Real estate investing

2023-05-09, Michael Thompson

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Real estate is one of the primary investment vehicles, alongside stocks and bonds. US real estate investors have enjoyed solid returns over the long haul, with few drawdowns. In this article, we’ll discuss the historical performance of real estate investments and five ways you can invest in real estate.

For further details on real estate investing checkout the Real Estate Quickstart Guide.

Historical performance

Index of publicly traded real estate securities

The Dow Jones Select Real Estate Securities Index has estimated the performance of publicly traded real estate securities from 1978 to the present. In that timeframe, the total return has matched the S&P 500, but with more volatility. Statistics follow.

Single-family housing and landlords

Historical real estate values in the US are available from Federal Reserve Economic Data (FRED). For example, the median US home price has grown from $18k in 1963 to $440k in 2023, representing a 5.5% annual increase. The annual increase over the last 20 years (2003-2023) was 4.2%.

Of course, landlords of these homes receive rental income, in addition to the appreciation of the property. According to a 2021 report by ATTOM Data Solutions, the average annual gross rental yield (rental income divided by upfront costs of purchasing and preparing the home) for single-family homes in the United States was 7.7%. Century 21 has quoted gross returns of 10%.

Realize that these gross returns are before costs like taxes, insurance, maintenance, repairs and potentially management fees and utilities. A large and highly fluctuating portion of gross income pays for these costs. After these costs, many landlords struggle to maintain consistent, positive cash flow.

Example landlord earnings

Let’s compute a very rough estimate for a landlord's total return, using this data. We aim to include net income and property appreciation, to arrive at a number comparable to other investments (REITs, stocks, or bonds). Suppose we buy a $100k home with 20% down, a 30-year mortgage, and earn a 1% compounding ROI excluding property appreciation (this is after all costs like paying the mortgage, taxes, repairs, management fees, …). If the property appreciates at 5.5%, and they sell it after 30 years (paid for), they will receive $498.4k. Over the 30 years, the landlord earned a 12.3% annual return (11.3% from leveraged property appreciation and 1% from the annual cash flow).

While 12.3% may sound good, realize that this is a concentrated/undiversified investment. If you happen to get a house with a lot of maintenance issues, bad tenants, or one where the market goes south, you could easily end up with a substantial loss. It also requires more work than buying and holding an index fund.

Five ways to invest in real estate

Purchase REITs

The simplest way to invest in real estate is to buy a real estate investment trust (REIT). Buying shares of a REIT is no more complicated than buying shares of a business like Apple. A REIT is just a special type of corporation. Some of the unique requirements of a REIT are listed below.

• At least 75% of gross income must be from rent, real estate financing and sales.
• At least 90% of annual taxable income must be paid as dividends.
• Must have at least 100 shareholders after the first year of existence.
• No more than half of shares may be held by five or fewer individuals.

You don’t need to do any work or even know what properties the REIT owns. You simply buy shares on a brokerage and sell them whenever you see fit, just like any other stock. A large portion of REIT profits come from dividends rather than share appreciation. One negative about this is taxes—dividends are typically taxed as ordinary income, which can be much higher than capital gains tax.

REITs often specialize in certain types of real estate. Below is a list of some REITs along with their specialization.

ETF of REITs

If you want to be even more hands-off and diversified, you can buy an ETF that holds a basket of REITs. For example, each share of the Vanguard VNQ ETF is spread over more than 150 different US REITs with various specializations. The price of such an ETF will generally be less volatile. Of course, you will pay a small fee for this convenience. At the time of this writing, VNQ has an expense ratio of 0.12%.

Be a landlord

This is the most hands-on option. You personally select a property, buy it, and manage it (or hire a management company). The potential upside is large, but so is the risk and inconvenience.

Skill can be very useful for a landlord. For example, you can boost returns if you’re willing and able to do home repairs. With REITs, you give up a portion of income to pay others to do maintenance, repairs and other management.

You have a lot of control as a landlord. You personally select the property you think will work best. If you think the property has become overvalued, you can sell it. If you think a renovation is in order, you can do it. You can manage tenants or choose who you want to manage them.

While returns can be high, there are significant risks and inconveniences. For one, many landlords have poor diversification and leverage. This can be a deadly combination. For example, a substantial portion of their wealth may be tied up in single-family homes in one region of the US. If this market goes south, they can lose their income and become buried in mortgage debt. Physical properties are also much less liquid than stocks, bonds and REITs. If you have an emergency and need money, you can't extract the market value of a property quickly, it could take weeks or even months.

If you talk to many landlords, you’ll hear extreme positive and negative stories. Several people have told me they have a handful of rental homes with long-term tenants that always pay on time and need minimal attention. They just watch the money roll in every month, along with equity in the property. On the flip side, I’ve heard many horror stories of frequent major repairs and/or bad tenants. One friend says he spent 2 weekends a month climbing through attics and dealing with other issues. He frequently had negative cash flow, and his last renter gave him a sob story every month about why he couldn’t pay rent. He recently gave up and sold his properties.

Paying a management company is no silver bullet. For one, the costs may prevent positive cashflow on the property. Also, just like a tenant, there's no guarantee employees of management companies will behave well. They may be slow to rent out the property, they may not work hard to collect rent, .... In general, a management company's goal is to maximize their profit, not your profit!

There may be licensing and other legal requirements to become a landlord. These vary by region. For example, see How to become a Landlord in Texas.

Join a REIG

Real estate investment groups (REIGs) are groups of individuals that pool their money to purchase a property like an apartment. The individuals meet to collectively make decisions about what property to buy, how much to charge for rent, when to sell, …. It’s like becoming a landlord while splitting the responsibilities and profits with your friends. REIGs are not subject to the restrictions of a REIT and shares are not for sale on public exchanges.

Crowdfunding

Crowdfunding is similar to a REIG, but typically involves more people who come together via an online real estate platform. Crowdfunding typically requires less capital per person.

Flipping and property development

There are of course many other ways to earn money in real estate. “Flippers” buy properties they believe are undervalued, and resell them as quickly as possible for a profit. This is akin to day trading in the stock market. Some flippers buy “ugly” properties, perform renovations, and resell them as quickly as possible. Flipping requires skill in selecting appropriate properties and knowing the proper renovations to increase value efficiently. A drawdown in the housing market can create huge problems for flippers, who may not even have money set aside to pay the mortgage over time.

Conclusion

Real estate investments have earned solid returns comparable to the S&P 500. With time and discipline, you could earn even higher returns as a landlord by doing some of the management, maintenance and/or repair work yourself. However, there are three major concerns:

1. being a landlord can take substantial time,
2. putting too much money in a small number of similar properties can be risky (particularly with leverage), and
3. a lack of liquidity (you won't be able to sell your investment quickly if you need money).

Investors that don’t want to deal with property management can buy shares of a REIT which requires no more work than buying shares of Amazon or Apple. While total returns may be similar to such stocks, more of the earnings will come from dividends which will typically incur higher taxes and reduce net returns. If you want diversification beyond a REIT, but don’t want to deal with researching and purchasing many REITs, a single ETF like VNQ may be a good option.

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