By Dr. Jim Dahle, WCI FounderDo you find real estate investing confusing? You need Real Estate Investing 101. Today, I'm going to assume you know nothing about real estate investing and discuss it “soup to nuts.” After you read this post and have a better understanding of real estate, I recommend checking out WCI's No Hype Real Estate Investing course. It will give you the foundation you need to learn about all the different methods of real estate investing.
What Is Real Estate Investing?
Investing is the process of not spending money now (i.e. saving) in order to be able to spend (or give) more later. By deferring the spending of this money and placing it into investments in the meantime, the money will grow, hopefully at a rate faster than inflation. As a general rule, the more risk you take on, the higher your potential return. Real estate investing is a fairly risky way to invest. Thus, it often produces high returns, and your money grows quickly compared to a less risky investment, such as a savings account. A real estate investment is simply an investment that involves real property, such as empty land, a house, a warehouse, a shopping center, or an apartment building.
Why Is Real Estate Considered an Investment?
Real estate is considered an investment because it generally increases in value over time AND produces income in the form of rents. There are two main categories of real estate investments: debt and equity. Within these categories, there are both publicly traded and privately traded real estate investments.
Equity Real Estate Investing
Most investors are familiar with the concepts of equity (stock) and debt (bonds). These concepts carry over into the real estate world and mean essentially the same thing.
With equity real estate investing, you are the owner of the property. A property is really just a business, and all profits from the business go to you. Any appreciation (increase in value) of the business (property) between the time it is bought and sold is also all yours, at least after you pay any taxes due.
If the business loses money in any given year, that's your loss. If it decreases in value between the time it is bought and sold, that is also your loss.
This is the riskiest but generally, in the long run, the most rewarding way to invest. It is the equivalent of buying stock in a company. You can lose your entire investment and, depending on how much leverage you used, even more.
Debt Real Estate Investing
With debt real estate investing, you don't own the property. You are loaning money to the owner.
Hard Money Loan
Typically, this is some type of a mortgage, often called a “hard money loan” when issued by a private investor for a short time period. You generally take “first lien position,” which means if the owner stops paying you every month, you can foreclose on the property and sell it to get your principal back (and maybe even some profit.) Even if you lose money, it is very rare to lose all of it because the property is still worth something, even if the rental business it is a part of is a money loser.
Investments Bridging the Gap Between Equity and Debt
Mezzanine Debt or Preferred Equity
In the public markets, there are investments that sit between equity and debt, often called “preferred stock” or “convertible bonds.” There is a similar investment in real estate, called mezzanine debt or preferred equity. Risk and return are intermediate between equity and debt investments.
Mezzanine debt and preferred equity give the borrower or the sponsor of a deal leverage options in addition to common equity (the portion that the equity investors own of the property) and the hard money loan. You are generally paid a higher interest rate on mezzanine debt because you are not in first lien position. If the property must be foreclosed on, the person in first lien position must get all of their capital back before you get a penny. With preferred equity, you get paid before the common equity folks but have a cap on how much you will be paid.
Capital Stack
There is a “capital stack” in a well-performing real estate deal. The bottom 65% or so of the property value is debt and earns returns such as 4%-10%. The next 15% or so may be mezzanine debt or preferred equity and earn returns of 10%-14%. The top 20% is common equity and may earn returns of 14%-30% (or could lose everything.)
Ideally, a sponsor might love to simply borrow 100% of the property value. But no lender in their right mind is going to offer that large of a loan, because it is too hard to get enough money out of the property through foreclosure to make it worthwhile. So, the sponsor has to go elsewhere for additional funding and pay a higher price for it. So they offer mezzanine debt, preferred equity, and/or equity. Every deal has a slightly different-looking capital stack, but you should know where you stand in the stack with your investment. Obviously, when things go bad, they are worst for the equity investor and best for the lender in first lien position.
How to Get into Real Estate Investing
There are almost innumerable ways to invest in real estate. These range from building houses to renting out a field to a farmer to loaning money to a house flipper.
Lots of people don't want to invest in real estate because they don't want to get “3am toilet calls.” Most methods of real estate investing don't involve getting calls like that or even dealing with tenants at all. Investing in real estate can be as simple as buying a stock or mutual fund and as complex as building an entire neighborhood. I suggest you start out with the more simple methods and progress as your interest, time, and resources allow.
Passive vs. Active Real Estate Investments
One of the most important aspects of real estate investing is to match your interest, desire for control, time, and abilities with the requirements of the investment. A mismatch here can lead to frustration. If you were hoping for a very hands-off investment and you find yourself getting 3am toilet calls, you will be frustrated. Likewise, if you want to control every detail of the investment, such as how much is charged in rent and when and how the investment is sold, you may be very frustrated if the investment does not allow you to do so. There is a spectrum of investments from passive to active. On the passive end, you minimize your hassle. On the active end, you maximize your control. Only you can decide where you fit on the spectrum. On the most passive end of the spectrum, you can simply invest in an index mutual fund of publicly traded real estate stocks called REITs (Real Estate Investment Trusts).
On the most active end of the spectrum, you personally own and manage a single-family home down the street from yours. This allows you the most control (and tax benefits) from the investment, but it also requires the most work and provides the least diversification.
In between these two options are private real estate funds, REITs, syndications, and turnkey properties where somebody else is doing all of the work after your initial investment. They obviously charge fees for doing that (and sometimes A LOT of fees), but it does allow you to put your limited time to its best use.
Sources of Real Estate Investment Return
In a typical equity real estate investment, there are four sources of return:
#1 Rental Income and Expenses
Rental income is the most obvious. If you put enough money down (and I recommend you do), the property should be cash flow positive. That means it pays you more than it costs you.
Every property has expenses such as:
- insurance
- property taxes
- maintenance
- vacancies
- management costs.
A general rule of thumb is that these expenses add up to about 45% of the rent you can charge on a property. That leaves 55% of the rent that must cover any mortgage on the property. If it does not, you have a cash flow negative property that you must feed periodically from some other source of income or assets.
