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Investment Diversification: Is Real Estate for You?

We're talking about buying a single family rental home as compared to other investment types. If you want to diversify, this information should help you to decide if real estate is for you.
10/27/2015 01:09pm ET | Updated October 27, 2016
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This article isn't about totally passive real estate investing, as in buying shares in a REIT, Real Estate Investment Trust. That strategy works for many, but it's a lot like stocks in that you are buying not only a share of ownership or debt, but also paying fees for the expertise of the REIT managers. This article is about making your first investment in ownership of a rental home.

I'm not saying that you must take a very active role in the management of the property if you don't want to. This will increase your costs with the hire of a professional property manager, but if you can still get the return on investment you want, then you can be pretty passive. The major difference is that the selection of the property, and most of the major decisions will still be yours to make with the advice of your property manager to help.

So, we're talking about buying a single family rental home as compared to other investment types. If you want to diversify, this information should help you to decide if real estate is for you. I'm directing this toward investors who can move or gather enough cash to make a down payment on the home and use a mortgage for the purchase. Of course, you could pay all cash, but leverage is acceptable if you make the right decisions as to location and the property. We're going to take a look at the risk and reward profiles for dividend paying stocks, a popular choice for investors who are seeking income with a desire to minimize risk.

Stock Dividend Performance

I'm getting this information from a September 28, 2015 report at FactSet.com. A chart in the report titled Top 10 Companies by Dividend Yield - TTM Basis (TTM is Trailing Twelve Months) shows yields between 5.0% and 5.9%, with the S&P 500 average at 1.9%. Now, if you were really amazing, you may have held stocks in that Top 10. But, it's far more likely that the vast majority of investors were earning far below that group's results. I just wanted a benchmark for when we look at an example rental property in a moment, so that we can compare the different investments better.

Stock Risk Factors

Generally, stocks that pay dividends carry less value fluctuation risk than growth stocks. They're established and have a history of profitable performance, and share those profits with their investors through dividends. Sure, they vary based on current performance, but they usually hold within a reasonably expected range. So, it's a small risk when you talk about variation in dividends, but it is there.

However, when it comes to inflation, it's a whole new ballgame. When you're consistently pulling down let's say 4% in dividend income on stocks that appreciate slowly in value, then a spike in inflation can carry a heavy toll. USInflationCalculator.com shows an average inflation rate from 1914 through 2014 of 3.304%, going from negative numbers some years to a high of over 15% back in the 1920s.

It is true that in 2014 the rate was only 1.6%, but that puts a pretty big hole in that 4% return we're using for our example. If the rate picks up closer to average the next year and you're still holding the same stocks, you could actually end up with a sub-1% return on your investment. So, inflation is a risk factor in dividend stock investing. Just a mention here if you want to consider bonds instead. They usually have lower overall returns that dividend paying stocks, so the results would be worse.

Rental Property Risk Factors

This is a good comparison, as a drop in the value of the stock shares would not necessarily scare you out of the investment, as you can simply hold on and collect the dividends until the value recovers. This is the same for a rental home, so not a comparison consideration. When the market crashed in 2007, landlords who weren't in other financial stress simply held their properties and continued to collect positive cash flow rents. Now values have regained much of what was lost.

When it comes to inflation, real estate exhibits different characteristics in some important ways. Inflation is by definition rising costs for labor and materials. Labor and materials are the bulk of the costs in building. If those costs rise, builders adjust their home prices upward to retain profits. Generally, when new home prices rise, existing home values rise as well. Also, if rental demand is steady, rents can often be increased too. So, inflation can actually work for you in real estate.

Rental Property Investment Returns

Over at HomeUnion.com, a report in November of 2014 stated that the average ROI for rental homes was running 9.06% in the third quarter. That's more than double what the average dividend investor would expect, so a great start. But, one of the best things about rental home investing is that you can play a larger role in your ROI.

Sure, your market is going to be a major factor. RealtyTrac.com reports with some great color coded charts, that average results for non-spectacular markets are in the 7% to 9% range. But, in many markets double digit returns are the norm, some as high as 25% or better.

The thing is that you do have some control by doing your homework and due diligence and buying right in a good rental market. So, if you're trying to make a diversification decision, check out the links here to get a pretty good idea of whether real estate is right for you portfolio.