $40,000 (20%) as a down payment and borrow the remaining $160,000 at a fixed interest rate of 7%.

In the first year, your rental income is $1,200 per month or $14,400 per year. Assuming your expenses (such as property taxes, insurance, and maintenance) add up to $5,000 per year, your net operating income is $9,400.

Now, let's consider how inflation affects this investment. With a 3% inflation rate, the rental income and property value will increase by 3% each year. In the second year, your rental income will be $1,236 per month ($14,832 per year), and your property value will be $206,000. Your expenses will also increase by 3% to $5,150 per year.

However, since you borrowed $160,000 to purchase the property, your fixed interest rate of 7% remains the same. This means that the real value of your debt decreases over time due to inflation, making it easier to pay off with the rental income you receive. In other words, as the general price level rises, the fixed amount of your mortgage payment stays the same, but the value of that payment decreases in real terms.

Over time, as the rental income and property value increase due to inflation, your investment in real estate should grow in value and generate increased cash flow. This helps you hedge against inflation by maintaining the purchasing power of your investment over time.

Can I Invest in Real Estate with $10k?

Yes, you can invest in real estate with $10k or even less. There are various ways to invest in real estate with a small amount of capital, such as through crowdfunding platforms like Fundrise or investing in real estate mutual funds.

How to Invest in Real Estate as a Beginner?

If you're new to real estate investing, it's important to do your research and understand the different investment options available to you. Here are some steps to get started:

1. Set your investment goals and determine your risk tolerance.

2. Educate yourself on the various types of real estate investments, such as rental property, REIT companies, and real estate mutual funds.

3. Research different markets and analyze the potential returns on investment.

4. Develop a solid investment strategy and create a diversified portfolio.

5. Network with other investors and professionals in the industry.

Pros of Real Estate Investing

• Potential for long-term capital appreciation and cash flow

• Diversification of investment portfolio

• Tax benefits such as depreciation and deductions

• Hedge against inflation and market volatility

• Tangible asset that can be leveraged for financing

• Opportunity for value-add strategies and creative financing

Cons of Real Estate Investing

• High upfront costs, including down payment and closing costs

• Illiquidity and difficulty in selling property quickly

• Ongoing maintenance and management expenses

• Market and economic factors can impact property value and cash flow

• Tenant turnover and vacancy can lead to lost income

• Requires extensive research, due diligence, and management skills.

Can You Lose Money in Real Estate?

As with any investment, there is always a risk of losing money in real estate. However, with proper research and due diligence, you can minimize your risk and increase your chances of success. It's important to remember that real estate is a long-term investment and to have a well-thought-out investment strategy.

What is an REIT Company?

A Real Estate Investment Trust (REIT) company is a publicly traded company that owns and operates income-producing real estate properties. REIT companies are required by law to distribute at least 90% of their taxable income to shareholders as dividends.

What is a List of REIT Companies?

Here are some examples of popular REIT companies:

• Simon Property Group (SPG)

• Prologis (PLD)

• Public Storage (PSA)

• American Tower Corporation (AMT)

• Equity Residential (EQR)

What is a Real Estate Mutual Fund?

A real estate mutual fund is a type of mutual fund that invests in real estate-related securities, such as REIT companies, real estate developers, and property management firms. Real estate mutual funds offer investors diversification, professional management, and liquidity.

Conclusion

Real estate investing can provide a path to financial success, but it's important to educate yourself and develop a solid investment strategy. Whether you choose to invest in rental property, REIT companies, or real estate mutual funds, be sure to conduct thorough research and seek professional advice when needed. With a disciplined approach and a long-term perspective, real estate investing can be a rewarding and profitable venture.