Most experienced real estate investors recommend avoiding this situation, especially in the long term. You can turn a cash flow negative property into a cash flow positive property by:
- getting a lower interest rate on the loan
- getting a longer loan
- getting a smaller loan (by putting more money down)
- reducing your operating costs
- by charging more in rent, or
- by increasing non-rent income (parking, laundry, etc).
#2 Appreciation
Appreciation is also an important source of return, especially in the long run. While the actual building generally decreases in value, the land it sits on generally increases in value. While there is no guarantee of appreciation because it is an inefficient market where location matters a great deal, it would not be unusual for a property to appreciate at about the general rate of inflation of 3%-4% over the long run.
#3 Debt Paydown
Debt paydown is also a significant source of return. In a cash flow positive property, the rent is covering all of the non-mortgage expenses, the interest on the mortgage, and the principal on the mortgage while also putting some money in your pocket. The expenses and interest are just throwing money away, but that principal pay down is increasing your wealth each month and it eventually will pay off the mortgage and dramatically improve its cash flow.
#4 Tax Benefits
Finally, there are significant tax benefits to real estate ownership. I'm not just talking about writing off the expenses of the business. Any business can do that. But with real estate, most of the value of the business is the house or building sitting on the property. Tax laws allow you to depreciate that building.
Depreciation
Depreciation is a tricky concept to wrap your mind around, but the basic idea behind it is that the building and everything in it will eventually need to be replaced. To compensate you for that fact, the IRS lets you take a deduction each year for the depreciation of the building. Even though you are maintaining it and even upgrading it, you still get to take this deduction. In a well-structured real estate business, the depreciation “covers” most or even all of the income from the property. This has a tax-deferral aspect to it which is very useful, especially if you are in your peak earnings years.
Bonus Depreciation
Bonus depreciation lets you take even more depreciation. It applies to the capital expenses of all kinds of businesses, including real estate businesses. In fact, you can take a massive chunk of the depreciation on the property in the very first year. An example might be that one could take a $300,000 bonus depreciation deduction in the first year after buying a $1 million property. You might have only put $300,000 down on that property, and in return, you got a deduction that was the exact same size!
When you sell the property, all depreciation has to be “recaptured” (i.e. the deduction has to be paid back to the IRS), but it is only recaptured at up to 25%. If that deduction was worth 37% to you when you took it, paying it back at 25% is a pretty great deal.
But guess what? If you die before selling the property or simply exchange one property for another instead of selling it, that depreciation is not recaptured at all. You may also find some other valuable tax benefits to property ownership, such as writing off trips to go check on it or to work on it.
Pros and Cons of Real Estate Investing
Like with anything, there are pros and cons when you invest in real estate.
The Benefits of Real Estate Investing
There are five main benefits of real estate investing:
#1 Low Correlation
Real estate generally has low correlations to more traditional stock and bond investments. When stocks do poorly, real estate may do well, and vice versa. This diversification benefit allows for steadier growth, which results in better long-term portfolio returns—at least when asset classes have similar long-term returns.
#2 High Returns
Equity real estate returns are generally stock-like. There are lots of alternative asset classes out there, but many of them only keep up with inflation in the long run. Equity real estate provides high returns. In fact, they are high enough that some real estate investors don't bother investing in stocks at all. For the record, I think this is a mistake and gives up valuable diversification.
#3 Leverage
While a stock or bond portfolio can be leveraged, it is simply easier to do with a real estate portfolio. You are generally limited to 50% leverage in a stock margin account but can go much higher with real estate. About 65%-75% of real estate leverage is actually pretty justifiable most of the time, although there won't be much cash flow at those amounts. With stock investing, margin accounts offer variable rates and can be called when the market drops. But most real estate loans cannot be called, and they are often fixed.
You cannot leverage up stocks in a retirement account at all, but leveraged equity real estate can be placed into self-directed IRAs (not recommended) or self-directed individual 401(k)s (better due to no Unrelated Business Income Tax, but I still don't recommend it.) This leverage generally results in higher returns in the long run.
#4 Depreciation and 1031 Exchanges
Depreciation, as discussed above, is a major benefit to real estate and is the reason I generally do not place equity real estate into a tax-protected account. I don't really understand why one is allowed to 1031 exchange one real estate property for another without recapturing depreciation or paying capital gains taxes but cannot do the same for a stock or mutual fund. But that is the way the laws are written.
#5 Inefficient Markets
Inefficient markets can be a positive or a negative when it comes to real estate. All real estate is local and there are far fewer potential purchasers for a given property than there are for a publicly traded blue-chip stock. There are a lot fewer buyers, sellers, operators, and analysts in the market. Most real estate is also not publicly traded. This inefficiency allows a talented investor to take advantage of less talented investors and earn “alpha” for their ability. Obviously, the opposite is true for less talented investors, who are providing that alpha.
The Downsides of Real Estate Investing
Unfortunately, real estate investing is not all puppies and rainbows. There are downsides, too. Let's go through them.
#1 Illiquidity
Many real estate investments, particularly those not traded in the public markets, cannot be readily sold. It might take months or even years to liquidate them. Real estate partnerships often tie up your money for anywhere from 1-10 years. While investors hope there is a “premium” (additional return) paid to them for this illiquidity, there is no guarantee.
#2 High Transaction Costs
If you have ever bought or sold a house, you know transaction costs can be high. The realtor commission alone may be 6% of the value of the house, and that's not including appraisals, title insurance premiums, and attorney costs.
#3 Leverage
Most real estate purchases involve the use of significant amounts of debt. In a downturn, debt amplifies your losses and makes it easy to lose even more than your entire investment.
#4 Hard Work
Many investments require little work at all. One can buy every stock in the world in 30 seconds with a few clicks of a mouse by simply purchasing some index funds. Purchasing and managing your own real estate properties has many aspects of a second job.
