If you’re considering an investment in income-generating real estate, the correct strategy can lead to potential wealth generation. One such approach is a direct real estate investment.
Diving into the world of direct real estate investments can generate multiple advantages to help you reach your investment goals. However, there can be several challenges involved with buying directly versus an indirect investment type like REITs, DSTs, or real estate funds.
Understanding the pros and cons of direct real estate investing is essential for knowing what to expect when purchasing, owning, and selling real property.
A direct real estate investment occurs when you buy and manage real estate, typically for income generation or appreciation. Unlike indirect real estate investments, the direct method means you can control the asset and make decisions about tenants, maintenance, improvements, and financing.
There are two types of direct real estate investments:
This article focuses on using equity for a direct real estate investment.
As mentioned above, one main benefit of a direct real estate investment is that you have direct control over the property’s operation and management. You determine who to rent to, when to make capital improvements, what financing strategies to use, and when to sell.
Other advantages include:
Appreciation potential. Real estate can appreciate over time, potentially generating positive returns and wealth generation. The value of your real estate investment could increase based on location, demand, and economic growth. This means you might realize substantial capital gains when it’s time to sell.
Possible steady income. Regular tenant payments through rent could generate consistent cash flow. You determine the rental rates and expenses to help improve the property’s income and potentially increase your profits.
Tax benefits. You might be able to deduct mortgage interest, depreciation, repairs and operating expenses from your real estate. Additionally, when you want to sell, using a 1031 exchange could help defer capital gains taxes and depreciation recapture fees.
Inflation hedge. As inflation increases, so can your property’s value and rental income. Additionally, real estate investments are tied to economic cycles and business trends rather than stock market movements. This means your income-producing real estate might mitigate risks while diversifying your investment portfolio.
Investing directly in income-producing real estate can provide portfolio stability, tax advantages, and potential appreciation. However, the following downsides should also be considered before you invest.
Multiple upfront costs. Buying property means forking over a lot of money upfront. The downpayment and closing costs can be expensive. Other fees include title searches, appraisals, property inspections, broker commissions, and more. These and other expenses must be paid before you can benefit from rental income or appreciation.
Time- and resource-intensive. Investment real estate requires a great deal of upkeep. Someone has to maintain the landscape, find tenants, collect rent, pick up trash, and perform repairs on HVAC and water systems. These tasks and others take time and money. Hiring an outside property management firm to help is one solution–but it requires more capital.
Market risks. Economic conditions can play havoc on your property’s value and rental income. Furthermore, your tenants might not want to renew their leases. These factors could impact your return on investment. In some cases, you might also need to put more capital into the property while maintaining the vacant space and covering operating deficits until a new tenant is found.
A high degree of illiquidity. Investment real estate might appreciate. However, it’s not a liquid asset because you can’t sell that property and generate immediate cash. Most real estate sales take time. Transaction costs can add up when you sell, reducing your capital gains. Finally, selling that asset can trigger capital gains taxes and depreciation recapture unless you decide to dispose of the asset through a 1031 exchange. The like-kind exchange has complex regulations that must be followed.
Direct real estate investments can give you asset control, potential appreciation, steady cash flow, and certain tax advantages. However, there are also multiple challenges when buying and owning real estate directly. Understanding the upsides and downsides of this investment type can help you decide whether direct real estate investment can help you reach your financial objectives.
If you’re considering buying or selling investment real estate through a 1031 exchange, contact the Realized 1031 experts for assistance. The team knows the ins and outs of property exchanges and can help successfully guide you through the process. To set up a no-obligation consultation, visit realized1031.com.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.