Most places you turn these days, someone is talking about “sophisticated” investors and “diversification,” but more often than not they’re only talking about the stock market. The stock market can provide good returns in healthy economies, but stocks are also a volatile asset and should be balanced with other assets in order for an investor to be truly “diversified.” Even then, most people consider diversification to mean a variety of stocks, some bonds, mutual funds, a CD and cash. But what truly savvy investors know is that real dversification means an entirely different asset class altogether, and one that may be the most lucrative of them all: real estate.
So why is real estate, and specifically residential real estate, the true benchmark for diversification? The reason is simple: cash flow. Truly sophisticated investors know that an asset’s value comes not only from its appreciated value, but how much cash that asset can pay them on a regular basis. In an article from The Economist in July of 2013, Nobel-Prize winning economist Robert Merton discusses the importance of defining a retirement income when planning for retirement. For Merton, it isn't the size of the asset, but how the asset pays you, or what the ultimate cash flow looks like.
For stocks, cash flow is typically realized in the form of dividends (unless they’re sold). Yet not all stocks yield dividends. In fact, nearly half of the stocks in the NASDAQ and 15 percent of the S&P 500 pay no dividends, and those that do usually don’t pay out much. In June of 2014, the average dividend yield for the Dow Jones Industrial was 2.68 percent, the NASDAQ was 1.11 percent, and the S&P 500 was 1.93%. Unless you own a significant number of stocks in these indices, the dividend return, or cash flow form these stocks is infrequent and small.
If we look for a continually recognized source of consistent cash flow, the answer is clear. It’s real estate. Real estate, properly purchased, pays on a monthly basis in the form of rent. The key is to make sure that rental income outweighs expenses. The formulas for determining this are actually pretty simple, and a qualified real estate agent usually can give you a fair estimate if you ask.
Not only does real estate offer significant benefits in terms of cash flow, but tax benefits and appreciation as well. Real estate can be depreciated, and capital taxes can be deferred upon sale with 1031 exchanges. Historically, housing has appreciated at over 5 percent per year (including the recent housing crash), and more recently appreciated nearly 12 percent in 2013!
But how “sophisticated” does someone have to be to invest and benefit from real estate? The answer may surprise you. Despite what you may have read about institutional investors and billion-dollar hedge funds buying up real estate, 98 percent of the residential rental market is made up of individual mom and pop investors, whose average yearly income is only a small percentage higher than the average homeowner’s. The difference is that these investors have seen the opportunity and seized it, and are now reaping the benefits.
 http://www.economist.com/news/finance-and-economics/21580493-pension-plan-members-need-focus-right-measure-pot-luck Buttonwood Blog, “Pot Luck,” The Economist, July 6th 2013. Retrieved 24 April 2014.
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