03 May Should you Invest in Rental Property or the Stock Market?
Investing in a real estate rental property can be an excellent way to diversify your income stream and create some flexibility with your taxes. This could come in the form of a traditional single-family rental or a one-unit apartment. Another form of real estate investment we see a lot of is private placements that offer access to a broader spectrum of rentals – entire condo buildings or even housing developments.
But is a rental property a smart investment? To answer that question, we fall back on the principles of investment analysis we use to determine whether any other investment belongs in your portfolio. What are the goals for the given investment? How likely is it to meet your target rate of return? What is the correct position size for the investment in the overall financial picture?
Should You Invest in Real Estate?
Real estate investments are just one piece of your portfolio. Because of the nature of these types of investments – often illiquid, long-term, and can drop precipitately in market downturns – they impact your overall risk profile, and you need to ensure that all other areas of your plan are covered before you put funds towards them. These include:
- Having an emergency fund (3-6 months of living expenses)
- Maxing out employer retirement plans (401k, 403b, 457)
- Funding IRAs (backdoor Roth)
- Hitting college savings goals
- Maxing out HSA contributions
Evaluating a Potential Investment
Rental properties should be evaluated similarly to all your other investments. You want to align your portfolio with your risk profile. For example, a conservative investor who has 60% of their portfolio in bonds should not consider investing in a high-risk luxury condo private placement.
Because of the illiquid nature of real estate investment, there’s opportunity cost to locking up your capital for an extended period. Before deciding where to deploy your money, you should determine if investing in the stock market is a better option. The metric that makes the most sense to compare these two options is the required rate of return on cash flow. To facilitate the analysis for our clients, we’ve built a private equity profit valuation tool that can help calculate the expected internal rate of return (IRR) of a given investment. It can then be compared to historical data on the long-term return of stocks to illustrate if the real estate project or your investment portfolio has a higher expected return.
A Peek at Property Types
Now that you understand how to evaluate a potential real estate investment, what type of property do you want to invest in? There are two broad buckets: local properties and private placements.
Local investments have advantages, but they also usually require that someone will be responsible for ongoing maintenance and any emergencies that arise. Unless you plan to DIY it, the expense of a property manager needs to be factored into the investment. It will impact both your taxes and your overall returns. The same with keeping the property rented, dealing with turnover damage, building in a vacancy rate that makes sense for your local area, insurance on the property, and even the expenses of buying into the investment in the first place. Our tool takes these into account.
Investing in a private placement takes the responsibility of managing the property off your shoulders. However, costs and fees still eat into your returns. There will most likely be acquisition fees, set up fees, management fees, administrative fees, and other deal-specific fees. One indicator for evaluating the level of fees that may be charged is realizing how many steps away you are from the deal. The more layers of management and deal brokers that stand between you and the property, the lower your net return will be.
Real estate deals incentivize the manager by creating a “waterfall.” The first tranche of inflows into the waterfall go to pay guaranteed fees. After this, capital is returned to everyone who put money in. Then come preferred returns, which can range from 6% to 15%. If there is any remaining profit, it’s then split between the capital providers (that would be you, the investor) and the deal provider. It’s easy to see how much of a difference where you stand in relation to the waterfall makes.
Investing in real estate can be a solid way to diversify your overall portfolio but before you begin, make sure that you’re eating your financial vegetables – emergency fund, retirement savings, etc. mentioned above.
Define for yourself what you want to put into the investment, and what you want to get out of it to determine if a traditional single-family rental is right for you, or if you’d rather participate in a private placement. Whichever you choose, doing the research to understand your required rate of return and then comparing that to the opportunity cost of investing the equity markets is the only way to make an informed decision.
Thinking about real estate investments in the same terms as any other investment can help you make the right decision to keep your portfolio on track with your long-term goals.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content has not been reviewed by FINRA.