5 things to know before investing in real estate
February 27, 2013
Low bank rates have practically eliminated the value of savings accounts as income vehicles. While FDIC-insured deposits remain an important source of stability and security, as long as savings account rates remain below 1 percent, investors in need of income will look elsewhere for more productive alternatives.
Real estate is one income-producing alternative that offers strong growth potential. According to the MSCI U.S. REIT Index, Real Estate Investment Trusts (REITs) have averaged a 12.3 percent annual return over the past 10 years -- an impressive track record under challenging circumstances. However, before low savings account rates drive you to invest in real estate, it is important to understand just how wide the gulf is between savings accounts and the real estate market.
Here are five things you need to understand before investing in real estate:
- Real estate is an inefficient market. Looking at national, regional or even local trends can only tell you a very limited amount about what any individual property is worth. Each property has unique characteristics that make it difficult to compare to other properties. That brings a level of subjectivity to pricing real estate that benefits knowledgeable and experienced investors -- and therefore works against people without that knowledge or experience.
- Liquidity can be unreliable. Forget about the instant liquidity of a savings account -- individual real estate properties aren't even as liquid as publicly traded investments such as stocks and bonds. Private markets can grind to a halt at times, meaning it can take months or even years to get out of some real estate investments.
- Cash flow can work both ways. So you want to invest in some property to generate cash flow from rentals. Just be advised that in real estate, cash flow works both ways: While there may be income from rentals, there are also taxes and maintenance costs to be paid. You need to compare rental levels and occupancy rates with the ongoing costs of the property to get a sense of what the net cash flow will be.
- REITs offer some diversification, but also management risk. REITs invest in groups of properties, and thus provide some benefits of diversification that you won't get by investing in an individual property. Remember, though, that depending on how narrowly based the REIT's investment scope is -- it may be based on a very specific region or type of property -- the diversification benefit may be limited. Also, you will be depending on the expertise of the people managing the REIT to make good decisions.
- Today's mortgage rates represent a form of risk. You've probably heard that low mortgage rates are helping to support the real estate market. The problem is that current mortgage rates are unusually low, so what happens to the real estate market when rates return to more normal levels? A sudden lift to mortgage rates could change things quickly.
U.S. REITs have built an impressive track record under the difficult circumstances of the past 10 years, and can represent a source of portfolio income. However, the success of an investment generally comes down to the specifics. You need to know the market characteristics that any given REIT represents, and have a strong sense of how the price you pay relates to the income and appreciation potential of the investment.
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