Because it offers competitive risk-adjusted returns, real estate may improve the risk-and-return profile of an investor’s portfolio. In contrast to bonds and stocks, the real estate market is generally less volatile.
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Comparing real estate to more conventional forms of income return reveals another allure. This asset class is particularly appealing when Treasury rates are low since it normally trades at a yield premium over US Treasuries.
Protection and Diversification
The possibility for diversification that comes with real estate investing is another advantage. Real estate typically rises during periods of stock market decline since it has a poor and occasionally negative connection with other main asset groups. In other words, adding real estate to a portfolio may increase return per unit of risk while reducing volatility. The better the hedging, the more direct the real estate investment: Publicly traded, less direct entities like REITs will mirror the performance of the stock market as a whole.
Direct real estate also entails less principal-agent conflict, or the degree to which the investor’s interest is reliant on the honesty and skill of managers and borrowers, because it is supported by physical real estate. There is some protection available even for investments that are more indirect. For instance, REITs require that at least 90% of their income be distributed as dividends.
Hedging against Inflation
The positive correlation between GDP growth and demand for real estate is the reason behind real estate’s capacity to withstand inflation. Rents rise in response to the demand for real estate, which boosts economies and raises capital values. Therefore, by transferring some of the inflationary pressure onto renters and integrating some of the inflationary pressure in the form of capital appreciation, real estate tends to sustain the buying power of capital.
The Leverage Power
Leverage is one instrument that investors in real estate have access to that stock market investors do not: with the exception of REITs. Using debt to fund a greater purchase than you have sufficient cash for is known as leverage. Unless you are purchasing on margin, you must pay the whole purchase price of the stock at the moment the buy order is placed. And even then, because of that enchanted financing technique called a mortgage, the proportion you may borrow is still far lower than it would be with actual estate.
A 20% down payment is often required for traditional mortgages. However, you may be able to get a mortgage that demands as little as 5%, depending on the location of the house you buy in. This implies that for a little portion of the whole worth, you may get ownership of the entire property and the equity it contains. Of course, how much ownership you actually have in the home depends on the size of your mortgage, but you have power from the moment the papers are signed.
This gives landlords and real estate flippers alike confidence. They can make down payments on two or three other houses and take out a second mortgage on their own residences. They own these assets even if they have only paid for a small portion of their entire worth, whether they choose to wait for a chance to sell for a profit or rent these out so that renters pay the mortgage.
How Do I Expand My Portfolio to Include Real Estate?
In addition to directly purchasing real estate, regular individuals can buy REITs or funds that invest in REITs. Real estate investment trusts (REITs) are pools of capital that hold, manage, or own mortgages for real estate.
Why Is Property Seen as a Risk Against Inflation?
Inflation and home values typically grow together. This is due to the fact that homebuilders’ costs increase in line with inflation and must be transferred to new home purchasers. But existing properties also increase in value due to inflation. If you have a fixed-rate mortgage, your regular monthly payments actually get more reasonable as inflation increases. Additionally, if you’re a landlord, you may raise the rent to compensate for inflation.
Why Do Interest Rates Affect Home Prices?
Since real estate is such a huge and expensive asset, financing its acquisition sometimes requires taking out loans. As a result, increases in interest rates increase the cost of mortgage payments for both new and current adjustable-rate loans, such as ARMs. Because they have to account for the expense of maintaining the property month-to-month, this may deter purchasers.
The Final Word
With the ability to generate wealth and a consistent income, real estate may be a wise investment. However, illiquidity—the greater difficulty of turning an asset into cash and cash into an asset—remains a disadvantage of real estate investing.
A real estate deal may take months to finalize, in contrast to a stock or bond transaction, which may be finished in a matter of seconds. It might take weeks to identify the suitable counterparty, even with a broker’s assistance. Real estate mutual funds and REITs, of course, provide superior market pricing and liquidity. However, because they have a far stronger link to the stock market as a whole than direct real estate investments, they come at the cost of increased volatility and diminished diversification benefits.