ForeclosuresMass - ForeclosuresMass Monthly - Finance Corner - A Good Fit: Real Estate in Your Investment Portfolio (June 2005)

"I'm going to use my investment property to pay for my kids' college tuition."

"At least I know my real estate will continue to grow in value. I'm not sure about my other investments."

"Investment property gives me a chance for much higher returns than other investments."

Financial planners hear comments about real estate investments frequently. Does investing in real estate truly offer financial opportunities? Many times yes, but not always for the reasons people think.

* Next 37 17 investors only!

The first step is to think big picture. Consider your reason for investing in the first place before deciding on which property to place an offer, or even more broadly, whether you'll invest in foreclosed property, fair market-priced multi-families, or undeveloped land.

Most likely, when you are 95 years old, you will not look across your hospital bed to your children and say, "I'm so content knowing we had an average annual return of 9% on our investment property." You will hopefully reflect upon your joyous retirement years, your children's successes, or some other memory that does not begin with a dollar sign.

Thus, the most important question you must ask yourself in determining your investment needs is: What dream do I want my money to fund and how much money will my dream take? The answers to the first part of the question might include:

For the second part of the question, we will use the example of funding a retirement. Figuring out how much money you will need includes considering the following things:

Once you answer these questions, determine - or have your financial advisor determine - what diversified investment portfolio might help you reach your goals suitably. Could real estate fit into that portfolio? Quite possibly, yes. But how?

Real estate is just one investment type, or asset class, out of dozens. Examples of other asset classes include cash, large, US-based company stock, and long-term, high quality municipal bonds. Successful investment portfolios, with success defined as investment portfolios that meet their owners' needs, become so through diversification - a commonly used and misused term.

Imagine two investors. Each has a portfolio. Each portfolio has identical average annual returns. The investor whose portfolio has the smoothest ride - the smallest ups and downs, the lowest volatility - almost always has the most money in the end. Diversification is the technique that provides that smooth ride. The secret is to hold investments that behave differently from each other. That is, while some investments may be losing value, others are gaining. No investment is ever guaranteed to go up in value. No investment guarantees a particular yield or return. Even a diversified portfolio can lose value. If you don't believe that, as a group, investments increase in value over time, you may be better off not investing at all.

So what about real estate? Many stock asset classes, such as large cap U.S. stocks, have historically behaved similarly, while real estate is an asset class that has historically behaved differently from such commonly held investments. So including real estate as a percentage of an investment portfolio may be a suitable way to diversify.

What types of real estate should you consider? Basically, two types of real estate are available for investment: residential and commercial.

Residential includes single-family homes, multi-families, residentially zoned undeveloped land, and apartment buildings (Your own home doesn't count. Even though it may be your most valuable asset, you are probably better off assuming that if you need money during retirement you won't be selling your kitchen).

Commercial includes office buildings, warehouses and distribution centers, shopping centers, and commercially zoned undeveloped land. Each real estate sector carries its own advantages and disadvantages. Some offer income, some capital growth, some both.

Investing directly in commercial property can be cost prohibitive. However, it can be accomplished through other investment vehicles. Often, businesses will form as real estate partnerships, operating companies or real estate investment trusts, also known as REITs (pronounced reets). These businesses offer shares publicly to investors or privately through intermediaries. Though these vehicles often have investment minimums and certainly have risk, the minimums tend to be less burdensome then buying a property directly, and they offer the opportunity to gain some of the benefits of owning real property.

These real estate investments typically focus on a particular sector, e.g. office buildings or warehouses, and give the investor exposure to that sector with some level of diversification within that sub-asset class. For example, a REIT that owns office buildings exclusively likely will own many. And it may own office buildings in different regions of the country (or world) so, as was the case in the late 1980s, the Midwest may be booming while the Northeast is busting. The REIT's investors get the benefit of that diversification.

Investing directly in residential property, including foreclosures, is typically less expensive than buying commercial property. But this market can be challenging, so it's important to learn what to expect - and expect the unexpected in many cases.

Foreclosed properties offer a unique challenge because buyers are often not allowed into the home before making a bid. This can make it difficult to determine the financial consequences of these investments. You may bid $200,000 on a property and win it, only to discover that it requires $100,000 in work to be suitable for you to live in, rent out or resell. Doing as much homework as possible before investing in foreclosures and being prepared to spend more than the purchase price makes sense financially.

Be aware that real estate investing - however you approach it - requires more than just writing a check and waiting for the investment to grow. As with any opportunity to make money, there is an opportunity to lose money.

Real estate does not increase in value every single year; despite the beliefs of many who incorrectly project the increasing value on their home onto the real estate market at large. The investment that offers the greatest potential for return also carries the greatest risks.

However, if your financial planning exercise determines that you need high returns to achieve your goals and you are willing and prepared to take on that risk, investing directly in real estate, including foreclosures, may be appropriate.

Whatever your decision with real estate and investing, always remember to keep the big picture in mind. How will this investment help me achieve my most important goals?

Christopher P. Gullotti, MSFP is a financial advisor with Canby Financial Advisors, LLC of Natick, MA (www.canbyfinancial.com). He has been published in the Journal of Financial Planning, appeared on local television, and lectured at local colleges on a variety of financial topics. Canby Financial Advisors is an independent financial planning and investment advisory firm. Securities and some advisory services offered through Commonwealth Financial Network, member NASD, SIPC, Boston Stock Exchange. He can be reached at (508) 655-5355 or cgullotti@canbyfinancial.com.

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