Real Estate Funds: Invest Now Or Miss Out?

Investing in real estate funds is a great way to protect against stock market volatility and diversify your portfolio. Real estate investment funds are similar to mutual funds but focus on property investments. They can be highly specialized, targeting a narrow slice of the real estate market, or they can invest in real estate on a broader scale.

Active real estate funds, in particular, offer more opportunities for investors to decide where to allocate investment dollars, rather than basing decisions solely on an average rate of return. They also have the potential to outperform real estate investment trusts (REITs), which are a popular vehicle for passive real estate investing.

However, it's important to do your research when choosing an active real estate fund, as the freedom to distribute funds can introduce variables that may negatively impact performance. Additionally, smaller funds may be riskier for investors compared to REITs, as they have fewer properties and investors, potentially resulting in a more significant negative impact if an investment is unsuccessful.

Overall, investing in real estate funds can be a great way to add property investments to your portfolio, but it's essential to consider the risks and choose funds that align with your investment goals and risk tolerance.

Tax breaks and deductions

Investing in real estate can bring several tax benefits, including various deductions and incentives. Here are some of the most notable tax breaks and deductions to consider:

Depreciation Deduction

Depreciation is a significant tax advantage for real estate investors. It allows them to recover the cost of their income-producing properties over time. The Modified Accelerated Cost Recovery System (MACRS) is commonly used, where residential rental properties and structural improvements are depreciated over 27.5 years, while appliances and fixtures are depreciated over 15 years. This deduction reduces taxable income and overall tax liability.

Tax Write-Offs and Deductions

Real estate investors can write off various expenses directly tied to the operation, management, and maintenance of their rental properties. These include property management fees, repair and maintenance costs, utilities, homeowner's association fees, property insurance premiums, legal and accounting fees, advertising expenses, and business equipment. These deductions reduce taxable income and can result in significant tax savings.

Capital Gains Tax Treatment

Holding onto real estate investments for more than a year can result in favourable capital gains tax treatment. If a property is sold within 12 months, gains are taxed as ordinary income. However, if held for over a year, the sale is typically taxed as a capital gain at lower capital gains tax rates, especially at the federal level. This strategy can help reduce overall tax liability.

Self-Employment Tax Reduction

Rental income from real estate investments is generally not subject to Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes. This is a notable exception for self-employed individuals, as rental income is not classified as earned income. This benefit can lead to substantial tax savings, especially when compared to other self-employed income sources.

1031 Exchange

The 1031 exchange, named for Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes by selling an investment property and using the equity to purchase another property of equal or greater value within a specified timeframe. This strategy helps investors reinvest their profits without immediately paying capital gains taxes. It is a powerful tool for those looking to build wealth through real estate while minimising their tax burden.

Opportunity Zone Funds

The Tax Cuts and Jobs Act of 2017 created Opportunity Zones, which are designated areas in the United States offering tax benefits to stimulate economic growth. Real estate investors can benefit by investing in Qualified Opportunity Funds (QOFs), which invest in businesses or properties within these zones. By reinvesting capital gains into a QOF within 180 days of selling an asset, investors can defer paying taxes on those gains until 2026 or when they liquidate their stake, whichever comes first. This strategy provides both tax deferral and potential tax elimination if held long-term.

Passive Income and Pass-Through Deduction

The Tax Cuts and Jobs Act of 2017 introduced a pass-through deduction, allowing real estate investors to deduct up to 20% of their qualified business income (QBI) on their personal taxes. Rental income is considered QBI, and this deduction can result in significant tax savings. However, it is important to note that this provision is currently set to expire on December 31, 2025.

These tax breaks and deductions can significantly impact an investor's financial profile and should be carefully considered when making investment decisions. It is always recommended to consult with a tax professional to ensure compliance with tax laws and to maximise the benefits of available deductions.

Build equity and wealth

Building equity and wealth is one of the key reasons to invest in real estate. As you pay down a property mortgage, you build equity—an asset that's part of your net worth. And as you build equity, you gain leverage to buy more properties and increase cash flow and wealth even more.

Real estate investors make money through rental income, appreciation, and profits generated by business activities that depend on the property.

The benefits of investing in real estate include passive income, stable cash flow, tax advantages, diversification, and leverage.

Real estate investment trusts (REITs) offer a way to invest in real estate without having to own, operate, or finance properties.

Active real estate funds can also be a good option for investing in real estate. These funds can be highly specialized, targeting a narrow slice of the real estate market, or invest in real estate on a broader scale. Returns from active real estate funds may outstrip those of REITs because they offer more freedom to reinvest earnings.

