Real estate investing has long been considered one of the most reliable avenues for wealth creation. Whether you’re a seasoned investor or a newcomer to the world of real estate, understanding the inherent risks and opportunities is crucial for making informed decisions. In this article, we will explore the various facets of real estate investing and discuss the potential risks and opportunities that come with it.

Opportunities in Real Estate Investing

Potential for Appreciation

One of the most enticing aspects of real estate investing is the potential for property appreciation. Over time, real estate tends to increase in value, especially in desirable locations. By holding onto a property for the long term, investors can benefit from capital appreciation, allowing their initial investment to grow significantly.

Historically speaking, housing has generally increased above the rate of inflation (inter-year volatility aside), making it a great inflation-adjusted or real-rate-of-return asset. Furthermore, and somewhat related to the above, many investors see physical real estate as an inflation hedge, as the value generally keeps in line with, or exceeds the rate of inflation. 

This is because a major cost of housing is tied to the physical commodities that go into the actual construction, along with labor wages, which both make up a major component of the official inflation rate. 

If housing values were to decline lower than the cost of construction for too long, housing wouldn’t be constructed and the whole industry would grind to a halt or not exist at all. Of course, cyclical factors and timing can throw this relationship out of whack in the short-term, but when thinking long-term, these basic principles must hold true. 

Rental Income

Investing in residential or commercial properties can generate a steady stream of rental income. This income can be a reliable source of cash flow, helping investors cover mortgage payments and expenses while potentially providing a profit. Effective property management can maximize rental income and ensure a consistent return on investment.

This form of income is considered passive, which means very little work (when compared to an actively run business such as a manufacturing business or service-based businesses) goes into producing the income stream. Investors can even outsource property management to enjoy the benefits of a cash flow producing business all while being very little involved in the actual day-to-day handling of your investment. These steady and reliable cash flows are a staple of real estate investing. 

Diversification of Investment Portfolio

Real estate offers an excellent way to diversify an investment portfolio. Unlike stocks and bonds, real estate tends to have a low correlation with broader financial markets. This means that when other assets decline in value, real estate investments may remain relatively stable, providing a cushion during economic downturns.

Many investors can keep total returns of their overall portfolio stable or the same, all while reducing risk; given the historical correlation relationship to financial markets noted above. 

Tax Benefits

Real estate investors can take advantage of various tax incentives and deductions. These include deductions for mortgage interest, property taxes, and depreciation. Additionally, long-term investors can benefit from favorable capital gains tax rates. These tax benefits can significantly enhance the overall return on investment.

To dig a little further into the tax benefits of depreciation, let’s look at an example. Let’s say you have a property that is rented for $24,000 a year and your total expenses including maintenance, interest, property taxes and other costs are $12,000. In a normal business, you’d claim $12,000 in pre-tax profit on your tax return. 

With the power of depreciation, you can claim a percentage of your original total cost of the property as depreciation expense (actual calculation can vary from jurisdiction to jurisdiction and year by year given tax changes). Let’s say based on the original purchase value, the allowable amount of depreciation is $12,000. From a tax perspective, your income is $0 and you’d pay no taxes at all! 

Assuming the principal portion of your mortgage payment is less than $12,000 per year, you are now generating cash flow, all while avoiding any tax. This generated cash flow can then be used or saved to buy other property and restart the process all over again. This non-cash expense can have real life cashflow benefits, making real-estate one of the most tax-favorable investments out there.

To expand on the favorable capital gains treatment, passive investments like rental properties have profits on selling the property treated as capital gains which have a lower effective tax rate. As a comparison, interest earned on bonds can be treated as ordinary income, which subject you to the higher personal tax rates, depending on your jurisdiction. 

Finally, there’s always the ability to refinance your rental property if rental rates have increased enough to cover the new, higher mortgage amounts. A refinancing can be a tax advantageous way to take a large sum of cash out of your property tax free. These large cash sums can be used to buy additional property to then rinse and repeat the process.

To summarize, depreciation, refinancing and capital gains’ tax treatment make real estate one of the most favorable tax advantageous investments out there. 

Risks in Real Estate Investing

Market Volatility

Real estate markets can be subject to cyclical fluctuations. Economic downturns, changes in interest rates, or oversupply of properties can lead to declining property values. Investors who do not anticipate market volatility may find themselves facing financial losses.

Although not as volatile as financial market investments like stocks and bonds as noted above, real estate investing is still subject to its own market volatility. 