#5 Scammers
Real estate can be lucrative, and this attracts both entrepreneurs and criminals. Ethical standards in the real estate space can be surprisingly low. Caveat emptor (“Buyer beware”) applies in spades when investing in real estate. I have met dishonest mortgage lenders, appraisers, and home flippers, and that was before I even bought any investment real estate.
Real Estate Investment Terms
Like medicine, investing (and especially real estate investing) has its own vocabulary. Until you understand it, it will be difficult for you to even have a conversation with others in the field. Let's go over a few basics about real estate investments.
Real Estate Asset Classes
There are a lot of different real estate asset classes, including single-family homes, duplexes, triplexes, apartment buildings (multi-family), industrial, retail, student housing, senior housing, storage, and mobile homes to name a few. Each of these has its own risks and benefits. Most real estate investors tend to specialize in their preferred area.
Lots of people talk about NNN or “triple-net” properties as well. These aren't really a separate asset class but merely a way to structure the rental agreement. In a NNN agreement, the tenant is responsible for paying the property taxes, insurance, and maintenance/repairs. So, your rent is already “net” those expenses. Obviously, this means you can't charge as much for rent, but it does make your cash flow a bit more predictable by putting the risk of those expenses increasing on the tenant. These deals generally fall in the industrial and retail asset classes.
Real Estate Investing Strategies
There are a lot of different strategies used by real estate investors.
Flipping
“Flipping” has been made popular by numerous TV shows. The idea here is to buy a property for much less than it is worth, improve it rapidly, and sell it to another buyer. Most people would describe this as a job or a side hustle rather than an investment because the workload is so high in such a short time period and must be continually repeated.
Speculation
Speculation is also an occasionally used strategy. Empty land is a good example. If a property does not produce any rent or other form of income, you are entirely reliant on appreciation to achieve your return. Investors purchasing cash flow negative property could also be speculating, at least until such time as they can turn the cash flow positive. There is a lot of risk in this method.
Private Real Estate and Syndication Strategies
Private real estate funds and syndications generally follow one of four strategies, listed in order from lowest risk/return to highest:
#1 Core
A core strategy uses lower leverage (0%-30%), and it has stable, predictable cash flows. These properties are fully leased to “high-credit” tenants. They are often “Class A” properties (more on that below) in gateway cities. They require little in the way of improvements. They are the most liquid of real estate investments (although still dramatically less liquid than publicly traded stocks, bonds, and REITs). They are appropriate for those looking for capital preservation and long holding periods.
#2 Core Plus
A core-plus strategy uses more leverage (30%-50%). Tenants and properties aren't quite as good and will likely require a bit more work. Risk is higher in exchange for higher returns. Think of it as a core strategy with additional leverage.
#3 Value Add
A value-add strategy is medium to high risk and return. It often involves “Class B” or “Class C” properties. These properties need work, so the investor comes in, buys the property, makes some improvements, increases the rent, leases it up, and then sells it. These properties have management/operational problems, capital constraints, or often physical problems that need to be fixed or upgraded. Once the problems have been fixed, the property is worth a lot more, and it is sold for a significant gain. These investments are typically held for 3-7 years. They generally provide some cash flow to investors with significant upside potential. Leverage is generally 40%-75%.
#4 Opportunistic
An opportunistic strategy is value add on steroids. It needs a lot of work. This might involve developing raw land or a niche property. Leverage is high, and risk of loss is high if the business plan is poorly created or executed. Borrowing terms are not generally favorable. Done well and in favorable conditions, the potential returns here are the highest.
Property Classes (Grades)
You will often hear properties described as “Class A” or “Class C” properties. There is no precise definition of what these terms mean, but the following general descriptions may be helpful:
Class A
These are the highest-quality, professionally managed buildings in an area. They have the best amenities and were built in the last 10 years. They generally have the highest income tenants and the least maintenance issues, and they charge the most in rent. Despite that, cash flow is generally the lowest here due to higher purchase prices. These are the “easiest” properties to own.
Class B
These are older buildings with lower-income tenants, and they may not be professionally managed. Rental income is lower and there may be some deferred maintenance or management issues. These are often targets of “value-add” strategies to bring them up to Class B+ or even Class A. They were generally built in the last 10-30 years.
Class C
These properties are 30+ years old, and the tenants are generally working class or on government subsidies due to the lower rents. Expect numerous repairs and ongoing maintenance. The purchase price is lower so cash flow is generally quite good, as long as it doesn't get eaten up by the expenses.
Class D
These properties are in the bad part of town. They are as old as Class C properties but not as well maintained.
It has been said that you would live in a Class A property, you could live in a Class B property, you might visit a Class C property, and you would rather camp than live in a Class D property.
Real Estate Investing Fee Structure and Waterfalls
When you own a property all on your own, there is no fee structure or waterfalls. All of the profit and all of the expense are yours. But when you move into property syndications (where dozens or hundreds of investors pool money to buy a large property, hire management, and benefit from economies of scale) or private real estate funds, you will find the fee structures to be much more like a hedge fund than an individual property or even a typical mutual fund. You're doing well if you can get the fees down below the “standard 2 and 20” (meaning 2% a year plus 20% of any profits.)
A typical project is purchased by a Limited Liability Company (LLC) paying taxes as a partnership. There is a General Partner (GP) who buys, manages, and sells the property. You are generally a Limited Partner (LP) who has little control over the investment but also limited liability. Your potential loss is limited to the amount of money you invested. The “waterfall” just explains who gets money when.
A typical waterfall looks like this, from first person paid to last person paid.
#1 Management Fees Paid to the GP
May include an acquisition or set up fee of 1%-3%, plus an annual fee of 1%-2%.
#2 The Mortgage
Next, the debt is paid off. This includes the “first lien” mortgage as well as any mezzanine debt or preferred equity.
#3 Return of Principal
Now all of the common equity investors, including the LP and GP get back the money they invested.
