As an investment, the case for real estate remains a good one. Not only has the sector outperformed the S&P 500 over the past 40 years (an average annual return of 9.3% for the NCREIF Property Index versus an 8.7% return for the S&P 500), it’s done so with dramatically less volatility (7.8% compared to 16.4%), according to the S & P Dow Indices and NCREIF.
Real estate has a low correlation to stocks and bonds. Because it’s a lagging economic indicator — it rises and falls well after the rest of the economy — it moves differently than stocks or bonds. What’s more, real estate markets are unique. The factors that can sink home prices in one market can have no bearing on another, although that’s not always the case.
Although the real estate market has plenty of opportunities for making gains, buying and owning real estate is a lot more complicated than investing in stocks, bonds and mutual funds.
Perhaps the biggest difference between a rental property and other investments is the amount of time and work required. If you invest in a rental property, there are many responsibilities that come along with being a landlord. You should also consider the amount of time required to deal with the investment. You may want to consider hiring a real estate property management company to handle the day-to-day operations of your real estate portfolio in exchange for a percentage of the rental revenue.
Because of the time involved in managing real estate, many investors prefer passive investment. A real estate investment trust (REIT) is created when a corporation (or trust) uses investors’ money to purchase and operate income properties. REITs are bought and sold on the major
exchanges, just like any other stock.
REITs are unique because of their tax structure, which was designed to encourage smaller investors to invest in real estate projects they otherwise wouldn’t be able to afford. Corporations that have opted for REIT treatment pay no Federal income tax on their corporate earnings as long as they follow a few rules, including a requirement to distribute 90% or more of profits to shareholders as dividends.
One downside of investing in REITs is that, unlike common stocks, the dividends paid out on them are not “qualified dividends,” meaning the owner can’t take advantage of the low tax rates available for most dividends. Instead, dividends from real estate investment trusts are taxed at the investor’s personal rate.
Another excellent real estate strategy is the 1031 exchange. This tool allows an investor to sell a property, reinvest the proceeds in a new property, and defer all capital gain taxes. There was a time when 1031 cases needed to be simultaneous transfers of ownership, but under current law, a contract to exchange properties in the future can be used as well.
Family Limited Partnerships (commonly called FLPs) are frequently used to move wealth from one generation to another, and can be a useful structure for holding and transferring real estate within a family.
FLPs are typically holding companies, acting as an entity that holds the property contributed by the members. FLPs have several benefits. They allow family members with aligned interests to pool resources, thus lowering legal, accounting, and investing costs. They allow one family member, typically the General Partner (GP), to move assets to other family members (often children who are Limited Partners, or LPs), while still retaining control over the assets. Because the LPs have no rights of control, they cannot liquidate their partnership interest. The timing and amounts of distributions is up to the GP(s). That means a distribution cannot be made to one partner (GP or LP) unless all partners receive their pro rata portion of any disbursements.