Thinking about investing in real estate? You’re not alone. Real Estate Investment Trusts (REITs) have made real estate investing more accessible to the average person, but many investors still don’t understand the unique benefits and risks associated with investing in real estate. We talked to Brandon Jenkins, COO of Fundrise, an online real estate investment platform, about what investors should know before they start.
This interview with Brandon Jenkins has been condensed for clarity. Have something to contribute? Email us at media[at]valuepenguin.com. We also talked with Brandon about how his company is changing real estate investing for the everyday investor -- see that interview here.
What should new real estate investors do before jumping in?
In real estate, like all investments, there are inherent risks. Anybody who’s thinking about investing in real estate should understand those risks and understand that they could lose that money -- no different than any other investment. What you also tend to see new real estate investors do, which probably isn’t the smartest thing, is focus on trying to pick winners. Similar to the stock market, someone will say, “I think company A is just going to kill it for X, Y or Z reasons, so I’m going to put all my eggs in one basket.” And just like in the stock market, putting all your eggs in one basket, or all in one property, is not a smart way to go about it. Diversifying is key. If you have an idea of how much you want to invest, you want to diversify that across multiple buildings, multiple markets and different types of assets.
The other big thing that new real estate investors should understand is that real estate has a natural yield to it. Whether it’s an apartment building, where people are paying rent on their apartments, or an office building, where someone is leasing office space, most real estate assets will generate a natural yield: a 5%, 6% or 7% return. The way that return increases is mainly through leverage. The more money you borrow to buy an asset, the more you can leverage your equity, and that’s how people start making 15% or 20% returns. But leverage makes the deal exponentially riskier. If you see a 20%+ return advertised somewhere, it can sound great, but you should understand the likelihood of how that is going to be attempted -- that’s primarily through leverage, which carries a greater risk.
Real estate can be a great investment, particularly if you view it as something that’s long-term where you use reasonable leverage and let time and the natural growth of the marketplace do the work for you. Trying to shorten the returns in real estate to two or three years is when you see big bubbles and big collapses, because people are trying to cram all this growth into a short amount of time, which just isn’t natural.
Editor’s note: Leverage is the use of debt to acquire more assets, meaning an investor borrows money to invest. Investors use leverage to multiply gains and returns. Let’s say you invested $10,000 in an asset and borrowed an additional $20,000 to also invest, totaling $30,000. The value of your investment increases 10% ($3,000) to $33,000. Because you only personally invested $10,000, your return would be 30% ($3,000 ÷ $10,000).
What are some of the risks that are unique to real estate investing that investors should be aware of?
Most people understand you have to build a building, and that it costs money to build a building, it may take time, it may go behind schedule or it may go over budget. But a lot don’t understand the risks that exist pre-construction: all the work that goes into something before you’re allowed to start building. For example, what are known as entitlement risks. If you want to build a building somewhere, you generally have to get approvals to do that. Certain jurisdictions and certain cities can be very pro-development, and certain areas can be very restrictive in development. It can be much more expensive and restrictive than a lot of people recognize early on.
What separates a great real estate investor from an average one?
That’s pretty easy: patience and discipline. All the great real estate investors are very, very patient and disciplined. The great real estate investors are great, not because of the investments they did make, but because of the investments they didn’t make.
Where you see people get in trouble is when they try to rationalize for themselves why an investment makes sense. People are oftentimes eager to make investments, and you need to have the patience and discipline to wait -- whether it’s weeks, months or years -- when the market is out of whack or the deals just aren’t priced the way they should be. You have to be patient and disciplined enough to say “no” until you see the right deal come along. To me, that’s the obvious but challenging secret to being a good real estate investor.
How much should an investor allocate to real estate as a percentage of their portfolio?
Every investor’s personal circumstances are different, but we like to talk about the 20% rule. If you look at a portfolio that just has stocks and bonds, compared to a portfolio that has 20% allocated towards real estate over the last 15 to 20 years, the portfolio with 20% real estate has outperformed the portfolio of just stocks and bonds. The 20% rule helps to give people a general perspective about the benefits of diversifying into real estate, but whether or not that holds true for each individual is going to be dependent on that person’s unique situation and what their specific investment objectives are -- that’s going to determine what makes the most sense for them.
What is the minimum amount of time that someone should be invested in real estate?
Three to five years is the shortest, and some real estate deals may start to pay off within that time, but I would say people should view it as a five to 10-year minimum investment. The best investors invest for a much longer periods of time than that: 10 or more years. Great real estate investments, when you get a hold of them -- there’s almost no reason to sell. The best real estate investors own assets for decades, or generations even. It’s over that long time horizon that you see really big returns occur. Generally speaking, the longer-term you can be, the better you’ll perform.