Real estate is a powerful way to invest your money and grow your wealth. It can offer you income, appreciation, equity, diversification, and tax benefits. But how much of your net worth should be in real estate? How do you decide how much to allocate to this asset class? How do you align your real estate allocation with your financial goals and risk tolerance?
The need for addressing these questions becomes even more crucial when considering that, according to some reports, the average percentage of net worth allocated to real estate for Americans is around 70%. In contrast, financial advisors often recommend a percentage between 25% and 40%. It's crucial to remember that these figures are not one-size-fits-all solutions, but rather broad averages or guidelines. Your personal situation, financial goals, and risk tolerance will significantly influence your ideal allocation.
In this article, we will help you answer these questions and provide some tips and factors to consider for determining the ideal percentage of net worth in real estate. We will also introduce you to Kubera, a smart net worth tracking software that can help you track and optimize your real estate allocation.
Understanding Real Estate Investing
Before we get into the details of real estate allocation, let’s first understand what real estate investing is and why it is attractive.
Real estate investing is the process of buying, owning, managing, renting, or selling property for profit. Real estate can include different types of properties, such as:
- Residential properties (such as single-family homes, apartments, condos, etc.)
- Commercial properties (such as office buildings, retail stores, hotels, etc.)
- Industrial properties (such as warehouses, factories, etc.)
- Land (such as vacant lots, farms, etc.)
Some of the benefits of real estate investing are:
- Appreciation: Real estate tends to increase in value over time due to factors such as inflation, supply and demand, location, improvements, etc. According to the Federal Housing Finance Agency (FHFA), the average annual home price appreciation in the U.S. was 6.8% from 2015 to 2020.
- Equity: Real estate allows you to build equity, which is the difference between the market value of your property and the amount you owe on your mortgage. Equity can be used as collateral for loans, refinancing, or cash-out options.
- Income: Real estate can generate passive income from rents, leases, dividends, or interest payments. According to Zillow, the median monthly rent in the U.S. was $1,843 as of November 2021.
- Diversification: Real estate can diversify your portfolio by providing exposure to a different asset class that has low correlation with stocks, bonds, and other securities. This can reduce your overall risk and volatility and enhance your returns.
- Tax advantages: Real estate can offer various tax benefits such as deductions for mortgage interest, property taxes, depreciation, maintenance expenses, etc. Additionally, real estate investors can defer or avoid capital gains taxes by using strategies such as 1031 exchanges or opportunity zones.
However, real estate investing also comes with some risks and considerations that you should be aware of:
- Home prices vs home value: The price of a home is not necessarily equal to its value. The price is determined by what buyers are willing to pay in the market at a given time. The value is determined by factors such as location, condition, features, amenities, etc. Sometimes, the price may be higher or lower than the value due to market fluctuations, supply and demand imbalances, speculation, etc.
- Market value may change over time: The value of your property may increase or decrease over time due to changes in market conditions, housing trends, interest rates, economic factors, demographics, etc. For example, the COVID-19 pandemic caused a surge in demand for suburban and rural properties, while urban properties saw a decline in popularity.
- Liquidity: Real estate is not a liquid asset, meaning it cannot be easily converted into cash without losing value. Selling a property can take time, effort, and money, depending on the market conditions, buyer availability, listing price, negotiation process, closing costs, etc. According to Zillow, the median time to sell a home in the U.S. was 17 days as of November 2021.
- Leverage: Real estate often involves using borrowed money (such as mortgages) to finance a large portion of the purchase price. This can amplify your returns if the property appreciates in value, but it can also magnify your losses if the property depreciates or if you default on your loan payments.
- Management: Real estate requires ongoing management and maintenance to keep it in good condition and attractive to tenants or buyers. This can involve costs such as repairs, upgrades, landscaping, cleaning, insurance, utilities, etc. Additionally, if you rent out your property, you have to deal with tenant issues such as screening, collecting rent, handling complaints, evictions, etc.
Assessing Financial Goals and Risk Tolerance
Determining the right real estate allocation requires a thorough understanding of your financial goals and risk tolerance.
