For many investors, real estate is an appealing investment option for a variety of reasons including diversification, returns, risk, and tax. Real estate investing is quite different from investing in stocks and bonds, but nonetheless offers unique benefits that make it a worthwhile option for many investors to consider.
Financial Assets – Property vs. Stocks and Bonds
When compared to equity and fixed income securities, real estate involves different types of risks and activities as well as a greater time commitment. However, real estate investments also allow an investor to diversify their portfolio and gain exposure to returns that are unrelated to the overall stock or bond markets.
Purchasing Property vs. Investing in Property Funds
There are two main ways of investing in real estate. The first is buying property directly, and the second is investing in a real estate fund.
As an investor, you can buy a property directly and retain ownership of it. Your investment gain will be based entirely on your ability to sell the property for more than it cost you.
In contrast, you can also indirectly invest in real estate by investing in a real estate fund, such as a REIT. Like ETFs and Mutual Funds, these investment vehicles provide diversification within the sector and are less time intensive than investing in numerous stocks individually.
Pros and Cons of Each
Control: Investing in a property gives you strong direct control over your investment’s success or failure. While there are still many factors beyond your control, such as the overall housing market, natural disasters, etc., you are able to determine the property’s features, improvements, development, and income-generation.
Time: Owning a property is a significant time commitment, as there are a lot of activities that take careful and active management.
In contrast, real estate funds allow one to be invested in real estate without having to actively partake in its management. Furthermore, real estate funds allow the investor to own parts of multiple properties, which gives a diversification benefit that reduces the risk and impact of something especially negative happening to one property.
Real estate funds also prevent you from being able to determine the success or failure of the property. Rather, others will be managing the use of your investment on your behalf. Real estate funds also lack some of the tax benefits of directly owning a property.
Real estate brings with it unique tax considerations that are very different from other classes of securities.
Bonds and stocks are taxed in a relatively straightforward method. Long- and short-term capital gains on bonds and stocks are taxed at their disposition. If there is a loss, the loss is similarly deducted at disposition. Income generated from bonds and stocks is taxed in the year in which it is received.
Real estate ownership differs in that it allows you to depreciate your property over the course of owning it, which allows you to reduce your current tax burden by deferring taxes.
Investing in real estate directly also allows for the deduction of a variety of expenses. For example, repairs to a property can often be deducted from your income for that tax year. These deductions allow you to improve your property while reducing your tax liability immediately.
Why Does This Matter to Me?
As an investor, it is important to consider the pros and cons of both, when deciding whether to diversify into property stocks or real estate proper. For some investors, real estate might be an attractive option while for others it might not be ideal, taking into consideration the time commitment and high levels of liquidity risk.