Portfolio diversification

Diversification is a commonly used investment strategy, where an investor's portfolio is spread across many different types of assets. The aim is to spread out investment risk across different asset classes, sectors and strategies, so that poor performance in one area will not significantly impact the overall performance of the portfolio.

Real estate is an ideal opportunity to diversify a portfolio due to its low correlation with conventional equity and bond investments.

Diversifying by Asset Type

The variety of different asset types is one of the things that makes real estate investing unique. You can invest in single-family homes, small multifamily properties, large apartment complexes, retail, industrial, office space, self-storage, and more. By investing in different types of assets, you can hedge against broader macro changes to the economy.

Diversifying by Geographical Location

Real estate is hyperlocal, meaning that while one city may be booming, a neighbouring town could be experiencing a slowdown. By diversifying across different geographies, you can take advantage of the ups and downs of various markets.

Diversifying by Asset Class

It's important to understand human behaviour during booms and busts. For example, in good times, people tend to rent bigger and more luxurious apartments in nicer areas. In tough times, they might need to downsize or find a more moderately priced apartment. There are asset classes that fare well in good times and others that fare well in bad times, so it's important to diversify across asset classes to ensure your portfolio is profitable in all parts of the market cycle.

Diversifying by Strategy and Hold Time

Another way to diversify your portfolio is to change up your investment strategy and hold time. While one rental property might be a buy-and-hold, another might be better suited for the BRRRR strategy (buy, rehab, rent, refinance, repeat).

Diversifying by Active vs Passive Investing

Introducing a mix of active rental properties and passive real estate syndications can be a great way to diversify your portfolio. Rental investments tend to be smaller residential properties, whereas passive syndication investments tend to be larger commercial properties like apartment buildings.

Diversification Through Real Estate and Infrastructure

Both real estate and infrastructure constitute attractive investments for risk-averse investors, especially during bear markets. There are similarities and differences between the two, and you can construct an optimal portfolio by fully exploiting them. Real estate and infrastructure are often bundled together in securities such as real estate investment trusts (REITs), master limited partnerships (MLPs), or mutual funds that target these sectors.

Real estate leverage

• Leverage allows investors to purchase properties that are more expensive than what they could afford with their own capital. It also enables them to spread their cash across multiple properties.
• The most common way to leverage real estate investments is through a mortgage, where investors use their own money to leverage the purchase. A standard 20% down payment usually gets you the property you want, but some programs may require less.
• Leverage can increase your potential returns, especially when real estate values rise. However, it can also lead to losses if values decline.
• Calculating leverage is important before deciding if it's right for your strategy. You can calculate leverage by dividing your property financing by the cost of the property (Loan-to-Cost or LTC) or by dividing the amount of your mortgage by the current value of the property (Loan-to-Value ratio or LTV).
• One of the risks of leverage is that high levels of appreciation are not guaranteed. Past performance does not predict future results.
• Another risk is ending up with too high of a monthly payment. With higher leverage, the monthly payments will also be higher.
• It's important to make sound investment decisions and account for mortgage payments, vacancies, and potential economic downturns to avoid leveraging risks.
• Real estate leverage can be a powerful tool for investors who want to grow their portfolios and increase their returns. However, it's essential to carefully consider the risks involved.

Competitive risk-adjusted returns

Real estate funds offer competitive risk-adjusted returns, making them an attractive investment option. Risk-adjusted returns are a measure of the return on an investment compared to the amount of risk undertaken. By taking into account the level of risk, investors can make more informed decisions and better compare different investment opportunities.

Real estate has historically provided stable and attractive returns, often outperforming other asset classes over the long term. The tangible and finite nature of property can contribute to its resilience and potential for capital appreciation. Additionally, real estate funds provide investors with access to a diversified portfolio of properties, reducing the risk associated with individual investments.

The risk-adjusted returns of real estate funds can be further enhanced through careful investment strategies and active management. Fund managers employ various techniques to mitigate risks, such as thorough due diligence, strategic asset allocation, and proactive property management. By actively managing the portfolio, they can aim to maximise returns while minimising potential drawbacks.

When considering risk-adjusted returns, it is essential to evaluate the volatility and potential downside of an investment. Real estate funds typically exhibit lower volatility compared to other investments, providing a more stable option. The inherent characteristics of real estate, including its limited supply and potential for income generation through rent, contribute to its ability to weather market downturns and maintain long-term value.

By investing in real estate funds, individuals can access the benefits of the real estate market without the challenges and risks associated with direct property ownership. These funds provide diversification, professional management, and the potential for steady returns, making them a competitive option for those seeking risk-adjusted investments. However, it is important to remember that past performance does not guarantee future results, and the real estate market is subject to various economic and market factors that can influence returns.

Frequently asked questions