Those investing in real estate have to be prepared for the baggage that comes with it. If you’d rather not bother, there are two investment opportunities that offer the benefits without the baggage: REITs and limited partnerships.
Among all of the asset classes available to the average investor, physical real estate stands alone with its beautiful simplicity. After all, the tangibility of such property — and its straightforward path to income generation — is unique in today’s landscape of digital ticker symbols and complex investment vehicles.
In spite of the attraction that real estate might hold for many Americans, one point should be clear: This asset class is not bulletproof. It is very possible to lose money in the property market, and depending on an investor’s savvy and geographic location, it may even be likely.
Further, the time commitment associated with property management often forces investors to make an unpleasant choice between sacrificing a large chunk of monthly cash flow or many hours of their own time.
Fortunately, there is a viable alternative: securitized real estate investing. This piece will examine many of the common pitfalls that investors in physical properties deal with, and take a closer look at the alternative offered by real estate investment trusts (REITs) and real estate limited partnerships (LPs).
What investors get wrong: Valuation and aggravation
The first and most obvious evaluation of whether a real estate investment will be successful involves the economic relationship between the purchase price of a property and its capacity as a cash generator. This relationship is best defined by a metric known as capitalization rate, or as it’s often used informally, “cap rate.”
While factors such as supply and demand, personal financial stability and economic cycles can impact the final return on these investments, the cap rate offers an objective, big-picture distillation. It’s calculated as follows: Net operating income (“NOI”), divided by the purchase price (whether actual or proposed.)
A low cap rate may indicate that the seller was able to charge a premium for their property relative to its income potential, whereas a higher rate may favor the buyer under certain market conditions. What is interesting is how few buyers of physical real estate even take into consideration this simple metric when making investment decisions.
It is surprisingly common for investors to incorrectly evaluate their property. Purchasing a property that costs too much and then seeing stagnant appraised values or rental rates can be disastrous on an investment as large as a house or commercial property. It also may be difficult to forecast the exit on a real estate investment as rental market dynamics, construction starts and interest rates often dictate when and whether investors can sell properties at a profitable level.
Those are some of the financial implications. There are other, more mundane challenges to this type of investing that often get overlooked. Hassles in negotiating with tenants and the time commitment and cost involved with property management should also be primary considerations.
I’m talking, of course, about the dreaded Four T’s: taxes, tenants, termites and toilets. Each of these variables is mostly self-explanatory. The tax consequences of owning property can be significant, depending on your local tax codes. Tenants themselves can be unreliable — they’re people! Vacancies can occur. Sometimes the rent is late. And renters don’t always treat the properties with the same level of care as an owner; hence, the need for security deposits.
Termites can be looked at as the literal pests they are … or as a metaphorical proxy for the wear-and-tear that happens to any property. And toilets — the cost of maintaining the dwellings that house your tenants — represent a significant expense. Your pocketbook and your schedule need to be prepared for the investment in real estate before…