More Investors Eye Real Estate to Generate Income
Investing in real estate often conjures up images of slick moguls buying up properties.
But today, you don’t need to be a tycoon to make the leap into real estate. In fact, many investors are turning to property-based investments to generate income and build appreciation. This is confirmed by a recent Gallup Poll which showed that investors preferred real estate to stock investing by a 35% to 27% margin.
Real estate investing is not rocket science but investors still need to do their homework. There are basically two major ways to invest in real estate for income-producing purposes.
- Rental Properties
- Real Estate Investment Trusts
Rental Properties
It is probably best not to think of this type of investment as “passive” income. There is plenty of participation and work required of the investor. But the payoff can be significant including a steady cash flow from rental income and the development of equity and property value appreciation through improvements and demand.
However, to reap these benefits, the “owner” needs to be prepared to identify the most suitable properties, promote the property to prospective tenants, screen tenants, hire and work with a property manager and fund and implement repairs and improvements.
Types of rental properties
Two types of rental properties that are not difficult to manage are single-family units and duplexes and triplexes. A single home or condo can be purchased and rented out to just one tenant, and most investors are very familiar with this type of property, as opposed to commercial properties. The availability of these properties is huge. According to the U.S. Census, there are more than 70 million single-family houses in the U.S. Maintenance is usually not complicated and it is generally not difficult to sell when the investor is ready, However, when vacant, a single unit will bring in no income at all.
Some of the same kind of advantages are possible with duplexes and triplexes, properties with two to four units. With more tenants, these properties can be more of a burden to manage than a single-family unit, but easier than apartment buildings. On a positive note, they can provide more income but have the heightened risk of multiple vacancies to fill.
Properties with five or more units are generally in the apartment building category. Financing is possible through commercial loans, instead of residential loans. Plus, there are some economies of scale. On the downside, investors often will be competing with well-capitalized private equity firms. Secondly, managing a multi-tenant property can be difficult, especially in tough times such as a recession or Pandemic when it may be tough to collect rent from some tenants. Also, it stands to reason that the more units there are the greater the potential for problems.
Long-term leases from retail tenants of commercial properties provide a steady source of income. However, commercial tenants can be more difficult to replace and tend to highly customize the property to their business needs. Investors should plan for longer vacancies, as well as having to bear the expense of remodeling spaces between tenants.
Gaining the attention of more individual investors are Industrial property and self- storage. Commercial warehouse, storage, or manufacturing facilities can provide steady performance while requiring minimal management. It should be noted that tenant turnover can lead to extended vacancies.
Self-storage facilities continue to be very much in demand and can be found almost anywhere in the U.S. During the recent Pandemic, many individuals used storage facilities as they temporarily moved from urban areas to suburban or rural locations. All facility costs and vacancies can be spread across many units. This results in a relatively low per-unit cost. However, these facilities require a customer service and management team, often staffing the premises for extended hours. In addition, owners should factor in security and insurance expenses.
Real Estate Investment Trusts (REITS)
REITs are generally an excellent way to invest in income-generation and a sound vehicle for diversifying a portfolio that might be heavily geared to stock and fixed income.
Simply put, a REIT is a company that owns, operates and finances various types of real estate. Think of it as a kind of mutual fund where the capital of many investors is drawn upon to fund investments. What makes it attractive is that REITs allow relatively small investors to participate in real estate and earn dividend income without having to invest large funds and minus the headaches and time of managing and financing properties. In addition, most REITs provide liquidity.
REITs investors can gain access to office towers, shopping malls and a variety of billion-dollar commercial properties
Investing in REITS
REIT activities resulted in the distribution of $69 billion in dividend income in 2019 (the most recent data available)
There are plenty of REITs to choose from, over 225 publicly-traded RIETS in the U.S. Like other investments, investors need to assess the REIT management and performance record. Explore anticipated growth in earnings per share, and dividend yields. Also look at funds from operations (FFO).
REIT returns have been exceptionally strong over a very long time period. An investor who put $10,000 in the equity REIT index in 1971, found that $10,000 would be worth just over $2.1 million at the end of 2019. REIT total return performance for the last 20 years has outperformed the S&P 500 Index, other indices, and the rate of inflation. The REIT Index boasts a dividend yield of 3.3%. That is much higher than other asset classes. Treasuries are under 1% for most maturities. Some savvy REIT investors believe it is entirely possible to gain higher yields by selecting individual high performing REITS.
But don’t count on REITs as a value appreciation investment. REITs must pay out at least 90% of their taxable income. That’s why their average dividends are relatively high. REITS have large tax advantages in that they pay no corporate taxes. Because of the high payout of most of their income, REITS are classified as “pass-throughs” entities.
For the most part, REITS specialize in specific segments. For example, there are Mortgage REITS, Residential REITS, Office REITS, Industrial REITS, Healthcare REITs, Data Center REITS, etc.
Still there are risks. Rising interest rates have a negative impact on REITs. Specifically, when the longer-term interest rates paid by risk-free assets like Treasury securities rise, REIT share prices tend to decline
Then there is the problem of oversupply. This is a risk factor in all areas of real estate, but especially comes into play with property types expected to grow like self-storage.
In recessions, many REITs see their vacancies jump and their pricing power fall. There is a wide variety of cyclicality economic conditions among REITs. But this depends on the REIT you invest in. Hotel REITS do poorly during an economic decline but Healthcare REITs are generally more stable.
Also, on the downside, REIT dividends are taxed as ordinary income, and some REITs have high management and transaction fees.
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