Investing in real estate is great for accumulating ongoing passive income, providing inflation protection and diversifying your portfolio.
But real estate also offers better protection against recessions than most assets.
But there are many ways to invest in real estate. If you’re thinking about either buying rental properties or investing in real estate crowdfunding, how do you choose between them?
Let’s look at the options and some things to consider for each one.
The case for rental properties
Buying properties directly comes with plenty of advantages. As you explore rental investing, keep the following perks in mind.
Potential for high returns
Experienced real estate investors consistently earn high returns on their investments. Returns that beat out stocks, bonds, and other investments.
I recently earned a 47 percent return on a house flip, and it only tied up my money for six months. That’s nearly a 100 percent annualized return. If I had kept the property as a rental, I would have earned about a 15 percent annual yield on the net cash flow — and then earned an even bigger paycheck years from now when I sold it.
Granted, it takes skill to earn high returns on real estate. And that skill takes time, effort and often money to develop. But once you know how to invest in real estate effectively, you can easily earn higher returns than the average investor can earn through traditional investments.
And when you finance your real estate deals, you can earn even higher returns.
You can buy investment properties with other people’s money, with a minimum of your own cash.
Lenders often cover 75-85 percent of the purchase price for investment properties. Good luck finding another asset that someone else will provide you that much money to buy.
Leveraging other people’s money can improve your returns on good deals. If a property would pay an 8 percent annual yield if you bought it with cash, that could rise to a 12 percent cash-on-cash return (the return on your down payment) if you get a low-interest rate on a mortgage.
Leverage also boosts your protection against inflation. Your monthly mortgage payment stays the same for the next 30 years, but rents rise over time, and the difference between the two will grow disproportionately faster than the rate that gross rents increase.
Just beware that leverage can cut the other way too. On a bad deal, you could go from earning a low return to losing money on negative cash flow.
You can write off every conceivable expense that you incur on your rental properties. That includes costs like mortgage interest, property management fees, repairs, maintenance, insurance, property taxes, and even travel and your home office.
You can also deduct for the depreciation of the building, even as it actually appreciates in value.
Best of all, you don’t have to itemize your personal deductions to write off these deductions. Your rental income and expenses take place on a completely separate tax form (Schedule E), so you can also take the standard deduction personally.
When it comes time to sell, you can also defer or reduce capital gains taxes through techniques, such as 1031 exchanges or simply passing their properties on to their children as part of their estate.
You maintain control over your investments with rental properties. Compare that to buying stock in a company, over which you have no control whatsoever.
For example, you can make renovations to improve your property value and raise your rents. You can accurately run the numbers on what a renovation project will cost and how it will affect your property value and rent. Which means you know the return on investment before spending a penny.
You can also mitigate risk through aggressive tenant screening, through buying in stable neighborhoods, by buying rent default insurance.
Again, this all comes with a downside as well: get it wrong, and you can also lose money. But experienced real estate investors know how to control their investments to minimize risk and maximize returns.
The case for real estate crowdfunding
For all their advantages, rentals come with their share of challenges and drawbacks. For the average investor, real estate crowdfunding investments can offer a balance between the advantages of real estate without the headaches, labor and skill required.
Rental properties are not 100 percent passive investments. It takes work to find good deals, to conduct due diligence, to line up financing, to advertise vacant units, to screen tenants, to collect rents, to make repairs and so on.
Real estate crowdfunding investments don’t come with any of those hassles. You just create an account and transfer money over, then roll over and go back to bed. The returns arrive in your checking account — end of story.
No skill required
Real estate investing requires a complex skill set and one you don’t pick up overnight. Even after extensive reading and online courses, most new real estate investors lose money on at least one of two of their first few deals.
I lost six figures on my first wave of real estate investments. I could have quit and never touched real estate again. Instead, I considered it the cost of tuition, to earn an informal degree in real estate investing.
But real estate crowdfunding investments don’t require any skill to invest. It helps to do your homework on a given crowdfunding platform before investing of course, but once you decide to invest, you just create an account and transfer funds. Anyone can invest in real estate crowdfunding, with no background in real estate required.
Even with borrowing a mortgage, it still costs tens of thousands of dollars to buy a rental property, between the down payment and closing costs. Sometimes hundreds of thousands.
But real estate crowdfunding investments let you buy into funds owning dozens of properties, for as little as $10. Or you can spread your money among hundreds of loans secured by real estate. In either case, you can spread your money across many properties in regions all over the country, for simple and safe diversification.
You also get exposure to different types of real estate including not just residential rentals but commercial properties, large apartment complexes, and sometimes even niche investments, such as self-storage facilities. This kind of fractional real estate investing keeps you from having too much money tied up in any one property.
Whether you invest directly in rental properties or indirectly through real estate crowdfunding investments, you can still earn on both income yield and property appreciation. Consider that in 2021, the average U.S. home price grew by 16.9 percent — higher than the average annual home appreciation, but it goes to show how powerful appreciation can be.
Couple that with strong ongoing yield, and real estate makes the perfect counterweight to stocks in your portfolio.
If you’re interested in investing in real estate as a hobby or side business, consider investing in rental properties. If you just want to diversify your portfolio, invest in real estate crowdfunding. Try Fundrise, Streitwise and Groundfloor as easy ways to start, all open to non-accredited investors.
G. Brian Davis is a real estate geek and co-founder of Spark Rental.