Just about everyone who invests does so in major asset classes including stocks, bonds, and cash equivalents. When it comes to real estate, though, you’ll find widely divergent opinions about its importance in an investment portfolio. There are some well-respected people and institutions who say that real estate investing is unnecessary, and there are others who will tell you it should be your primary asset class. I’ve recently debated whether I should start investing more heavily in real estate, so I wanted to lay out the basic arguments for and against real estate investing.
What is Real Estate?
The answer to this question is not simple because real estate investing comes in many forms. There are relatively passive ways of investing in real estate, such as Real Estate Investment Trusts (REITs). According to Investopedia, a REIT is “a type of security that invests in real estate through property or mortgages and often trades on major exchanges like a stock.” In other words, you can simply invest in a REIT like you do any other stock, mutual fund, or exchange-traded fund (ETF). Just send your money to your investment company, and you own a little slice of passive real estate.
There are more active methods of investing in real estate, such as fixing and flipping. You purchase a property, you make improvements to it, and then you sell it to someone, hopefully for a profit. As you can imagine, this would take quite a bit more work than investing in a REIT.
There are probably over 100 other ways you can invest in real estate. If you’re interested, I’d check out an article on Bigger Pockets, one of the largest websites about real estate investing, entitled “The Top 100 Ways to Make Money in Real Estate.”
Arguments Against Investing in Real Estate
Regular readers know that Vanguard is my go-to source for both advice and my own investments. Vanguard considers real estate an alternative investment, and according to them “alternatives usually come with more risks and higher costs.” They believe that a diversified portfolio of stocks and bonds provides enough diversification and that alternative investments are unnecessary. Only “sophisticated investors” should consider alternatives, and they see direct real estate investment as “expensive and time-consuming.” Most people have exposure to real estate in the equity in their house and diversified stock/bond funds that often include REITs, real estate companies, and mortgage-backed securities. For these reasons, Vanguard doesn’t think additional investment in real estate is necessary.
Another argument against real estate investing is that it can quickly become a second job. While you can hire property managers, they are probably not going to provide the level of service that the owner would provide. Most of us are already fully employed and don’t need a second job. In addition, owning investment properties can create additional legal risk.
When you purchase an individual property, it is like buying a single stock. You are taking what is called an uncompensated risk. Larry Swedroe defines an uncompensated risk as, “Risk – that is, the risk of owning single stock or sector of the market – that can be diversified away. Since the risk can be diversified away, investors are not rewarded with a risk premium (higher expected return) for accepting this type of risk.” Essentially, you are putting all your eggs in one basket that is not diversified by location or property type. Investing in real estate via a REIT can avoid this problem because REITs invest in properties that are diversified.
Real estate is an illiquid asset class with high transaction fees. While I can sell my stock or bond mutual funds or ETFs in seconds on-line and pay extremely low expenses to do so, it will take me weeks or months to buy or sell a property. In addition, I’ll likely pay 5-10 percent of the price in transaction costs.
Arguments for Real Estate Investing
Real estate is easily acquired, most often by purchasing your own single family house or condominium. You have to live somewhere, and there are several tax advantages to owning where you live. Interest payments on your mortgage and property taxes are probably tax deductible. If you sell your property, capital gains of up to $250,000 if you’re single or $500,000 for couples are tax-free. In addition, paying a mortgage forces you to save by making regular payments, some of which pay off the principle balance of your loan. That is money you’ll get back when you sell.
When compared to stocks or bonds, which have a global, efficient market, real estate often has a local, inefficient market. This means that if you are willing to look, you can probably find some bargains out there much more easily than you can find a bargain stock. Here’s a review of a good book on real estate investing for physicians.
One of the goals of diversification is to have investments that are not correlated with each other. In other words, when investment A drops in price you have investment B that does not. When compared to stocks and bonds, real estate is not perfectly correlated with other investments and therefore provides diversification. An article about the diversification benefit of REITs makes for an interesting read, if you’re interested, although it is a little old. Vanguard came to the conclusion that over-weighting REITs in a target date fund was not worth it. And this very well regarded guy doesn’t believe in over-weighting REITs either.
You can use leverage or “other people’s money” to increase investment returns. Instead of buying a property for $120,000, you could buy three $160,000 properties with a $40,000 down payment on each. This can increase your returns, but in a down market it can also dramatically increase your losses. As many found out during the housing market crash, leverage is a double-edged sword.