#4 The Preferred Return
This goes to the LPs (including the GP if they put money into the deal, as you would hope) and often ranges from 6%-10%. The purpose of the preferred return is to prioritize and thank the LPs for investing and to motivate the GP to exceed this return (because they don't get paid until they exceed it.)
#5 The Promote
This is where the GP makes most of their money in a deal that goes really well. Theoretically, the management fees are supposed to just cover their expenses, and the preferred return is simply paying them for the use of their capital. The purpose of the promote is to incentivize the GP to choose a really great deal and execute it well. After the preferred return is paid, the remainder of any return on the project is split between the LPs and the GPS 80/20, although that can range from 70/30 to 90/10. Pay attention to whether there is a “catch-up” for the GP on the preferred return, i.e. if the preferred return is 8% and the project makes 10%, is the promote 2% or 0.4%? About half the time, there is a catch-up, and half the time, there isn't.
Obviously, these fees are dramatically higher than the expense ratios of a mutual fund. You should not pay them if you can get the same risk-adjusted returns without paying them. But most real estate investors consider that an apples to oranges comparison.
First, these investments are all actively managed, unlike an index fund (which is a good thing given the inefficiency of the market.)
Second, the size of these investments does not allow for the same economies of scale you'll see in a Vanguard index fund. A syndicated apartment complex might cost $10 million, of which only $3 million is equity. A big mutual fund might have $100 billion in it but a large private real estate fund might only have $100 million in it.
Third, all of the companies in a mutual fund have expenses that are not included in the mutual fund expense ratio, including the compensation to their executives. You see that more directly in a private real estate investment.
Fourth, while low expenses are the best predictor of future mutual fund performance, that doesn't necessarily apply to a private real estate investment. What you really care about isn't the expenses but rather the after-expense return on your money. That said, the same basic principle of investing applies—the more you pay in expenses, the less you keep in return. All else being equal, lower expenses are better.
Best Way to Invest in Real Estate?
Everyone wants a shortcut, but unfortunately, there is no easy answer to this question. There is no “best way to invest in real estate,” but there is a best way for you. As mentioned earlier, the key is to match your desire for control and willingness to deal with hassle and work to the requirements of the investment. The right choice for some people will be to invest directly and manage their own properties, choosing their own tenants and doing their own maintenance. The right choice for others might be purchasing syndications and private real estate funds. Still others might prefer buying a publicly traded REIT mutual fund. This flowchart may help:
Should I Invest in Real Estate?
Unless simplicity is the very most important aspect of your investment portfolio, I think the answer is yes, you should invest in real estate in some form. It is a major investment asset class with an excellent long-term track record and investment characteristics. Estimates are that 90% of millionaires become that way through owning real estate, and many of the world's wealthiest billionaires became so through real estate. Real estate can be used both to grow your nest egg rapidly and to provide additional tax-advantaged, spendable income during your working years.
Is Investing in Real Estate Worth It?
I can understand why someone would wonder whether a particularly active method of real estate investing was worth the hassle. It is very reasonable for high-income professionals such as doctors to conclude that it does not make sense for them to screen tenants and to fix screen doors themselves. However, there are so many different ways to invest in real estate that it is pretty easy to find one that will provide enough benefits to justify any hassle involved.
How Are Real Estate Investments Taxed?
The taxation of real estate returns is highly variable, although as passive income, it is rarely subject to payroll taxes such as Social Security and Medicare tax. Investing in mortgages or notes can be very tax-inefficient. Your entire return is paid out to you as interest or non-qualified dividends each year, and it is taxed at ordinary income taxes rates. On the opposite side of the spectrum, all of the net income paid to you from rents on equity real estate investment is often completely tax-free as it is sheltered by depreciation. Selling a property will involve recapture of that depreciation, but only at a rate of up to 25%. Appreciation of the property, as long as it is owned for more than one year, is taxed at long-term capital gains rates, but these can often be avoided if you have lived in the property for two of the last five years. Depreciation recapture and long-term capital gains taxes can be avoided completely by 1031 exchanging from one property to another rather than selling a property. There are other tax breaks available as well, including Opportunity Zone investments, the 199A deduction on REIT dividends, and 721 exchanges.
Naturally, you can also invest in real estate through retirement accounts, health savings accounts, and even educational savings accounts. Investments inside these accounts grow in a tax-protected way, and contributions also often qualify for tax deductions. Withdrawals can also often be made tax-free, depending on the terms of the tax-protected account.
How to Get Started in Real Estate Investing
One of the easiest ways to invest in real estate is through a mutual fund that owns publicly traded Real Estate Investment Trusts (REITS), such as the Vanguard REIT Index Fund (VGSLX or VNQ for the ETF version).
I have been investing in that fund for almost two decades myself. However, if you are interested in private real estate investing, whether done passively via syndications or funds or actively by investing directly, some additional education is advised prior to buying anything.
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 25 hours of content, and it gives potential investors the foundation they need. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course!
Real Estate Investing FAQs
Let's address some of the more common real estate investing questions.
How Much Money Do You Need to Start Investing in Real Estate?
Surprisingly little. You can invest in real estate without much money. For about $100, you can buy a share of the VNQ ETF. Even if you want to own real estate properties directly, there are some “nothing down” techniques that are possible. House hacking (renting out your home or parts of your home to others) is also an option.
However, as a general rule, you need money to make money. When buying investment property, it is a good idea to put down 25%-33% of the value of the property to ensure positive cash flow. That means if you wish to buy a $200,000 property, you will need at least $50,000 to do so. Many private real estate investments also have minimum investments ranging from $5,000-$1 million. You can simply match the minimum investment to the amount of money you have, remembering to always ensure sufficient portfolio diversification.
How Can I Invest in Real Estate with Little Money?
Start small and work your way up. Publicly traded REITs are an easy place to invest with little money. When you have a few thousand dollars, you can invest in private REITs. A few tens of thousands of dollars provide entry into direct real estate investing and private syndications and funds. You can also partner with somebody else that has money; you provide the labor and they provide the capital for the investment, and then you split the returns in a fair way.