Just think of the 2008 housing crisis or the commercial real estate trouble caused by the new era of work from home. It’s important to be ready for these generally unforeseen cyclical risks by building additional cash buffers, being extra careful during your due diligence process by understanding what type of real estate or markets you’re investing in, or by making sure to put up an adequate down payment to have a larger equity buffer. 

Property Management Challenges

Owning and managing real estate properties comes with its fair share of challenges. Property maintenance, tenant issues, and unexpected repairs can be time-consuming and costly. Inefficient property management can erode profits and create headaches for investors.

Unforeseen maintenance or repairs can be a major risk to your investment. Try to think ahead and make routine inspections to determine what items might need replacing in the near and medium-term future. You can also put a percentage of the generated cash flow from your real estate investment to the side and keep it as a rainy-day fund for these unforeseen items.

When investing in residential rental properties, be extra careful about who you select as tenants. Make sure to evaluate credit, employment history, and who the actual tenant is. 

Some of this risk can be mitigated by choosing certain locations over others depending on the type of tenants you want. If you’re looking for a young family, try choosing a property close to elementary, middle or high schools. If you’re looking for stable government sector workers, choose a location near major public sector offices. 

Then you may decide you want exposure to university students because you can generally charge higher rent if there’s not an adequate supply of close-to-campus options. If that’s the case, just make sure your rents are higher than they’d otherwise be to cover additional damages that will probably come about. Always get rewarded for the additional risk. 

Financing Risks

Many real estate investors rely on financing to acquire properties, which introduces financial risk. If interest rates rise or if an investor cannot secure favorable loan terms, it can negatively impact cash flow and profitability. Additionally, taking on too much debt can increase the risk of foreclosure in the event of financial setbacks.

There is a famous saying in real estate that debt is your best friend until it isn’t. That’s because the leverage that comes along with real estate investing allows you to buy a more expensive asset than you’d otherwise be able to buy.

Just think of this example. You have $100,000 and you can either put it into the S&P 500 index which has an average return of ~12% per year historically or you can buy a home worth $500,000 with a down payment of $100,000. 

Your investment in the S&P 500 index would yield about $12,000 in total return before taxes per year. Alternatively, your real estate investment would return $50,000 per year if it just yielded 10% on average every year. Even at just 5% per year, your total return before tax would be $25,000; roughly double the total return on your stock portfolio, while only being half the percentage return. 

Now the dark side; assume there’s a recession, and you lose your job. Your stock portfolio drops 20%, but you’re able to liquidate part or all of your portfolio to scrape by until you find a new job.

On the other side, your house drops by the same 20% to $400,000 which was your original mortgage amount. You’re now jobless, have $0 equity and have a mortgage to pay every month.

The same type of risk can be applied to a rental property when your tenant loses a job, stops paying, or your house sits vacant for a prolonged period of time. Your tenant may not pay, but you still have to pay your mortgage as banks are less forgiving as we all know.

The power of real estate is the ability to leverage your investment, but it’s also its biggest risk. 

Lack of Liquidity

Real estate is not a liquid asset like stocks or bonds. Selling a property can take time, and during market downturns, it may be challenging to find a buyer at the desired price. Investors may find themselves in a bind if they need to access their capital quickly.

This risk is also related to the above financial risk and compounds it. Even if you had equity remaining in your home to draw on in the event you needed it, you may not be able to liquidate your investment in time. 

Regulatory and Legal Issues

Real estate investing is subject to numerous laws and regulations at the federal, state, and local levels. Violating these rules can lead to legal disputes and financial penalties. Staying informed and complying with all relevant laws is essential for investors.

Having a trusted go-to lawyer is a great solution to help address these issues. Compared to other lawyers, they are generally less expensive and it’s always good to get a second opinion.

Try your best to read about applicable tax treatment related to your real estate investments as well. As mentioned in the opportunity section, real estate generally has unique tax advantages that you can draw on, but they can also be tricky to navigate. You want to make sure you’re not offside on the application of relevant taxes, while getting the most out of the favorable tax  treatment on your investment. 

Real estate investing offers a range of opportunities for wealth creation and portfolio diversification. However, it is not without its risks. As with any investment, thorough research, careful planning, and prudent decision-making are essential. Investors should assess their risk tolerance, financial goals, and market conditions before embarking on a real estate investment journey. When approached with diligence and a clear strategy, real estate investing can be a powerful tool for building long-term wealth.