Explainomics: How to invest in real estate without buying a house

Mutual Funds

Americans love investing in real estate. When asked their preferred way to invest money they won’t need for more than 10 years, Americans’ No. 1 choice is real estate. And yet there are many challenges to owning a house or rental property. The upfront costs can be daunting — a down payment might be anywhere from 5% to 20% of the home price and average closing costs run between about 2% and 5% of the loan amount. Once you own the place, you’ll still need to pay for property taxes, as well as the costs of maintenance and upkeep. And if you rent it out to someone else, you’ll need to deal with the stress of finding and screening a tenant, paying for repairs and covering the mortgage during any vacancies.

But what if you could invest in real estate without ever buying a physical property? Here are three things you need to know:

Know your options

For everyday investors who want easy access to their capital, there are publicly traded instruments that are liquid, meaning you can buy and sell them at anytime, just like stocks. Some popular options are real-estate investment trusts (REITs), real-estate mutual funds, and real estate ETFs.

A REIT is a company that owns and operates real estate that produces income and returns most of that income to its shareholders. Some REITs have a diversified portfolio of properties, while others focus on specific types of real estate, such as hotels, office buildings, warehouses or hospitals.

When you own shares in a REIT, you become a mini-landlord of sorts because REITs are obligated by law to return at least 90% of their taxable income to shareholders in the form of dividends.

To achieve higher diversification, some investors like real-estate mutual funds, which can be seen as baskets of REITs and other kinds of real-estate investments. And real estate ETFs have grown in popularity because they are similar to real-estate mutual funds but offer lower fees and often track a broad index, such as the MSCI U.S. REIT Index or the Dow Jones U.S. REIT Index

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All of these investing vehicles share some common features: they allow individual investors to buy into real estate without any of the headaches of owning property, like property taxes and high maintenance fees. What’s more, they enable you to invest as little as a few dollars in a sector that would otherwise require prohibitive amounts of capital as a barrier of entry.

Know the risks

Every investment strategy comes with risks, and real estate is no different. First, anything that might affect real-estate prices could inevitably affect REITs and other real estate holdings. “Remember, real estate is cyclical,” said Jared Feldman, a partner at the accounting and advisory firm Anchin who describes his job as being a “CFO to high net worth individuals and families.” Cyclical assets rise and fall with the economic cycle. As such, real-estate prices tend to rise when the economy is booming, and fall during economic contractions and recessions.

Another thing to monitor, according to Feldman, is rising interest rates. Traditional buyers of real estate closely watch interest rates mainly because higher rates mean a higher cost to finance a purchase. But even if you’re not buying a physical property, rising interest rates could be negative for your real estate holdings. That’s because when bond yields rise, the yields on REITs start to look relatively less attractive and investors tend to sell them. But there is a silver lining. If interest rates are going up because the economy is improving, REITs’ rental income may be increasing and the value of the properties they hold may go up as well.

Finally, most of the traditional risks associated with physical real estate — such as structural problems in different properties, bad tenants, or too much leverage — also exist in REITs and other real-estate investments. “People might think it’s easier because you won’t be the landlord yourself. But make no mistake, those risks are priced in,” said Anora Gaudiano, CFP, a senior advisor associate at Wealthspire Advisors.

Know your goals

If you’re wondering whether you should buy physical property or invest in other real estate holdings, the answer is “it depends.”

“Like everything else in your portfolio, you need to have a reason why you own real estate,” said Gaudiano. For most people, investing in real estate basically means “their home,” she said. “For the average American, that’s where a lot of their net worth is tied up. And that’s mainly because people need shelter and a place to raise their families.”

But when it comes to REITs and other real-estate investments, it’s a different story. “The main reason to own them is to reduce volatility, increase diversification and provide a source of income,” writes Paul Merriman, founder of Merriman Wealth Management.

REITs can be a good income source, thanks to the high dividend payout (remember, at least 90% of the taxable income is returned to shareholders). But there’s a catch: the REIT payout is considered ordinary income, which means it will be taxed at a higher rate than capital gains, Gaudiano said.

As for diversification, a way to think about your portfolio is “diversification equals insulation,” or in simpler terms, “protection from the bumpiness of the marketplace,” said Duy Nguyen, Chief Investment Officer for Invesco Solutions.

Real estate traditionally falls under the category of “alternative” investments, which Nguyen says are “anything that is not equities or fixed income.” (Also check out this video, where Nguyen explains in detail how to invest in alternatives.)

But liquid real-estate investments are also “directional,” which means they have some correlation to the broader market — just not as high as broad equities. In other words, according to Nguyen, the positive aspect is that your money is not tied up (i.e. you can sell anytime), but the negative aspect is that there’s higher volatility.

That volatility can “break your heart” in the short term, Merriman writes. But he also points out that from 1975 through 2006, a portfolio divided 50/50 between the S&P 500 and a REIT index returned 15.2%, vs. 13.5% for the S&P 500 alone. The frosting on the cake: Risk was 12% lower than that of the S&P 500 by itself.

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