Is Your Personal Home a Good Place to Start with Real Estate Investing?
It can be, but only if you somehow use your home to produce income. That usually means renting all or part of it out for a portion of the year. The home you live in, as a general rule, is a consumption item, not an investment. It costs you money to own it (insurance, property taxes, and rent), although, theoretically, it does pay you “dividends” in the form of saved rent. Most real estate investors do own their own homes. The experience gained from purchasing your residence helps you when you start buying investment property since the process has many similarities.
Investing in Real Estate vs. Stock Market
Both real estate and stocks (fractional ownership of publicly traded companies) can be excellent long-term investments, and they have great track records. Personally, I invest in both and enjoy high returns and low correlation with the other parts of my portfolio. Stocks are more liquid and generally qualify for lower qualified dividends and long-term capital gains tax rates. Real estate is easier to leverage, and it provides a higher percentage of the return as spendable income while also having its own unique tax advantages. Both provide passive income and the benefits of compound interest. You can learn more about the age-old debate between stocks and real estate.
Do I Need a Real Estate License as an Investor?
No. However, many direct real estate investors do become realtors. It helps them to understand the real estate market better, provides access to the Multiple Listing Service (MLS) in their area, and allows them to save realtor commissions on their purchases and sales.
How to Invest in Real Estate Without Buying Property?
You can buy property indirectly by becoming a partner in a partnership or a member of an LLC that buys property. You can also be a stockholder in a publicly traded REIT. However, you do not actually have to own property to be a real estate investor. You can also lend money to real estate investors or developers and enjoy regular income from your mortgages and notes. This is called being a debt real estate investor.
The Bottom Line Investing in Real Estate Investing
Real estate is a great asset class. Katie and I put 20% of our portfolio into it (5% publicly-traded REITs, 10% equity, 5% debt). It is not a mandatory asset class for physicians to be financially successful, but the majority of the most successful ones have invested in real estate in some form with some portion of their portfolio. It is easy to overweight publicly traded REITS in your portfolio by adding a REIT Index Fund to a mix of stock and bond index mutual funds. Anything else is going to take more work and expertise to do effectively, but in my opinion, you are likely to be rewarded for your efforts there.
Interested in exploring private real estate investing? Make sure to sign up for the free White Coat Investor Real Estate Newsletter that will give you important tips for investing in this profitable asset class while also alerting you to new opportunities. Make sure to start your due diligence with those who support The White Coat Investor site:
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What do you think? What else should be included in a Real Estate 101 post? How do you invest in real estate and why?
[This updated post was originally published in 2020.]
Awesome and comprehensive intro to real estate investing!
My strategy involves active REI mainly although 5% of my index fund investing is allocated to REITs according to my written financial plan.
I focus on multi family B/C class properties in path of progress areas with expected cash on cash returns of 10% or more after tapping any hidden value. This is a more active than passive pursuit in some ways but is a wealth accelerator.
My wife and I just bought our first investment property and can’t wait to do more!
With that said though I completely agree with the hybrid approach that you advocate. With our 41% savings rate, about 1/3 goes to real estate. The other 2/3 goes to debt and stock/bonds.
The Prudent Plastic Surgeon
Wow, super comprehensive rundown of a complex subject. I got everything, except the catch-up on preferred returns. Is there a pre-K level explanation? thanks!
The catch-up is for the general partner, not the limited partner getting the preferred return.
Think of it this way. If there is no catch-up and the investment makes 13% with an 8% preferred and then an 80/20 split, the LP gets 8% + 80% of 5%, or 12% and the GP gets 20% of 5%, or 1%. If there is a catch-up and the investment makes 13% with an 8% preferred and an 80/230 split, the LP gets 8%, then the next 2% goes to the GP, then the last 3% is split 80/20. So the LP gets 10.4% and the GP gets 2.6%. So with the catch-up, the GP makes 2.6X what he makes without the catch-up.
Hope that helps.
Wow, that’s quite a difference in returns. Thank you for breaking it down.
Great and very helpful intro! I think I recall you don’t like second homes and yet many have them, and there seems to be no consensus on whether (or how much of) one’s primary residence should count as a real estate investment. How do you recommend thinking about these? Are they just separate considerations altogether?
I would not consider either your main home or any secondary homes to be investments. They are primarily consumption items. If you can afford a second home, great. Enjoy it. It will likely maintain its value better than a wakeboat, but it still doesn’t qualify as an investment unless it is rented out most of the time.
So very helpful, thank you Jim! I have recently been exploring some of the RE crowdfunding websites mentioned on this site as well as over on PIMD’s site and this primer has helped a lot in terms of clarity and confidence.
https://humbledollar.com/2020/05/betting-on-bricks/
“CEM Benchmarking’s 2019 study reviewed asset class returns of public and private sector pensions, and found that their REIT returns over the last 20 years significantly outperformed both private funds and internally managed real estate.”
https://www.reit.com/sites/default/files/media/DataResearch/NAREIT_CEM_ES_2019_October.pdf
“All styles of unlisted real estate underperform listed equity REITs by between 1-3 percent depending on style, primarily driven by differences in investment fees (see ES5)…
• Listed equity REITs provided the highest Sharpe ratio of all real estate implementation styles”
https://pdfs.semanticscholar.org/20e5/f24617ac8fabe32069bba4bdac582b7ba9f4.pdf
The above link is to a research paper from Vanguard on REITs. The following is from the period of 1984-2010.
“the cumulative returns of public and private real estate have not been meaningfully different over longer periods when private real estate is adjusted for differences in how benchmark returns are reported”
“we believe it is unnecessary for investors to incur the illiquidity, high costs, and manager risk of a relatively concentrated privately managed portfolio of commercial properties…we have shown that REITs offer liquid, diversified, transparent, and low-cost exposure to commercial real estate”
https://joi.pm-research.com/content/27/1/109
“The author decomposes real estate investment trust returns into their factor betas to show that real estate is a hybrid asset class, with returns explained by a rich mix of compensated risk factors plus uncompensated sector risk. He shows that the same is true for private real estate, but with the additional contribution to risk from misappraisals.”
