How Much of Your Portfolio Should Be in Real Estate?

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: Matthew Staver/Bloomberg
Matthew Staver/Bloomberg
Looking for a good return on your investment? That 12 percent jump in home prices from April 2012 to April 2013 makes real estate sound pretty good.

If you own a home that has appreciated in recent months, perhaps you're thinking it's time to buy an investment property. If you prefer a more hands-off approach, you may be considering putting your money in a real estate investment trust, or REIT.

Financial and real estate experts have varied views about the best way to invest in real estate, but all agree that it's important to have a diversified portfolio. Here's their advice about how much property should be in your portfolio.

Why Real Estate?

In spite of the recent housing crisis, real estate historically has been a safe, sound, solid investment, says Theresa Bradley-Banta, founder and CEO of Theresa Bradley-Banta Real Estate Consultancy in Denver and author of "Invest in Apartment Buildings: Profit Without the Pitfalls."

"Real estate tends to go up in value, can provide cash flow from rental income, and offers tax benefits and incentives," she says. "Also, over time, equity value increases as the loan is paid down and appreciation can be forced by making improvements to the property."

Another way to look at real estate is through the lens of how the sector compares to other investments in your overall portfolio. Frank Armstrong, president and CEO of Investor Solutions in Miami, agrees that real estate should be part of your investment portfolio. "Real estate is a great asset class with little correlation to the stock market, which means that it can over time reduce portfolio risk and increase returns in a properly structured portfolio."

That said, like any asset class, real estate isn't immune to the market's roller coaster, as we all learned just a few short years ago.

"Real estate is a cyclical, interest-rate-sensitive investment," says Keith Newcomb, a certified financial planner and portfolio manager with Full Life Financial in Nashville, Tenn. "For all the good times, there will also be bad times. Fortunately, there are usually signs along the way."

Direct or Indirect Investment

Your first decision as a novice real estate investor should be to choose whether you want to be a passive or active investor -- whether you want to own actual property or pool your money with other investors into more hands-off investments.

A benefit -- and a risk -- of direct ownership in a property is that you have a say in the management, maintenance, and sale, says Bradley-Banta: "With direct ownership, an investor has a much greater opportunity to build wealth." The more active leadership role investors take, the better their potential returns -- provided the investors are well-educated about real estate investing.

While some direct investors hold on to their properties for long-term growth and income, others opt to flip properties when market conditions are right.

Newcomb says real estate does best when you're able to purchase it at distressed prices from a forced seller, although financing can be harder to obtain in a declining market. Buying without financing in a down market -- if you can swing it -- can be the most profitable real estate investing scenario. On the other hand, when the real estate market is doing well and interest rates start to rise, Newcomb says, "the party has already peaked and may be nearing its end. At these times, it is best to keep the cash raised from reducing real estate holdings on hand and wait for the upcoming buying opportunity to unfold."

It's important to remember that direct real estate ownership is much more burdensome than buying professionally managed REIT common or preferred stocks, ETFs, or mutual funds, Newcomb says. As a landlord, you're responsible for maintenance and repairs, and your income stream is dependent on keeping your properties occupied with tenants who pay their rent on time.

And there are sure to be times when that's not how it goes: Landlords need to be financial prepared for those periods when the residence is unoccupied. A good rule of thumb for property investors, Newcomb says, is never to own more direct real estate than you could afford to hold with zero real estate income for an extended period of time.

The case for passive investments

Armstrong is less bullish on becoming a landlord; he recommends passive real estate investing.

"By now, we should have learned that speculating in houses carries a load of undiversifiable and unrewarded risk," says Armstrong. "When the housing market crashed, it took far too many individual investors with it. Additionally, it's a huge time sink to manage individual properties. Even if you don't lose your shirt, it may not be worth the effort and aggravation to be a landlord."

Armstrong suggests that a maximum of 20 percent of your risk assets be divided between domestic and foreign REITS, preferably index funds and ETFs.

REITs can own a wide variety of properties such as apartments, offices, hospitals, storage facilities, and retail sites -- areas where an individual may not otherwise be able to invest.

Another benefit of REITs is that, as an investment, they're more liquid than physical real estate. Selling a property isn't as easy as selling shares of a REIT. Therefore direct ownership should be viewed as a more long-term investment.



Michele Lerner is a contributing writer to The Motley Fool.

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8 Comments

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phil.ayres

Thanks for the great post that shows there are two sides to the discussion about whether to invest directly through ownership of real estate or to invest more passively through REITs and funds. It should also be noted that while the speculative nature of direct real estate investing can lead to a higher potential profit, the time it takes to buy, manage (either directly or through agents and service providers), rehab and sell property can make it a full time job. And more.

In between the fully passive REIT model and direct investing is equity investing in real estate, where you buy shares in real estate projects, giving you exposure to the real estate development, cash flow and appreciation directly, while avoiding the hassle of management and the full risk of a small number of properties.

An intro to equity real estate investing is here: http://www.repse.com/content/the_how_of_real_estate_investing.php

June 09 2014 at 5:46 PM Report abuse rate up rate down Reply
steve

real-estate should be more than half your portfolio [esp. your primary-res.],......prices are rebounding as we type.

July 18 2013 at 5:13 PM Report abuse rate up rate down Reply
Sparky5229

NONE

July 18 2013 at 4:46 PM Report abuse +1 rate up rate down Reply
Spinnaker

I can't spare more than $200 .................I have to buy gasoline.

July 18 2013 at 4:08 PM Report abuse +1 rate up rate down Reply
erink91321

Doing the Math I see another Housing Bubble that is looking for a sharper needle than last time and this bubble Will burst more suddenly than before and perhaps by this years end. Banks are back to making risky loans and the Fed has printed way too much Worthless Cash and Natural Resources are being depleted at a Very rapid pace. This type of Federal intervention was tried in Germany in the 1920s and it Failed Astronomicly leading to the disasters of the 1930s and the Nazi party. There is absolutely no reason why this type of intervention would work now. Just do the Math

July 18 2013 at 1:18 PM Report abuse +1 rate up rate down Reply
1 reply to erink91321's comment
steve

I believe the housing-market will just get stronger and better,....no more fraudulent mortgages, corrupt-loan officers, shady-bankers [crosses-fingers],....it's definitely a new world out there for first-time buyers.

July 18 2013 at 5:16 PM Report abuse rate up rate down Reply
tfarnon

The most recent real estate bubble and crash isn't the first one, the first one in my lifetime, or even the first one in my adult life. And I'm not even old enough to retire yet. I had some money in a REIT mutual fund before the most recent crash, but I sold while prices were still high. It wasn't a planned move--it's just that I was changing brokerages and had to sell the fund to move my account. Dumb luck, maybe, but I won't knock it. I just got back into a REIT mutual fund last week, because I think it's time. That said, I invested only about half a percent of my portfolio. There's probably another percent or two scattered in assorted other mutual funds I own, but my overall exposure is still less than five percent. I'll re-examine the REIT fund in about five years.

July 18 2013 at 10:53 AM Report abuse rate up rate down Reply
Mikerat42

Had one of the best REITS around before the crash. Thornburg.. DOA..

July 18 2013 at 9:08 AM Report abuse +2 rate up rate down Reply