Advantages of Creating a Well-Balanced Real Estate Portfolio
Investing in real estate can be scary and uncertain for many people. There are many considerations to evaluate and questions that need to be understood and answered. Although those issues may appear daunting, there are significant advantages to adding real estate to one’s investment strategy that should not be overlooked.
The Benefits of Real Estate Investments
Real estate investments offer many benefits that stocks or bonds do not provide. Individuals seeking a secure and well-balanced portfolio, regular cash distributions, and price appreciation realize that real estate is the avenue to achieve these goals. Logging on to check your stock and bond portfolio can be fun but also somewhat abstract. Something is appealing to having a tangible investment — something that one can see, visit, and touch. Adding real estate to an investment portfolio also brings one closer to self-reliance and self-assurance.
Among the advantages that real estate investing can provide to a knowledgeable investor are:
- Less volatility
- Cash flow plus appreciation
- Diversified portfolio
- Historically good performance
- Limited supply
- Tax advantages
- Stocks Versus Real Estate
Investing in good stocks can produce an excellent return for those with higher risk tolerance. However, stock prices can also drop and occasionally go to $0. There are many notable examples of major corporations whose stocks have failed — Enron and MCI/WorldCom are two examples. In contrast to stocks, real estate investments can provide more security. Real estate values have never been reduced to $0. The land itself will always retain some value. The land retains inherent use and value even when an old structure sits on it and must be demolished. As a result, there is an enhanced level of security with real estate investments over stock alternatives.
We have all witnessed days when the Dow Jones Industrial Average increased or decreased by more than 1,000 points. This volatility can be very unsettling to many investors. When stocks fluctuate in this manner, some investors wonder what is the real value of a company if its price can change so dramatically in a short time. Real estate prices are much more stable and generally not subject to drastic price adjustments. Its more stable pricing nature and long-term value are two primary reasons people choose to invest in it.
There are typically two investment approaches associated with stocks — growth and value. Growth stocks, which generally include most of the tech sector, are primarily focused on price appreciation and less so on paying dividends. Their investors prefer these companies reinvest their profits into research and development to grow, as opposed to using it to pay shareholders a dividend.
Value-oriented stocks, such as the consumer staples and energy sectors, are focused on paying investors regular dividends. This means there is less cash flow available to reinvest into research and development or future acquisitions, but these companies provide steady cash dividends that have appeal to certain investors.
Bonds Versus Real Estate
Bonds, another investment vehicle many conservative investors consider, can be more secure than stocks. When a company has cash to distribute, bondholders are paid before dividends are issued to stock investors. However, bonds only offer regular interest payments to their investors. There is no ability to experience any appreciation from bonds.
In contrast to either value- or growth-oriented stocks and bonds, real estate generally provides investors with BOTH cash dividends (through rents) and appreciation. This unique feature of real estate leads most investors to add it to their investment portfolio.
Creating a Well-Balanced Portfolio with Real Estate
A well-balanced and diversified investment portfolio is like a three-legged stool. One leg represents stocks, the second one bonds, and the third leg is real estate. Real estate provides diversification that would otherwise be absent when your portfolio consists of only stocks and bonds. Part of the reasoning behind this is the fact that real estate pricing is determined and impacted at a local level, whereas pricing for a particular stock or bond is established uniformly. Every property is unique, whether in style, location, or functionality, but the product is the same wherever one purchases a bottle of Clorox or a McDonald’s burger.
From a long-term perspective, real estate offers investors historically good performance. Since the construction process is detailed and laborious in many jurisdictions, it can often take years from conception to completion. As a result, real estate values can be insulated because adding new supply is difficult. Second, real estate investments frequently utilize financing, often at extremely low rates (i.e., current commercial interest rates can range from 3.5% to 4.0%), significantly enhancing investors' returns.
Another uniqueness of real estate compared to stocks or bonds is that land is finite. There is only so much of it, and in some markets, particularly on the east and west coasts, there is so little developable land, prices have been steadily increasing. This will become even more apparent in the coming decades as our population grows.
There are also significant tax advantages for real estate investors. The two major advantages are depreciation and tax-deferred like-kind exchanges. Neither of these options is directly available to stock and bond investors. Depreciation permits an investor to deduct a portion of the property’s purchase price over a specified number of years. This can help some investors shelter net profits from rents. The second advantage is the ability to defer capital gains upon sale by investing the proceeds in another real estate investment. These two tax benefits can give investors a significant advantage over stocks and bonds.
Want to read more about how investing in commercial real estate can enhance your portfolio? Would you also like to see how Kenwood’s real estate returns compare to the S&P 500’s?