Real estate is an inflation hedge. Burton Malkiel says, “A good house on good land keeps its value no matter what happens to money.” Rents and property values tend to rise as prices rise, preserving your purchasing power. Since your mortgage payment doesn’t change with inflation, while rents are going up your mortgage payment remains the same. Stocks do hedge inflation somewhat, but the companies they represent and the stocks themselves tend to get hurt as the prices of raw materials rise.
The Bottom Line
There are a lot of different ways to invest in real estate, passively investing in REITs, fixing and flipping, owning rental properties, and all sorts of other investment opportunities. Like Vanguard, I don’t think it is necessary to invest in real estate, but it is something to consider if you think you will either enjoy it or believe the value it adds to your investment portfolio is worth the effort.
My brother Jarad is famous for having run every street and alley in Washington DC:
He scored a sabbatical from his teaching job and today he started his walk/run across the entire US, Forrest Gump style, to fight cancer. If you’ve ever appreciated the blog, you can show it by donating to his cause here:
He’s chronicling he journey on Instagram if you want to follow along and see how he’s doing.
Interested in updating your will? Have a question about family law or landlord/tenant issues? These are just a few of the matters with which a military legal assistance office can assist.
The link below allows you to search for any CONUS military legal assistance office regardless of Service branch. Simply enter the state and whether you have a preference for an office of a particular branch of service, and the
site will provide a list of offices with contact information, websites, and maps.
Throwback Thursday Classic Post – A Simple and Military Specific Summary of How to Save for Retirement
I’m a huge fam of Jim Lange. He’s a noted expert in financial management, saving for retirement, and estate planning. He’s written a number of books, some of which you can get for free on this page. If I ever move back to Pennsylvania, I’ll probably have him do my estate planning so that I don’t have to worry about anything in retirement.
He sends out a monthly newsletter that I get via snail mail, and it usually has a useful article in it. If you want it, you can get it here.
A previous edition had a section called “Jim’s Point-by-Point Summary of the Whole Retirement & Estate Planning Process.” It was simple but extremely useful. Below in bold are each of the points he lists for people who are still working, which is most of my readership. Let’s take each bolded point and militarize it for you so it is specific to those of us in the military.
Contribute at least the amount to your retirement plan that your employer is willing to match or partially match.
For those under the legacy retirement plan, this is not an option. For those under the new Blended Retirement System (BRS), you need to contribute 5% of your basic pay to the Thrift Savings Plan (TSP) to get the pull 5% DoD match:
You also need to make sure you contribute 5% every month and don’t fill the TSP too early. If you max it out in October, you won’t get a match in November or December.
If you can afford to, contribute the maximum allowed to your retirement plan even if your employer does not match.
This is $19,500 in 2021. You can do an extra $6,500 if you are 50 or over. You can even do more if you are in a combat zone.
Once you have maximized contributions to your plan at work, contribute the maximum you can to an IRA, even if you cannot take a tax deduction on it.
If you are able to fill your TSP account, next you’ll need to open an IRA at an investment firm. Vanguard is the obvious choice due to their across the board low investment fees and unique non-profit structure, but you can do this anywhere (Schwab, Fidelity, etc.).
If you make too much to contribute to a Roth IRA, you just use the back door Roth IRA option.
Consider your personal tax bracket when trying to decide if you should contribute to a Roth or a traditional IRA/retirement plan.
With a traditional plan, you take a tax deduction now and pay taxes later when you take the money out. With a Roth plan you pay the taxes now and the withdrawals are completely tax free.
The general principle is that if you are in a lower tax bracket now than when you are retired, you do the Roth. If you are in a higher tax bracket now, you use the traditional.
No one really knows what the future holds, though, making this decision tough. Here are some resources for you to check out when making this decision:
Do not take loans against your retirement plan. Allow the tax-deferred or tax-free status of the account to maximize the growth of your money.
While the TSP allows loans, I refuse to link to any information about it. Once you put money away for retirement, you don’t borrow from it unless it is an ABSOLUTE EMERGENCY.
The Bottom Line
Here are the point-by-point summary of steps Jim Lange suggests you take if you are saving for retirement:
- Contribute at least the amount to your retirement plan that your employer is willing to match or partially match, which is 5% of basic pay in the BRS.
- If you can afford to, contribute the maximum allowed to your retirement plan even if your employer does not match, which is $19,500 in the TSP ($26,000 if you’re 50+).
- Once you have maximized contributions to your plan at work, contribute the maximum you can to an IRA, even if you cannot take a tax deduction on it. Use a back door Roth IRA if you need to.
- Consider your personal tax bracket when trying to decide if you should contribute to a Roth or a traditional IRA/retirement plan.
- Do not take loans against your retirement plan. Allow the tax-deferred or tax-free status of the account to maximize the growth of your money.