Financial goals are specific objectives you aim to achieve with your money over a specific period. This could include purchasing a home, retirement planning, generating rental income, or pursuing financial independence.
Risk tolerance, on the other hand, gauges your comfort level with potential uncertainties for higher returns. It evaluates your comfort with debt, market fluctuations, tenant management, and legal or tax complexities.
The portion of your net worth you invest in real estate should be a reflection of these elements.
For example, if home ownership is your primary goal, a larger allocation could be appropriate as it's a lifestyle decision with substantial financial commitments. Alternatively, if you aim for passive income via rentals, a smaller allocation may be enough, given the steady cash flow they provide without needing asset liquidation. In this case, factors such as vacancy rates, maintenance costs, and tax implications should be factored in for a comprehensive understanding of profitability and sustainability.
Similarly, if wealth accumulation for retirement or legacy is your objective, a higher real estate allocation could be beneficial due to real estate's potential for long-term appreciation and equity growth. However, considerations such as liquidity requirements, diversification advantages, and capital gains taxes should also be evaluated to align with your growth expectations and risk comfort.
Risk tolerance should be a reflection of your personal circumstances and comfort levels. For instance, comfort with debt might suggest a higher real estate allocation given the potential for leverage-enhanced returns, but also the possibility of increased losses. Comfort with managing tenants or property maintenance might justify a larger allocation, but this must be balanced against the time, skills, and responsibility required.
In all cases, consider your overall financial stability, property location, market conditions, and other elements to make informed investment decisions.
Calculating Net Worth and Evaluating Real Estate Exposure
Calculating your net worth and assessing your real estate exposure is a critical step in optimizing your real estate allocation.
Net worth is the value of your total assets minus your total liabilities. Assets comprise everything of value you own, including:
- Cash and equivalents (e.g., checking, savings, money market accounts)
- Retirement accounts (e.g., 401(k)s, IRAs, Roth IRAs)
- Investments (e.g., stocks, bonds, mutual funds, ETFs)
- Real estate (e.g., primary residence, rental properties, land)
- Personal property (e.g., cars, jewelry, artwork)
Conversely, liabilities are all debts owed, such as:
- Mortgages (e.g., home loans, home equity loans, lines of credit)
- Personal loans (e.g., auto loans, student loans, credit card debt)
- Taxes (e.g., income, property, sales taxes)
- Other obligations (e.g., alimony, child support, legal fees)
Your net worth is simply your total assets minus total liabilities. For example, if your assets amount to $500,000 and liabilities total $300,000, your net worth is $200,000.
To assess your real estate exposure, calculate the value of your real estate holdings as a proportion of your net worth. If your net worth is $200,000 and your real estate is worth $100,000, your real estate exposure is 50%.
To ease this process, consider using a net worth calculator to quickly compute your net worth and real estate exposure by inputting your asset and liability values.
Factors Influencing Real Estate Allocation
Once you have calculated your net worth and real estate exposure, you can compare them with the recommended ranges and adjust them accordingly. However, there is no one-size-fits-all answer to what percentage of net worth should be in real estate. The optimal allocation depends on various factors that are unique to each individual. Some of these factors are:
- Home-ownership and primary residence: Your primary residence is one of the most common and important forms of real estate. It can provide you with shelter, comfort, stability, and pride. However, it also comes with costs, such as mortgage payments, property taxes, insurance, and maintenance. Additionally, it can affect your liquidity, mobility, and diversification. Therefore, you should weigh the pros and cons of owning a home and decide how much of your net worth you want to allocate to it. According to some experts, the optimal range for home-ownership is between 10% and 30% of your net worth.
- Rental properties and passive income: Rental properties are another common and attractive form of real estate. They can provide you with passive income that can supplement your other sources of income or cover your expenses. However, they also require management, maintenance, marketing, and dealing with tenant issues, vacancies, and regulations. Additionally, they can affect your cash flow, taxes, leverage, and diversification. Therefore, you should assess the value and performance of your rental properties and their impact on your net worth. According to some experts, the optimal range for rental properties is between 11% and 40% of your net worth.
