Why invest in real estate?

By Dan McDermott

Are you looking to diversify your investment portfolio or tired of worrying about the next market correction and how your portfolio or IRA will fair, or just looking to buy a stable asset that can provide income for you or your family? If so, I think you should strongly consider an investment in real estate.  There are many reasons for those considering an investment in real estate - however I think that two of the most compelling reasons are listed below. 

Cash flow:

The most compelling and attractive reason for making an investment in real estate is cash flow.  Cash flow, or profit, is the amount of money left over after subtracting the operating expenses and debt service (mortgage) from the rental income generated from the property. The wonderful thing about cash flow is that this passive income is earned with little to no effort from the investor.  Once the investor selects a property, acquires financing, closes on the property, and leases out the property; the investor can then sit back and enjoy their monthly income with little additional effort. 

Another great benefit of cash flow is that it is a great hedge for your larger investment portfolio against economic downturns. In economic downturns, real estate tends to not correlate directly to the wider market conditions. One interesting fact about rental properties is that rents generally tend to increase during times of market instability. This is due to the fact that many homeowners fall on challenging times during economic downturns and find it more cost effective to rent than own a home. This creates a higher demand for affordable rental units and in turn drives up the market rents. 

This is especially attractive for an investor since the typical financing used to purchase these properties are fixed rate mortgages. This means that the operating expenses and debt services will remain stable over the life of the investment all while rents are being driven up and generating more income and a higher return for the investor.

Leverage: 

Another compelling reason for making an investment in real estate is leverage. Leverage is defined as the use of various types of financing or borrowed capital to increase the potential return of an investment. This is commonly referred to as “other people’s money” by Wall Street and Main Street when talking about the real estate markets. Leverage can be used to increase the purchasing power of the investor and provide them with all the benefits that come from owning that property.

 Let’s take a simple example of an investor who has $100,000 to make an investment in real estate and let’s assume that in the current market properties are appreciating at 5% per year.   This investor could purchase a $100,000 property in full. At the end of 12 months this property would be worth $105,000 and the investor would have achieved a 5% return.  Now if that same investor used their $100,000 as a 20% down on a $500,000 property at the end of the year the property would be worth $525,000 and the investor would have also achieved a 5% return.  However, the investor would have earned $20,000 more plus the increased income that would have been generated from the $500,000 property vs $100,000. 

Leverage can drastically increase the potential expected return the longer the investment property is held.  Additionally, leverage allows an investor to acquire and realize the benefits of more properties with a smaller initial investment.

The benefits of investing in real estate are abundant and I have highlighted just a couple above.  While these benefits are attractive it should be noted that no investment, whether in the stocks, bonds, or real estate, comes without any risk. If you are considering an investment in real estate, I would recommend that you seek professional advice from an experienced realtor.  A realtor can provide you with depth of experience, hyper local market knowledge, and advise you as you make the exciting first step towards financial freedom.