As far as asset classes go, there are few that can offer the versatility and upside as real estate. But there are both pros and cons to real estate investing. Before you decide to incorporate real estate into your investment strategy, you need to understand both the benefits and downsides of real estate investments. We made a short list to help you out.
Pros
Potential for high returns: Real estate offers the possibility of generating higher returns compared to other investments, especially if the property appreciates in value over time. A fantastic return for an investment in mutual funds or the stock market might be 10-20%; home values have demonstrated an ability to increase far more dramatically, especially if you're considering a long-term investment. Only small cap companies have comparable return-potential, but real estate is far more stable and insulated from catastrophic failure.
Passive income: Renting out an investment property can provide a steady source of non-active income, which can be especially attractive to investors who are looking for a constant stream of income without having to do much other work. (If you want this stream to be totally passive, you can always hire property managers so you never have to lift a finger).
Investment Portfolio Diversification: Adding real estate makes for a well-diversified portfolio, reducing the overall investment risk of your money. You simply don't want all of your investments to be affected by stock prices or interest rates or some other macroeconomic factor beyond your control.
Potential for tax benefits: Real estate investors may be able to take advantage of helpful tax benefits, such as deductions for mortgage payments interest, property taxes, and other expenses related to owning and managing rental property. A 1031 exchange is a marvelous tool to avoid paying capital appreciation taxes when you swap one investment property for another on the market.
Flexibility: Real estate investing also makes it possible for you to take the reins of your investment portfolio and lead the decision-making apparatus. If you put your money into mutual funds or other established entities, then all of the investment decisions are at the discretion of the fund manager. An individual real estate investor can manage their own holdings.
Cons
High upfront costs: Buying a property can be extremely expensive, especially if you need to take out a mortgage to finance the purchase. The floor capital required for the initial investment is likely in the hundreds of thousands; hardly spare coins you can find in your sofa cushions. There may also be other upfront costs, such as transactional costs and repair / renovation expenses. And if you are indeed financing the purchase, ongoing debt service at unfavorable rates can eat you alive. This is a significant disadvantage compared to the overall stock market, where you can buy penny stocks with a shoestring initial investment, and never have to worry about nagging interest payments.
Management responsibilities: As a landlord, you will be responsible for managing the property, which can be time-consuming and may require you to handle maintenance and repair issues. If you hire a property management company, you're significantly diminishing your rental income each month.
Market volatility: Price fluctuations in the real estate market are common, so there is always the risk that the value of the property you own could decline. While time has shown that usually these downturns can be ridden out, if you ever face liquidity issues then you'll be in a position to take a loss on your investment or face financial hardship.
Tenant risk: As a landlord, you may have to deal with difficult or problematic tenants, which can be a source of stress and financial risk. Usually this is more prevalent in residential real estate than commercial or industrial.
Summary
Overall, real estate investing can be a good way to generate a smooth cash flow and potentially achieve high returns, but it is important to carefully consider the potential risks and drawbacks before making any investment. The responsibilities, market volatility, and hidden costs can make it less attractive than other asset classes.
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