- Home equity and mortgage payments: Home equity is the difference between the market value of your home and the amount you owe on your mortgage. Home equity can be a valuable asset that can increase your net worth over time as you pay down your mortgage and as your home appreciates in value. However, home equity can also be a liability that can decrease your net worth over time if you pay too much interest on your mortgage or if your home depreciates in value. Additionally, home equity can affect your liquidity, leverage, diversification, etc. Therefore, you should consider the role of home equity and mortgage payments in your real estate allocation. According to some experts, the optimal range for home equity is between 20% and 50% of your net worth.
- Cash flow and rental income: Cash flow is the difference between the income and expenses of a property. Cash flow can be positive or negative depending on how much rent you collect from tenants and how much you spend on mortgage payments, property taxes, insurance, maintenance, etc. Cash flow can affect your net worth, income, expenses, and taxes. Therefore, you should evaluate the importance of cash flow and rental income in your real estate investments. According to some experts, the optimal range for cash flow is between 10% and 20% of your income.
- Tax advantages and capital gains: Real estate investing can offer various tax advantages that can lower your taxable income and increase your net worth. For example, you can deduct mortgage interest, property taxes, depreciation, maintenance expenses, etc., from your rental income. Additionally, you can defer or avoid capital gains taxes by using strategies such as 1031 exchanges or opportunity zones. However, real estate investing can also have some tax implications that can affect your net worth. For example, you may have to pay capital gains taxes when you sell a property that has appreciated in value. Additionally, you may have to pay depreciation recapture taxes when you sell a property that has been depreciated over time. Therefore, you should consider the tax advantages and capital gains implications of real estate investing and how they affect your net worth.
Exploring four different real estate investment vehicles
Investing in real estate can be achieved in various ways through different vehicles, each offering unique characteristics, benefits, and drawbacks. Some common real estate investment vehicles include:
- REITs: Real estate investment trusts (REITs) are companies that own and operate income-producing properties or mortgages. REITs allow investors to buy shares of a diversified portfolio of real estate assets without having to own or manage them directly. REITs are required to distribute at least 90% of their taxable income to shareholders as dividends. REITs can offer high yields, liquidity, diversification, and professional management. However, REITs can also have high fees, low growth potential, market volatility, and tax inefficiencies.
- Single-family properties: Single-family properties are residential properties that house one family or household. Single-family properties can offer high appreciation potential, low vacancy rates, easy management, and favorable financing options. However, single-family properties can also have high maintenance costs, low cash flow potential, low diversification, and high competition.
- Multi-family properties: Multi-family properties are residential properties that house multiple families or households in separate units. Multi-family properties can offer high cash flow potential, high occupancy rates, economies of scale, and tax benefits. However, multi-family properties can also have high acquisition costs, high management costs, high tenant turnover, and complex regulations.
- Commercial real estate: Commercial real estate is property that is used for business purposes, such as office buildings, retail stores, hotels, etc. Commercial real estate can offer high rental income, long-term leases, appreciation potential, and professional tenants. However, commercial real estate can also have high entry barriers, high operating costs, market sensitivity, and environmental issues.
Asset Allocation Strategies and Risk Management
The final step in determining your optimal real estate allocation is to apply some asset allocation strategies and risk management techniques.
Asset allocation is the process of dividing your portfolio among different asset classes, such as stocks, bonds, real estate, etc., based on your risk tolerance, time horizon, and financial goals.
Asset allocation can help you optimize your returns, reduce your risk, and diversify your portfolio.
Risk management is the process of identifying, measuring, and mitigating the potential losses or threats to your portfolio. Risk management can help you protect your assets, avoid unnecessary losses, and cope with market volatility.
Some of the asset allocation strategies and risk management techniques that you can use for your real estate allocation are:
- The rule of thumb: A common rule of thumb for real estate allocation is to invest no more than 25% to 40% of your net worth in real estate, including your home. This range can provide you with the benefits of real estate ownership while giving you enough flexibility to pursue other investment opportunities. However, this rule of thumb is not a one-size-fits-all solution, and it may not suit your specific situation, goals, and preferences. Therefore, you should use it as a starting point, not a final answer.