Appraisal risk exists in both public and private real estate. But there is greater ability to diversify that risk with public real estate (REITs), compared to private real estate.
https://www.pwlcapital.com/wp-content/uploads/2018/06/WhitePaper_BenjaminFelix_Housing-Investment_05-2018.pdf
About irrational motivations to invest in private real estate, this paper mentions illusion of control bias (investors believe that they have a high degree of control over the outcome of their real estate investment) and overconfidence bias (investors believe that they have the ability to find mispriced properties).
Two things that make me at least question the data.
# 1 The source. All of those cited folks have a conflict of interest to encourage public real estate investing.
# 2 The time period. Any time period involving something publicly traded in the stock market that ends in 2019 may be benefitting from that stock market tailwind.
But you’re right that if there is difference in correlation and no additional returns, it doesn’t make sense to give up convenience, liquidity, and diversification to invest privately.
The latest Rational Reminder podcast (#219) is an extensive review of data on returns of asset classes. The whole thing is worth a listen.
They include a careful review, with references, of the performance of private real estate vs public. The data are NOT all from the REIT industry. They conclude that private real estate is no better and more expensive, than public.
The only exception MIGHT be if you can exploit the tax advantages for certain types of investments. The.podcast did not get into this and I have not seen any systematic data on after tax performance of public vs private.
If anyone knows of such data, please post a link.
Is the market inefficient? This is an empirical question and again I have seen no data to suggest that private real estate outperforms public. If the private market is both inefficient and that inefficiency is reliably exploitable, then there should be studies showing that private investors, as a whole, outperform the public investments. As far as I know, the data, including the papers cited by Park, say the opposite.
If the private real estate markets are less efficient than public they do not appear to reward investors with higher returns.
I’ll try to take a listen. I disagree that taxation can be the only possible difference. Privately traded real estate is generally smaller and may perform differently. Plus an illiquidity premium. Plus the potential for active management to work better.
It would make sense to counter data from what you consider to be a biased source with data from what you consider to be an unbiased source. It does not advance the discussion to assert that a source is biased, then present no data at all and make an argument that private RE is better. If there are good data showing the superiority of private real estate, then show it. Let’s not pretend it exists without evidence.
Same thing for illiquidity premium. If there is evidence that private RE investors capture such a premium, please cite it. It is hard to accept an assumption that the premium exists in the absence of any data.
As for active management, many would consider that a disadvantage. You cannot simply bet on RE. You have to bet on the active management performance of the manager. That could be you or someone else. If it is someone else, then you need to look at performance after fees. What are the data on performance persistence of active managers in RE? In many other areas of investing, active management, on average, has negative alpha after fees. And the performance of higher performing managers does not persist. If there is evidence that one can identify higher performing managers, then great, let’s discuss those papers.
But let’s not assume that private RE outperforms public, based on no data.
Let’s not assume private RE delivers an illiquidity premium, based on no data.
Let’s not assume that active managers deliver better returns, based on no data.
Let’s not reject the only data so far because it does not support the hypothesis when there is no other data offered to refute it.
Those selecting and managing investments in publicly traded REITs are actively managing just as much as those in a private fund. So that argument doesn’t apply.
Your other arguments are simply saying “prove it.” I don’t have any data that proves it. So you makes your bets and you takes your chances. You think you’ve got enough data to justify your decision. I don’t think there’s enough unbiased data to make a decision based on it. So I’m doing both.
Good luck with your choice. Hope it works out fine for you.
Good article.
Do you have any advice or knowledge about commercial investing vs residential? I’ve been reading about buying properties with triple net leases with large corporations (Like Walgreens) as the tenant on ~20 year leases? Are these investments any more “passive” than investing in traditional residential real estate like houses and duplexes?
One huge downside I see with commercial properties with long leases is you are stuck with low rent values if the real estate value dramatically increases throughout the lease term, unlike in residential housing where you can just increase the rent each year.
Probably less hassle, yes. But if you really want passive, you should probably buy a fund that invests in NNN leases to large corporations.
Dr. Dahle,
First off, that was a great article that was an easy digest without the hype of a lot of other RE platforms. And full disclosure, I do syndications. My wife is the physician, and we are very grateful for your books and content.
Second, there is a small issue in the order of the described waterfall. The waterfall describes who receives the residual cash flows after expenses and debts. Using the typical “as water flows from one bucket to another as the first fills up” approach, mortgage debt would be senior to on going asset management fees.
Third, the description of the promote is a little off. There may be no preferred return where the GP and LP are considered to be “pari passu”. Then you may have promotes based on hurdles that change the equity split on all cash flows above that. There may also be a preferred return where all cash flows flow to the LPs first, in which case the catch-up is supposed to bring the the GP back to pari passu.
Lastly I would like to add a few warnings to the people who read this far. Be prepared to spend time looking through all the paperwork and that you are protected. I would argue that a syndication is harder to get out of than trying to sell a home. Typically there are 3 layers of approval and negotiations that have to happen between LPs, then GPs, and then the public, with a chance for the LPs and GPs to buy at the public price before it can be sold outside the syndication. Also, vet the team and make sure you trust them. This is the single biggest risk in RE investing when investing in a specific deal in my opinion. Sit in on some of their investor webinars/pitches first and ask to be included in their investor update newsletters. Date before getting married, divorce is expensive.
Thanks for your kind words.
Help me understand a situation where the mortgage would be paid before asset management fees are paid. I guess if the asset manager has signed a personal guarantee on the mortgage that would effectively be the case, but as near as I can tell, most syndications consider their fees equal to all the other expenses of the syndication. Either way, it’s a pretty lousy syndication that couldn’t cover both the mortgage and the fees!
I agree there are various different structures for promotes and preferred returns. I think that’s all you’re saying.
