Union Bank begs the question: Is now a good time to invest in real estate?

U.S. economists agree that the housing market appears to be on the mend. This has many investors wondering: Is it safe to invest in real estate again? While many signs seem to point toward “yes,” it’s important to consider the potential impact this type of investment may have on your wealth preservation plan. Looking at two strategies — purchasing rental property and buying into real estate investment trusts — we cover the pros and cons of investing in real estate at the present time.

Rental Property
Buying a house, condo or multi-family unit with the sole intention of renting it to others is a popular way to invest in the real estate market.

The upside:
Low interest rates — Investors with solid credit can secure a mortgage for near-record low interest rates, making the prospect of purchasing property an affordable one. As of Jan. 3, 2013, a 30-year fixed-rate mortgage averaged 3.34 percent, and a 15-year fixed averaged 2.64 percent.1 Experts expect rates to remain low throughout 2013.
Low home prices— Foreclosure backlogs and other residual effects of the 2008 housing crash have been keeping home prices affordable. However, bear in mind that asking prices in December were up more than 5 percent year-over-year,2 and economists expect them to keep rising as the economy improves.
High demand— Tough economic times and stricter financing qualifications have turned many would-be homeowners into renters. Insiders predict the demand for rental properties will remain high through 2015 or 2016. (For more on the rental market, see Economic Outlook for the 2013 Real Estate Market.)
The downside:
Concentration — If you’re considering purchasing more than one rental property, be cautious of location. Having multiple properties in one area results in a lack of diversification that poses the same risks as putting all your money into one or two stocks in the same industry.
Red tape — Buying property, locating suitable tenants and drawing up lease contracts can be time-consuming tasks, filled with legal and financial considerations. Getting in — or out — of this investment is not a quick or cheap process.
Management costs — Owning property requires continuous maintenance and management duties, which you must either hire a third party to handle or take care of yourself.

Real Estate Investment Trusts (REITs)

A simpler and more affordable alternative to purchasing property outright, a REIT is a corporation that enables investors to pool their funds to invest in either rental/commercial property (equity REIT) or mortgages on these properties (mortgage REIT).
The upside:
Increasing momentum — Equity REITs outperformed the broader equity market in the first half of last year. While the S&P 500 Index reported total returns of 8.58 percent as of July 2, 2012, the FTSE NAREIT All Equity REIT Index came in at 16.11 percent.3
High dividends — REITs are required to distribute 90 percent of their annual taxable income in the form of dividends to shareholders, providing potentially attractive yields for investors. The Vanguard REIT Sector ETF returned an annual 20.4 percent over the past three years.4
Diversification — Balancing your portfolio with a REIT presents a third option, in addition to stocks and bonds. Furthermore, commercial real estate can be used as a tool for hedging against inflation, as REIT operators can simply raise the price of rent during inflationary times.
Liquidity — Unlike property ownership, it’s fairly easy to get in and out of your investment with a REIT. This could be a significant advantage if economic uncertainty continues in the U.S.
The downside:
Intricate taxation — REIT dividends are comprised of several different types of income, which may be taxed at different rates. The overall REIT is not considered a non-qualified dividend, but within the REIT there may be assets taxed at capital gains rates, current qualified dividend rates (where the corporate tax is still applicable) and even non-taxable capital return rates.5 With Congress’s decisions over taxes far from cemented, this could prove to be a confusing scenario for investors going forward.
Less control — Unlike physical ownership, investors have little to no control over the decisions and management of the property.

The Bottom Line

While both options present advantages and drawbacks, there is compelling evidence to suggest that real estate investments could be a smart move in 2013. Bear in mind, however, that both physical property and REITs are subject to changes in the economic landscape and fluctuations in the housing market.

What are your thoughts?