You’ve decided to invest in real estate. Now what?
Real estate has been a hot commodity of late, generating some outsized returns. But there are so many options: buying local property, crowdfunding sites, index funds and more.
Which option is best for you? And what does money expert Clark Howard have to say on the subject? Keep reading to find out.
Breaking Down the 3 Most Prominent Real Estate Options
1. Buy Rental Properties
| Pros | Cons |
|---|---|
| • You're in control of the timeline, transactions and usage. | • Buying a property can be quite expensive. |
| • You'll have the potential to earn passive income. | • Odds are high that you'll face maintanence and management headaches. |
| • The underlying asset can go up in value while generatnig income. | • A single rental property represents a concentrated (risky) bet. |
You probably know someone who owns and operates at least one rental property. This is a common way to invest in the real estate market. And it includes those two magic words: “passive income.”
However, it can require a lot of upfront capital (or a significant loan) to acquire a rental property. Depending on your overall financial picture, it can represent an outsized portion of your portfolio. In other words, you run the risk of lacking diversification.
Lately, neighborhood HOAs and municipalities have cracked down on short-term rental properties. Sometimes platforms such as Airbnb attract people wanting to throw parties — or at least crank loud music while on vacation.
Buying a property to rent out, only to have a local ordinance make it impossible, can create a financial headache (or worse).
If you are interested in buying rental properties or turning your existing home into a rental, Clark has a simple 1% rule you should know.
2. Invest Through Crowdfunding Sites
| Pros | Cons |
|---|---|
| • These sites offer the potential for higher return than a REIT index fund or ETF. | • These investments tend to be quite illiquid. |
| • Depending on the site, you can pick your own individual projects or invest more broadly. | • Sometimes crowdfunded real estate sites require you to be an accredited investor. |
| • These investments can feel more interactive and offer a level of participant fun. | • The fees that these sites charge can be extreme. |
I’ve seen dozens of advertisements on social media and on content websites for these types of investments in the last few years. They’ve shown up with greater and greater frequency.
Names such as Fundrise, Crowdstreet, DiversyFund and others have enjoyed massive growth in the crowdfunding real estate space. The slick ads and modern websites include phrases such as “Invest like an insider” and “Built to help smart investors invest smarter.”
There’s no one-size-fits-all version of these investment vehicles. But they often charge high fees and lock up your money for years at a time.
In some cases, you’ll get a chance to select specific projects or to interact with a community of like-minded folks all trying to identify the best choices. So in that sense, it’s more participatory than a typical stock market investment.
But in a lot of cases, as Clark is fond of saying, boring is better when it comes to long-term investing.
3. REIT Index Funds and ETFs
| Pros | Cons |
|---|---|
| • This option generally offers much lower fees. | • Your chances of getting outsized returns are probably tiny. |
| • It's easy to get your money in and out whenever you want. | • Many people may consider it a less exciting investment. |
| • Well-diversified options are easy to find. | • You'll have less control. |
Some of the most respected investors of all time have preached low fees, diversification and a long-term approach.
REIT index funds and ETFs offer all of those things. (REIT stands for Real Estate Investment Trust.)
Just like crowdfunding real estate, this option gives you a number of choices as a consumer. Some REIT offerings are concentrated in very few properties. Others offer exposure to a variety of different properties and locations.
Instead of locking up your money for years, you can buy and sell REIT shares any time the market is open. There’s no penalty for selling early.
This is a less risky approach than some other options. But the returns with REITs, although not guaranteed, can still be great. According to Nariet’s index of publicly-traded REITs, they outperformed with 11.6% annual returns for the 20-year period ending December 2019 compared to 6.1% for the S&P 500.
Clark’s Warns About Hidden Downsides of Crowdfunded Real Estate Investments
One of Clark’s podcast listeners recently asked about crowdfunding options and whether crowdfunding is a good investment idea.
Clark’s biggest reservation: the outsized fees that these companies often charge. They’re typically at least 1%. Compare that to the Vanguard Real Estate Index Fund with an expense ratio of 0.12%, or nearly 1/10th the cost (along with a 10-year return of 11.5%).
Often you’ll need to pay hefty penalties on top of those fees if you need to take your money out early. Many of those projects require you to lock in your funds for years.
“The real issue, any time you get involved in a real estate partnership, is what are the underlying expenses you’re having to pay to be in it,” Clark says. “There should be a disclosure document available to you that lays that out. I really want you to dig in and see what the underlying expenses are.
“The other thing is that when you go into one of these things, it is what’s known as ‘illiquid,’ meaning that if you needed the money at some time during the cycle that you’ve agreed to, the money isn’t available to you.”
Why Clark Approves of REIT Index Funds and ETFs
Clark made his preferences clear on a recent podcast. If you’re going to invest in real estate, putting money into a REIT index fund or ETF is the least risky option.
“There are choices you can go into [that are] ultra low cost where you diversify into little pieces of all different kinds of real estate with the ability to get in and get out at will, as you wish,” Clark says.
He points out that, often the fees you pay do more to dictate your future wealth than your annual returns. And even if you’re investing for a retirement decades into the future, being able to access your money without incurring financial penalties (beyond paying taxes on gains) can offer peace of mind.
Is It Safe To Invest in Real Estate?
By nature, investing is risky. In theory, you could lose every dollar that you invest. The money isn’t protected like it is sitting in a savings account with FDIC insurance.
However, inflation combined with the current low interest rates means that keeping all your money in the bank will erode the purchasing power of your dollars over time.
For most people, investing is an important component of financially preparing to support themselves in retirement. But there’s a huge difference between putting every penny you make into an ultra speculative penny stock and spreading your money across a number of comprehensive index funds or ETFs.
Clark says often that we should invest in the future of capitalism rather than in the future of individual companies. Real estate holdings aren’t necessarily companies, but the same ideas apply.
Within your overall portfolio, you can put every dollar you invest into a target date fund, never think twice about it and be setting yourself up well for retirement. So in Clark’s mind, for most people, investing in real estate is a needless complication. At the same time, there’s nothing wrong with it in moderation.
Within real estate investing, it’s less risky to invest in a large basket of properties through an index fund or ETF than it is to put all of your real estate funds into a single property or project.
Final Thoughts
It’s difficult to offer blanket statements on investing. Your specific goals, financial circumstances, risk tolerance and other factors matter a lot in terms of what investment vehicle makes sense for you.
If you really need investment advice, consider hiring a fiduciary financial advisor even on a temporary or hourly basis.
That said, if you’re going to consider just one factor when evaluating real estate investment options, prioritize paying as little as possible in fees.
Clark’s advice on real estate investment is very much the same as his philosophy on the stock market: Avoid fees, keep your risk low through diversification and aim for as much time in the market as possible.
