The phrase “don’t put all your eggs in one basket” applies to real estate, the level of risk exposure, and your investment strategy. There are numerous ways investors can diversify their real estate investment portfolio to potentially minimize risk exposure.
Let’s look at some real estate strategies and the advantages and disadvantages of each when we compare risk levels.
Direct real estate investment involves buying a specific property or a stake in one. Income is acquired through appreciation, rental income, and profits generated from business activities that depend on that real estate.
- There’s potential to generate cash flow and benefit from property appreciation.
- Tax advantages offset generated income by deducting the costs to manage and maintain the property. You can also lower your taxable income through depreciation, in which you deduct the cost of purchasing and improving the property over time.
- You have direct control over decisions regarding the location, property type, tenants, rental prices, and financial structure.
- Direct real estate investment is an illiquid asset.
- There’s a risk of default when investors use leverage to finance real estate property purchases.
- Due to maintenance problems, tenant troubles, and liability issues, more time and money is required to successfully manage the property.
Limited Liability Company
Investors can use an LLC to invest in real estate property, which acts as a separate legal entity that protects investors from personal liability.
- An LLC reduces the amount of liability for the investor.
- As its own legal entity, an LLC gives added protection to the investor’s personal assets.
- A real estate LLC is eligible for pass-through income taxation. Business income is taxed through the investor’s personal tax rate rather than the corporate rate.
- There’s more freedom through an LLC as there aren’t too many rules or restrictions that the investor must abide by.
- An LLC is dissolved upon the property owner’s death or with bankruptcy.
- There are extra fees when forming an LLC and keeping it in legal standing.
- Investors need to make sure that the LLC operates as a completely separate entity that can be distinguished from all LLC members. If not, investors may lose the protection offered through the LLC.
Investors can gain access to the real estate market through a crowdfunding platform, even with limited funds.
- Crowdfunding platforms have opened the door and made real estate investment much more accessible.
- Investors can make smaller investments with real estate crowdfunding.
- Crowdfunding offers a passive investment opportunity, which means the investor doesn’t need to worry about managing the property.
- There are lower relative returns compared to direct investments.
- It’s an illiquid investment and cannot be quickly sold for cash.
- The investor has less control over the property.
Triple Net Lease
A triple net lease (NNN) is a lease agreement on a property where the tenant pays property expenses including real estate taxes, maintenance, and building insurance.
- An NNN is structured for guaranteed, long-term tenant occupancy.
- Because the tenant pays the costs associated with the property, there’s less risk for the investor.
- A reliable stream of income due to structured rent and protection from additional expenses.
- Investors can use triple net property to build equity.
- Because of minimal to no landlord duties, investors aren’t required to closely manage the property.
- There are vacancy risks as well as the risk of default.
- There’s a cap on an investor’s earnings. Although the income is reliable, rent cannot be increased if property value in the area goes up.
A tenants-in-common (TIC) is where two or more investors share ownership rights in a piece of property. Each owner controls an equal or different percentage of the property.
- Owners are spared the burden of active property management.
- Investors can enter the real estate market more easily if they are working with limited funds.
- Owners have rights to the entire property.
- The number of owners can change over time.
- There is no right of survivorship. If one owner dies, their portion of the property goes to their estate.
- Owners have the right to sell their portion of the property. If one sells their share, the co-owners are forced to either buy their share or put the entire property on the market.
- Joint and several liability may apply, which means all owners are responsible for property tax no matter their percentage of ownership.
Delaware Statutory Trust
A DST is a separate legal entity that holds title to a piece of real estate property where investors hold a fractional interest and pool funds into the trust.
- DSTs are 1031 eligible.
- With a leveraged DST, loans are typically non-recourse and your assets outside of the loan are protected.
- There’s easier accessibility of high-quality assets.
- DSTs cannot be refinanced.
- DSTs cannot raise new capital.
- There’s less control with a DST.
- DSTs are illiquid assets.
Equity Real Estate Investment Trust
A real estate investment trust (REIT) is a company that owns and manages income-producing real estate.
- REITs are much more liquid than other types of real estate investment strategies.
- Stable cash flow through dividends.
- There’s potential for long-term capital appreciation.
- There’s risk-adjusted return on capital.
- Dividends are taxed as ordinary income.
- There’s potential for high management and transaction costs.
- There’s added market risk.
Before choosing a real estate strategy, investors need to weigh the risks and know their exit strategy before making a purchase. Discuss your options with your financial advisor to see what strategy best aligns with your long-term investment strategy.
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