Dear Jim,
I am 47, live in California, have three rentals in IL
These three rentals are under a CA LLC under my wife’s name and planning to buy 4 or 5 more in IL
I have heard that to establish an LLC based in Delaware, Wyoming or Nevada for Asset protection purposes
I find it very complicated to put each town house under a different LLC
What would you recommend for maximum asset protection purposes
Thank you
Sincerely,
Ravi
Maximum? Are you sure you want maximum? Because you can always do more crazy stuff.
Reasonable is just to make sure they’re all in an LLC. You can put them all into their own LLC if you really want, but that’s expensive in CA. Make sure you have plenty of liability insurance of course.
As near as I can tell, your biggest risk of losing these rentals is a divorce. The best asset protection might be date night in your case given they are her properties.
More on asset protection here:
https://www.whitecoatinvestor.com/asset-protection/
https://www.whitecoatinvestor.com/top-16-asset-protection-moves-for-doctors/
I wouldn’t expect a lot of extra benefit from putting the LLC in Wyoming or Nevada when the property is in California. I think most who aren’t selling Wyoming LLCs would agree.
https://www.whitecoatinvestor.com/asset-protection-with-jay-adkisson-podcast-199/
Hi Jim. Great post. Do you suggest holding real estate in a LLC or Land Trust? I’m in PA.
Have you ever discussed the pros and cons of owner financed mortgages? The property is a smaller commercial property which I own free and clear. Want to sell due to my age and simplify for my kids. Don’t want to due a 1031 for the same reason. Holding a mortgage will let me spread capitol gains over 7-10 years before a balloon payment comes due.
I’m not super familiar with land trusts, but putting investment property in an LLC is standard asset protection practice. If land trusts are similar but favored in PA, then I guess you can go ahead and do that. Per this article:
https://legalees.com/llc-vs-land-trusts/
there are 6 states that do land trusts, but PA isn’t one of them.
That article also says land trusts don’t provide the same asset protection as LLCs, so I’m not sure what the point of them is. Estate planning maybe?
I like debt real estate as an investment. A single note, of course, isn’t very diversified. You could also exchange that thing into an Opportunity Zone fund and give yourself more time with the kiddos and still not have to pay on a bunch of capital gains.
Jim,
Thanks for clarifying that I’ll be fine with an LLC in PA. I’‘m not familiar with Opportunity Zone Funds but will look into them. Appreciate you taking the time to answer and for the suggestion!
Real estate is excellent and a great way to make passive income. For those getting started the best in the game say to find a business real estate investment model that is already proven to work.
Afterwards, you can begin raising money. I spoke with a lending insider and he says to have your credit as high as possible but minimum around 580 to 600.
Anything below this will make the financing terms favor the lender and not the buyer. Build your credit score if you must.
Start with the end In mind.
Great post – thank you.
One question springs to mind though. You called out VNQ as a good option for an easy to invest in publicly traded REIT. I think I’m correct in saying that all of Vanguard’s REITs are a subset of their respective total market (ie VTI contains all the companies in VNQ). Wouldn’t this mean it’s just tilt, and doesn’t get the diversification benefits?
That’s correct that VTI also owns all publicly traded REITs. Some people, including me, “tilt” toward REITs because most real estate isn’t publicly traded.
Whether a tilt gives you more or less diversification depends on how you define diversification.
Could you elaborate on whether or not “tilt” gives you less diversification? If we define diversification as investing in uncorrelated assets, wouldn’t tilt meet the definition even if there is overlap between two funds?
My thinking is that while sure, you’ve double dipped into the same asset class while ostensibly investing in two different products (eg. REITs through both VTI and VNQ), the double dipped asset class is still uncorrelated with its comparator and therefore further diversifies the overall portfolio.
Appreciate your thoughts!
Depends on how you define diversification. If you define it as total number of securities, then tilting does not increase diversification. If you define it by factors (market, small, value etc), then tilting toward those factors does increase diversification.
When it comes to REITS, the question is whether they’re really a different asset class or just a flavor of stocks. I’m in the first camp, but the jury will forever be out there.
What about syndications that deal with farms
What about them? Like Acretrader? Here’s our affiliate link:
https://www.whitecoatinvestor.com/rei/s/acretrader
Great post. Can you elaborate on how to make renting out your home, say your basement to your parents work from a tax benefit perspective? Thank you as always for what you do.
It would probably increase the overall taxes paid if you charged them rent, but maybe you could depreciate part of your home. Might also allow you to pay some of your home maintenance costs with pre-tax dollars.
I am starting to consider real estate investing. REITs don’t really make sense to me because I am not doing it for portfolio diversification but for creation of monthly passive cash flows. My question is if you want to passively earn money, HYSA are at 5%+ why it would make sense to do passive real estate investing with 8% returns which will be even less after taxes when your HYSA is 100% risk free?
HYSA yields after tax are lower too. But you’re right that the higher the risk free rate, the less motivation to take on risk to try to earn a little more. If you can reach your goals with 5%, you can just use a MMF right now.
Hello
First time posting here, requesting advice.
I live in Las Vegas NV. I have saved and was hoping to invest and purchase a commercial property. In 2021 when I was looking to do the same .The $/sqft was around 125 for industrial and I was surprised and deflated to see that it has doubled to $250/sqft in 2024. I have no MBA and I am struggling to make sense that commercial property index shows a downward trend, investing has cooled due to the interest rates but the per square foot value has doubled. google tells me commercial property values increase value only 2-4 % a year .
Does that mean that the commercial real estate is heading for a crash and I should stay well away?
I would appreciate your thoughts in layman language please. Most of the content and math on this website goes above my head.
Thank you
Crystal ball cloudy. No idea what future returns of commercial real estate will be.
