Investing in real estate….passively :-)

Over the past couple months, I have been thinking about all things real estate. Basically, the question boils down to: in what ways can I add a real estate component to my financial portfolio.

  • First, I was thinking about what is a “good mortgage amount” that fits my criterion for FI in 10 years. My primary residence will not be an investment in real estate, but will add a real estate component to my financial empire ūüėČ
  • Second, the question that came to my mind was: can I somehow add a real estate component to my portfolio before purchasing my primary residence?
    • I use Personal Capital¬†to track where my portfolio is and it is an AWESOME tool to track all your finances in one place. The one feature I really like is that it breaks down all the funds in your portfolio into the following categories, JUST by taking the names of the different funds like VDIGX, VTCLX, etc. For example,
      • Large cap, mid cap, small cap split
      • Cash and bonds split
      • Alternatives (real estate, etc)
      • US and International split
    • Personal capital pointed out a weakness¬†in my portfolio diversification w.r.t. lack of investment in Alternative Investments like Real estate, hedge funds, commodities, etc.
    • Hence I started looking at how to add a real estate dimension to my portfolio.

This blog talks about the options I investigated.

Option 1: Rental Property Investment

I live in a HCOL (high cost of living area) on the west coast. Real estate is normally expensive in my HCOL area, but it is especially so in today’s market. There are many reasons for it, but primarily I would say that institutional investors and foreign investors are the main reason. For example, many houses that are listed in the market nowadays come from Berkshire Hathaway Property Holdings!

Anyways, I searched for a couple of rental properties (1B and 2B ones) in and around my area (radius of 25 miles max) and used my blog friend Well Rounded Investor’s Real Estate Income/Expenses spreadsheet. She is truly a well rounded investor, with investments in real estate and stocks. I played with numbers for some¬†rental properties using her spreadsheet and I somehow never broken even on any property….not even close.

I could go more than 50+ miles from my area where the nos are a little bit more friendly, but I would not know the area and it would be a maintenance nightmare. Adding the cost of a property manager will make the numbers very unfriendly.

Another option is to go out of state and invest in rental properties. For example, my office colleague invests in Washington State rentals, but his sister is the property manager…huge trust advantage ūüôā I do not have such an advantage and when I barely have time left to breathe…out of state property investment is too much of a reach.

So, I tabled this idea for now. I will continue to learn from the real-estate-wise blogging friends and hope to add one or more rental properties to my portfolio at a later date.

Option 2: Investing in REITs

REIT is a short form for Real Estate Investment Trusts. REIT funds invest in real estate investment trusts i.e. in companies that purchase office buildings, hotels, and other real estate property types and generate income from renting out the properties. Most of the income produced is distributed as dividends to the investors.

Take for example VGSIX/VGSLX (Vanguard REIT Index Fund). This fund invests in many real estate investment trusts..the top 10 holdings of this fund are:

  • Simon Property Group Inc.
  • Public Storage
  • Equity Residential
  • Health Care REIT Inc.
  • AvalonBay Communities Inc.
  • Ventas Inc.
  • Prologis Inc.
  • Boston Properties Inc.
  • HCP Inc.
  • Vornado Realty Trust

One can invest in a REIT Index (VGSLX) or invest in individual REITs themselves. But, I prefer index funds for diversification. We will talk about this later.

Advantages:

There are a few advantages to owning REITs or REIT funds

  • Adds real estate¬†exposure to one’s portfolio with minimal upfront cash.
    • For example, minimum purchase for VGSIX is $3000.
    • A relatively safe rental property investment in my HCOL area needs at least $70000 (20% on a 350K rental).
  • Diversifies the risk
    • A single rental property => all the risk in one single location and with one single tenant.
    • REIT investment => risk is distributed across multiple locations and multiple tenants.
  • Diversification of assets
    • REITs invest in different assets compared to most companies whose Stocks and bonds we invest in.
    • For example, a REIT that operates hospital buildings will generate ¬†income even in market downturns where stocks and bonds may tank.
  • Liquidity
    • A rental property is not a liquid asset i.e. it cannot be sold quickly to generate money….selling a REIT fund is as easy as one click…ofcourse, quick selling both assets can lead to a loss.
  • Low effort (passive)¬†Asset
    • Once you put in the effort to choose a REIT or a REIT index fund and set up the automatic investment option, there is no further effort required. A really nice asset for busy people ūüôā
    • A rental property requires much more effort to manage…even if you are using a property manager. The variables with a rental property are many….quality of tenants, quality of property manager, quality of the property, etc etc

Disadvantages:

  • A REIT is not a tax-efficient investment
    • A REIT generates dividends that are treated as Ordinary Income. So, for folks already in the high income tax bracket, the dividends are taxed at a very high rate.
    • A rental property on the other hand provides an opportunity to claim tax deductions due to mortgage interest deductions, property depreciation, etc etc.
    • For high income tax brackets, tax efficient properties can be a boon.
  • Capital appreciation potential
    • A rental property, bought at the right time, can appreciate many times faster than a REIT fund can.
      • Especially, those that were¬†bought around 2009-2011 time frame.
    • This is especially important when you leverage the buy using a mortgage i.e. pay $70000 down payment for a $350000 property and sell it when it reaches $550000 and make $200K profit leveraging money from a bank mortgage.
  • Single trick pony
    • Rental properties provide the triple threat of an ability to lower taxable income, potential for capital appreciation and doing all this by leveraging money from the bank.
    • REITs are a single trick pony….ordinary income every month.

Conclusion 

Both rental properties and REITs have their own charm. For me, at this point in my life, I am short on two things:

  • Time
    • I do not have time to spare. Between working full time and preparing for a job hunt, I am totally out of time. And a new job means putting in max effort in the first year to establish myself. So, I do not anticipate more time in the next year.
  • Down payment money
    • I am saving¬†for the down payment for my primary home and cannot afford another down payment in the immediate future.

Considering that, I decided to invest in REITs. More specifically, I chose a REIT index fund called VGSLX. It is a Gold rated fund from Vanguard, the low-cost king of mutual funds. I had an IRA in my tax-advantaged portfolio that had accumulated gains over the past 3 years. So, I moved some of my gains in the IRA target date funds into a new position in VGSLX. REITs have gone down a couple percent this year and are close to their 52 week lows. So, I am am getting in with a little bit of a cost advantage. I expect the REITs to go down more this year and I will move a little more of the IRA gains into my real estate position of my portfolio.

I do not expect to tap into my IRA/tax advantaged retirement holdings until many many years from now. If my¬†passive income strategy works out, I may never have to tap into it ūüôā Anyways, the REIT index fund will have many many years to compound all the dividends in a tax efficient way. So, go REITs !!