Should Every Investment Portfolio Include Real Estate?

I recently finished a new personal finance book, Beyond The Basics, by Sammy Azzouz, a financial advisor out of Massachusetts, and one of his investment topics “beyond the basics” is real estate.

Azzouz’ premise is that for most investors their basics will be three things:

1. career, because that provides your earning potential;
2. savings rate to ensure there are earnings left over to invest;
3. building a risk-managed paper portfolio that you can stick to in good markets and bad.

After Azzouz set up these basics, he introduced the benefits of adding real estate to a portfolio. This got me thinking: Should everyone add real estate to a portfolio?

Unlike Azzouz, I am not a financial advisor, so my ruminations are strictly that – ruminations, ideas, thoughts –not recommendations. Before changing your own portfolio, find a Sammy Azzouz or do your own research and decide for yourself. Here are three reasons for and against including real estate in an investment portfolio:

Team No: real estate should NOT be included in every portfolio

1 – The time and energy you spend on real estate may be better focused on your career

When Scott and I graduated from college, our first jobs were in management consulting, which is one of the higher paid entry-level jobs. Consulting also has a steep earning profile, and you can grow your salary quickly if you do well. Within a few years, we had both more than doubled our salary. If you’re on a similarly high-paid and fast-growing career path, it makes sense to prioritize investments in your career.

It is possible to invest in real estate on the side. House hacking, or renting out portions of your primary residence to generate income, is one potential side gig. However, devoting what free time you have to something that complements your fast-growth career might be the smarter financial bet. This could include getting an advanced degree or certification, learning a second language or other marketable skill or networking in your field.

One of my early colleagues in consulting didn’t pursue any activities unrelated to work for years, made partner before he turned 30 and then diversified his attention to angel investing and other things. It helped that he really liked his job. If you like your job and the earning potential is high, that could be the only wealth creation vehicle you need. Real estate would be an unnecessary distraction.

2 – Many tax-advantaged retirement accounts don’t allow real estate investing, and you may want to prioritize these first

Even though we are now majority real estate in our portfolio, we started with paper asset investing, and it was the right way to start given our circumstances. We started our careers in a high tax geography and both had high salaries at a time when the marriage penalty (i.e., paying higher taxes because we are married filing jointly) was in full force. It made much more sense to funnel as much money as possible into tax-advantaged retirement plans (in our case, our employer 401k plans) than to take a big tax hit and invest what was left over.

Furthermore, we both had company matching to our 401k contributions, so that was like getting a 100% risk-free return on every dollar contributed up to the match. Therefore, our first priority was always to max out our 401k contributions. The only downside with 401k plans is that they have limited investment options. I haven’t heard of a company-sponsored 401k plan that allows real estate ownership as an investment within the plan. Maybe you can invest in REITS, but that is still paper asset investing, just backed by real estate – you don’t own the actual real estate.

Even if we had wanted to branch out into real estate right away, we would need to save enough for our first down payment. We did eventually invest in real estate while still working in our corporate jobs, but that was after having invested first in paper assets through our employer tax-advantaged retirement plans.

3 – Passive paper investing is less hands-on than passive real estate investing

The final reason that it made sense for us to prioritize paper over real estate as a first investment is the time factor. Consulting is a highly compensated career for a reason – it entails long hours and lots of travel It is hard to maintain hobbies with many high-growth careers, much less pay attention to investments. While both paper and real estate investing offer passive methods of investing, passive is never 100% hands-off, and real estate requires more hand-holding than paper.

With paper asset investing, you can follow a buy-and-hold strategy or hire a money manager (or nowadays, a robo-advisor) to invest your money. With real estate investing, you could invest in turnkey real estate, where the turnkey company finds the property, renovates it, and rents it out. Sometimes they manage the property going forward, or you can outsource that too. Turnkey real estate investing sounds passive (it’s called “turnkey” because all you need to do is turn the key and you’re off!). However, turnkey real estate investing is not passive.

In our experience, you have to manage the process very closely. You need to do significant due diligence to identify a reliable turnkey company. Finally, the fees you pay – e.g., higher prices to acquire the real estate, ongoing property management fees – are higher than what you pay for a robo-advisor or to build up a buy-and-hold paper portfolio. If you want a passive investment in terms of time and effort, paper beats real estate.

Team Yes: every portfolio needs real estate

1 – Real estate is a hedge against inflation

While we didn’t start with real estate, as our investments grew and we were able to step back from the hamster wheel of non-stop work, we realized the powerful advantages real estate would add to our portfolio. One of the most critical advantages is that real estate acts as a hedge against inflation. The price appreciation of real estate follows closely to inflation. Rents also track inflation, so the value of the property, as well as the income from the property should cover you for inflation.

Having assets that move with inflation is critical because inflation is a silent drag on your portfolio. If all you see is price appreciation (e.g., the stock market benchmark going up) then it looks like you’re doing well, but you then have to account for inflation. If your portfolio grows by 7% but inflation is running 4%, that’s only a 3% growth rate, not the full 7%. The best way to look at the effect of inflation on your assets is to use a calculator that enables you to run different scenarios for your portfolio. My favorite calculate is the Ultimate Retirement Calculator from Financial Mentor.

2 – Real estate pays off in four different ways

When you own rental real estate, there are four ways you can make money. First of all, you get capital appreciation on the value of the property. Historically, this just tracks inflation but in some geographies real estate appreciation can be much higher. Secondly, you get rental income from renting out the property. Thirdly, if you have a mortgage on the property, you pay off some principal with each payment, so you get that forced savings from the principal repayment. If the rent you charge covers your mortgage and other expenses, your tenant essentially makes that forced savings contribution for you. Finally, real estate provides tax benefits because it depreciates each year, and you can offset that depreciation loss against your taxable income.

Paper assets may provide a tax advantage if purchased for a tax-advantaged account. They may provide appreciation and may provide ongoing income in the form of interest or dividends. But real estate provides more income streams and more reliable income streams.

3 – Real estate allows you to leapfrog your wealth creation through leverage

We are pretty conservative and have borrowed around 60% of the value of our real estate portfolio. You can borrow up to 80% in most cases. 60% leverage means that every $1 you have working for you in your portfolio only cost you 40 cents. You can use leverage to build a paper asset portfolio (using margin loans) but you can only borrow up to 50% of the value, and interest rates are higher for margin loans than mortgages. Therefore, if you want money working for you sooner than later, real estate will get you there faster.

Today’s mortgage rates are lower than the historical rate of inflation. Essentially, you are getting free money because you are paying back dollars that are worth the same or less than they are now. Yet, you enjoy the real estate right now.

With 20/20 hindsight we would have added real estate to our portfolio much sooner

We got serious about real estate in our early 40’s. Had we started in our early 20’s we would have a full 20-year head start. That would have meant 20 years of paying down a mortgage (or being mortgage-free if we took 15-year loans!). That would also have meant 20 years of price appreciation. While we gained tax advantages from maxing out our employer 401k plans, we could have received tax advantages from depreciation. Finally, the leverage would have helped us put more money at work right away.

The best time to plant a tree…was 20 years ago.  The second best time is today. 

—  Chinese Proverb

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At least, we got started, and we plan on introducing real estate to our kids’ portfolios much earlier than we did for ours. How about you? Do you have real estate in your investment portfolio? Why or why not?