When you think of investing in real estate, your first instinct may be to go big: Renting out houses, owning apartments, or even office buildings.
But you might not realize that you can also invest in real estate from the comfort of your home (or apartment) without owning any physical property. That’s because you can diversify your investment portfolio with real estate in several ways — making it a far more attainable asset than you may have imagined.
What is real estate investing?
Real estate refers to a portion of land and any permanent attachments to it — which can be natural (like trees or bodies of water) or man-made (like buildings). When you invest in real estate, you buy land or real property and use that purchase to potentially earn money. We’ll explain how shortly.
Types of Real Estate Investments
Like we mentioned earlier, a real estate investment can come in many forms. You can invest directly by purchasing a physical property or you can invest indirectly using means such as real estate investment trusts, a.k.a. REITs. Let’s take a deeper look at a few popular ways you can make real estate a part of your portfolio.
More than an idea of the American Dream, home ownership can also act as a staple long-term investment. That’s because home prices tend to appreciate — or gain value — over an extended period of time. Keep in mind, though, the real estate market may fluctuate in the short-term, so the longer you hold on to your property, the better chance you have at making a profit when you decide to sell.
If you’re considering homeownership, keep location and the costs of owning a house top of mind. Location is critical as not all markets are equally popular, and where you live can have a big effect on the value of your home. And when it comes to money, your mortgage isn’t the only cost you have to think about. You’ll have closing costs when you make your purchase. Plus, homes require upkeep, updating, and involve recurring expenses. The cost of regular maintenance, occasional repairs, ongoing property taxes, and homeowner’s insurance can cut into your overall return on the investment.
If you’ve ever rented a house, condo, or apartment, you know that rent can be a pretty significant chunk of change. By investing in rental properties, you can put yourself on the receiving end of those rent payments. But that also means you’ll assume the position of landlord, which comes with a set of responsibilities.
As a landlord, you’re in charge of tasks like paying the mortgage, taxes, and insurance. Plus, you have to keep up with the space and find tenants to occupy it. Without a property manager, it can be a lot of work. And you might not be pocketing the full amount from the rent payments you receive, as landlords typically use that money to cover the mortgage.
A more indirect way to invest in rental properties is through a real estate investment group, or REIG. REIGs act similarly to mutual funds, but for rental properties. One company owns and manages a set of apartments or condos, and investors can purchase units through that company.
With REIGs, you receive the benefit of rental income without having to manage properties yourself. But they can involve significant fees as the managing company keeps a portion of tenants’ monthly rent, and there is always the risk of unoccupied units, in which case you will not be receiving the rental income needed to offset the management company fees.
If you’re interested in real estate but not ready to buy a home or don’t have the time to rent out and manage a space, REITs offer a lower barrier to entry into the real estate market. A REIT is a company that owns (and usually operates) a real estate property that generates income. You can invest in REITs similarly to how you buy stocks, through a broker like Ally Invest or another financial institution. You can also invest in REIT mutual funds as well as REIT ETFs (exchange-traded funds that pool together the money of many investors to invest in a basket of securities).
Not only can investing in REITs be a cheaper option than investing in physical property, they’re also far more liquid. That means, because they are traded on an exchange, they’re typically much easier to buy and sell.
Earning Money from Real Estate
Real estate can be a smart asset for investors looking to earn passive income or diversify a fixed-income portfolio. The many forms of real estate investments offer several different avenues for earning income.
Appreciation is the most common way you can earn a profit through real estate. Whether you are a homeowner or own residential or commercial property, you can make a profit by selling property for more than you bought it. While it’s not a guarantee that a property’s value will increase, certain factors that impact a property’s value are the location, improvements and updates to the property, and proximity to new surrounding developments.
Leasing property to tenants can be an opportunity to add regular, passive income to your portfolio. Though as we noted earlier, as a landlord, you have the responsibility of paying the mortgage on the property as well as other expenses, while ensuring it’s properly managed. This means you might choose to use a portion of rental income to cover those costs and possibly pay for a property manager.
If you choose to enter the real estate market via REITs, your portfolio may benefit from regular dividend payments. That’s because companies that qualify as REITs have to distribute at least 90% of their taxable income to shareholders in the form of dividends. While returns are not guaranteed and REITs are susceptible to market volatility and price fluctuations, dividends may provide a steady stream of investment income you can then hold on to or reinvest.
Note: REITs are required to pay property taxes, which can affect the amount of income they have to distribute in dividend payments.
Real Estate Tax Implications
Like most forms of income, if you’re making money from real estate, you’ll have to pay taxes on it. But how you make that money will affect which type of taxes you’ll face.
Capital Gains Tax
If you sell an investment property after owning it for a year or more, you will have to pay capital gains on your profit. The more a property appreciates in value, the greater your capital gains will be. The capital gains tax percentage is based on your income and filing status.
What happens if you sell an investment property after owning it for less than one year? In this case, you may pay short-term capital gains tax, which is typically based on your income tax bracket.
Similarly, if you invest in REITs, the bulk of the dividend payments you receive is typically taxed as ordinary income. You should consult with a trusted tax professional on how capital gains might impact your tax liability.
Rental Income Tax
Whether you lease an apartment to college students or rent out your vacation home when you aren’t using it, you’ll have to classify the money you make as income on your tax return., The good news is that some of your expenses may be deductible, such as mortgage interest, maintenance expenses, and certain repairs, supplies, or materials needed to keep your property in good condition. So, if you choose to rent out real estate, make sure to keep thorough records (including receipts) of all your property-related expenses throughout the year.
Value of Investing in Real Estate
Investing in real estate can be an opportunity to earn passive income, but that’s not the only reason you might add this kind of asset to your portfolio. Another massive benefit is potential diversification. Because the real estate market doesn’t typically have a strong correlation (or any at all) with the stock market, investing in real estate can help protect your portfolio against volatility.
Pro tip: Because REITs can be represented in the S&P 500, their performance may fluctuate more closely with the overall stock market than physical real estate.
Real estate also offers investors the tool of leverage, assuming the property continues to appreciate in value. Meaning, when you buy a home, you usually don’t pay the full price up front. You take out a mortgage, and in exchange, make a down payment (perhaps putting about 20% of the home’s value down, for example). Even though you don’t have full equity in the home, you have control over it — and can rent it out or do work on it. Because of this, real estate investors can invest in multiple properties without necessarily being able to pay for their full value at the time of purchase.
When and How to Start Investing in Real Estate
Investing in property is typically not something you want to do on a whim. Buying a home or becoming a landlord is a big decision that takes some serious consideration, and you’ll want to make sure you have your financial ducks in a row beforehand. It’s a good idea to make sure you have built up solid emergency savings and you are contributing to your retirement fund before taking on the responsibility of a mortgage.
When you’re ready to begin investing in real estate, there’s no harm in starting small. That could mean investing through REIGs to lower your responsibility as a landlord. Or you might get in the Airbnb space to get a feel for being a landlord and working with renters on a lesser scale.
If you’re itching to get in the real estate market ASAP, you may consider starting to diversify your portfolio through REITs. That way you can gain exposure to this asset class without having to worry about all the implications of investing in physical property.
Let Ally help you get started.
Investing in real estate doesn’t mean you have to own and operate fancy hotels or manage a million different properties. With indirect investment options like REITs, you can take part in the real estate market without having to deal with a mortgage or work with renters. And at Ally, we make investing in REITs simple through our Ally Invest Self-Directed Trading platform. So, if it’s in line with your financial goals, don’t be afraid to explore the different avenues for entering the market to make real estate a part of your portfolio.
Diversifying your portfolio with real estate is easy with a Self-Directed Trading account.