- The age-based approach: Another common approach for real estate allocation is to adjust it based on your age. The idea is that as you get older, you should reduce your exposure to risky assets, such as stocks, and increase your exposure to safer assets, such as bonds. Similarly, you may want to reduce your exposure to illiquid assets, such as real estate, and increase your exposure to liquid assets, such as cash. This approach can help you preserve your wealth, avoid market fluctuations, and prepare for retirement. However, this approach may not account for other factors, such as inflation, life expectancy, income level, etc., that may affect your optimal asset mix. Therefore, you should use it as a guideline, not a rule.
- The goal-based approach: A more personalized approach for real estate allocation is to base it on your specific financial goals. The idea is that you should allocate more or less of your net worth to real estate depending on what you want to achieve with your money over a certain time frame. For example, if your goal is to buy a home for yourself or your family in the next few years, you may want to allocate more of your net worth to cash or short-term investments that can help you save for a down payment. If your goal is to generate passive income from rental properties for the long term, you may want to allocate more of your net worth to real estate that can provide steady cash flow and appreciation potential. This approach can help you align your real estate allocation with your financial objectives and preferences. However, this approach may require more research, planning, and monitoring than other approaches. Therefore, you should use it with caution and discipline.
Seeking Professional Guidance
If you are still unsure about how much of your net worth should be in real estate or how to optimize your real estate allocation, you may want to seek professional guidance from a financial advisor or a real estate expert.
A financial advisor can help you assess your financial situation, goals, and risk tolerance; create a personalized financial plan; and recommend an appropriate asset allocation strategy for your portfolio.
A financial advisor can also help you monitor and adjust your real estate allocation as your situation and goals change over time.
A real estate expert can help you assess the value of your real estate holdings, find and analyze potential properties, negotiate deals, manage transactions, and handle legal and tax issues. A real estate expert can also help you optimize your cash flow, appreciation, and tax benefits from your real estate investments.
However, hiring a professional does not mean that you can delegate all your financial decisions and responsibilities to them. You still need to be involved, informed, and educated about your real estate allocation and how it affects your net worth. You also need to choose a professional who is qualified, trustworthy, and aligned with your interests.
Utilizing Kubera’s Net Worth Tracking Software for Real Estate Allocation
Another way to determine your optimal real estate allocation is to utilize Kubera’s net worth tracking software. Kubera is a powerful tool that can help you track and optimize your real estate portfolio. Kubera offers various features and benefits, such as:
- Investment Tracking: Efficient tracking of real estate investments and their impact on your net worth is simplified with Kubera. Inputting property details updates their values using relevant data sources. Including other assets and liabilities provides a complete view of your net worth.
- Financial Monitoring & Analysis: Manage your rental income and expenses for precise cash flow calculations. You can monitor property values over time using market data. Additionally, Kubera's financial analysis tools help evaluate your investments. Its calculators offer metrics like IRR to keep you abreast with your real estate returns. You can also visualize portfolio performance over time using its charts and graphs.
- Portfolio Diversification Analysis: Kubera offers insights into your real estate portfolio diversification. It provides an overview of asset allocation, diversification across various asset types, and locations. If you've set up rebalancing alerts, Kubera provides timely and actionable advice.
Real estate is a significant asset class that can contribute to wealth generation and financial goal attainment. The optimal real estate allocation, however, is unique to each investor's circumstances and requires careful consideration. To make an informed decision, consider:
- Understanding real estate investing basics
- Assessing your financial goals and risk tolerance
- Calculating your net worth and existing real estate exposure
- Evaluating factors influencing real estate allocation
- Employing asset allocation strategies and risk management techniques
- Consulting with a financial advisor
- Leveraging Kubera's net worth tracking software
By adhering to these steps, you can tailor your real estate allocation to your personal finance situation, optimizing portfolio performance and returns, while mitigating risks.