Is bonus depreciation kind of like supposed to make it just as worth it to invest in a rental property as it would be to contribute to a tax-advantaged retirement account? For instance, if you put $100,000 into a DBP or your 401K’s that year and wrote it all off at 37%, and then paid those taxes in 20+ years at 25% you’ve got a nice “win” on that money. But if you instead put that same $100,000 (after-tax, obviously) into a down payment for a rental property (instead of the tax-advantaged accounts that year), and then claim that whole $100,000 as bonus depreciation, writing it off at 37% that year (and paying back 25% of that write-off in 20 years assuming no 1031), it kind of ends up being the same thing, right?
Is that why the IRS allows that, and am I thinking about it the right way?
Thanks!
No, I don’t think there is any connection between bonus depreciation and retirement accounts. Depreciation is because, well, things depreciate. Bonus depreciation merely lets you take that depreciation early.
Your probably can’t write off all $100K in that first year even if you get it then. But I do see the similarities. Both are some pretty nice tax breaks.
I had a question about the idea buying real estate, specifically turnkey rental properties, through a self-directed 401 K or IRA. From what I have read, the way to do this with the 401K is by taking out a loan against it— the loan being capped at 50,000. This is obviously not very much money for a deposit. However, when you use a self-directed IRA there is much more freedom and versatility. In order to make this happen with the self-directed IRA with a large enough amount of money, one would need to rollover one’s individual 401 K to a self-directed IRA. The downside to that obviously is the inability to do a backdoor Roth IRA anytime soon. So my question is, what are your thoughts on the loss of this backdoor Roth space, compared to the benefit of being able to manage and purchase properties through the IRA and have all of the tax advantage growth provided by it?
Many thanks.
I’m not a huge fan of equity real estate in retirement accounts. Mine (not counting VNQ) is all in taxable. There are A LOT of hassles to owning property directly in an IRA. For instance, let’s say you need to spend $20K on a roof or something. Where’s that going to come from? Not your checking account, I’ll tell you that. That would be an IRA contribution. And what are you going to do with the income from the property? Will it just sit there earning nothing in a checking account inside the IRA? It’s just a mess IMHO. Use the space for something else. If it must be real estate, then something like VNQ or a much more liquid debt fund. But fine to put stocks or bonds or whatever in there and just keep the real estate in taxable.
Do you have a significant taxable account? If not you may have no choice if you must have this asset, but I don’t plan to ever own equity real estate in a tax protected account. Not to mention your real estate income is likely already covered by depreciation so you’re losing the main benefit of a tax protected account.
Also, assuming the property is leveraged, you’ve got UBIT to deal with. Who needs that?
More info here:
https://www.whitecoatinvestor.com/equity-real-estate-in-retirement-accounts/
Question/comment regarding this:
“Let’s say you need to spend $20K on a roof or something. Where’s that going to come from? Not your checking account, I’ll tell you that.”
So, you are paying for this cost from the money in your IRA that was paid to you as rental income, just like if it was in a bank account, right? (I suspect). Whatever you budgeted ahead of time for repairs.
“And what are you going to do with the income from the property? Will it just sit there earning nothing in a checking account inside the IRA?”
I’m guessing some of that (whatever you budgeted for repairs, insurance, management fees, etc.) would sit as cash, the rest (whatever would have gone to you as net income) could just go back into equities or bonds and grow (or whatever your AA dictated). Is there anything that I am missing regarding this (that could prevent you from operating it this way)?
What do you think about if you did this as a turnkey style investment? It would make a lot of the bookkeeping easier.
Thanks again.
Yes, if you have enough. What if it happens in month 5 after you buy it? Now you’ve got to get another loan (increasing UBIT) or do some sort of IRA rollover if you can or delay it until you can make another IRA contribution which is then after-tax money etc.There’s just a lot of potential for pain and best to think about all that before going in. If you’ve also got $100K in bonds in that IRA, great, problem probably solved. But you’ve got to think about that stuff in advance.
Turnkey like with our sponsor Southern Impressions has lots of attractions, especially for someone already in Florida, although FL doesn’t have a state income tax anyway to worry about for us out of staters. You pay fees in order to get out of hassles, pretty straightforward transaction.
Are you just all retirement account money is that why you’re looking at this? Or are you trying to leave taxable money invested in something else?
Part of the draw of equity real estate for most is the cool tax advantages like depreciation. That all goes away in an IRA and is replaced with painful tax treatment like UBIT.
I am all tax-deferred and Roth right now. We have individual 401K’s from myself and my wife, we do backdoor Roths, and we have a defined benefit plan. I am 42, so I can put a good chunk into it. Between all of those buckets I think I have a tax-advantaged space I can use this year of somewhere between 160K-170K. (I used one of your sponsors for the DBP, btw). The arbitrage of that tax-advantaged space right now at my marginal tax rate (compared to later) just beats the pants off of anything else I think I’m going to get, before even considering the investing gains themselves. I plan to keep the defined benefit plan for a number of years, so I really do not anticipate having a surplus of disposable income to go in a taxable account, or to save up for a deposit for any physical real estate, any time soon. REITs are okay, but I like the idea of physical property and increasing net worth through cash flow and appreciation and rental income as an inflation hedge, and all the other ways you have mentioned in this article and others. When I am looking at our investing plan and our usage of the tax-advantaged buckets and how I plan on doing that for the next 10-ish years, I don’t really anticipate having 100,000 sitting around for a deposit that I’m not already using elsewhere, any time soon. And if I can manage to keep saving in all of the above buckets, AND have more money for taxable, then that means I am working too much, and my wife probably misses me 🙂
That is why I have been thinking about using it from a self-directed IRA instead.
All of your points above are great and definitely merit consideration. Thank you.
And thank again so much again for all you do. You have changed/improved so many lives. Glad you are on the mend from the Tetons too, btw.
Yea, you do have a dilemma. It’s not necessarily a bad thing to have so much tax protected/asset protected space.
I’d try to use a self directed solo 401k instead of a self-directed IRA if you can. Not only are contributions bigger in some potential futures where you can contribute, but you avoid the UBIT issue. And the price isn’t all that different. You’d need a little SE income to do it though. Don’t forget to keep something else in the account in case you need roof money.
Good luck!