If you are thinking of tiptoeing into real estate as an investment, you have two basic approaches:

Buying shares in a real estate investment trust.

Or

Direct ownership

Buying shares in a real estate investment trust. You can invest in a REIT, but doing so involves buying shares of a portfolio of properties. It’s really more like buying a stock or buying into a fund. It’s a completely different animal from owning real estate directly. There are three layers of value – the real estate itself, the management and cash flow that supports the trust, and the fund based on the trust. It’s a very different vehicle than buying real estate, but most of us can’t just go out and buy 1 percent of a skyscraper.

Adding a REIT to your portfolio can complement stock and bond funds, but you must be sure you understand how the real estate fund is designed and how its managers will likely extract value from the holdings. You can buy shares of REITs and real estate-based funds, but the performance of the funds is based on both cash flow and gains from occasionally selling properties – a very different scenario from the typical performance drivers of stock and bond funds.

Direct ownership. This is anything but a passive investment, People think it’s easy money, that there’s not a lot of work, that tenants will pay on time and that pipes never leak. Some individuals enter the market by buying a small apartment building, you should research diligently to find a good deal on a building that produces positive cash flow and has no hidden defects that will require expensive repairs. Don’t take investment guidance from a real estate agent, to them; everything is a good investment, because they only win a commission when you buy.

Don’t assume your personal experience as a homeowner translates to managing rentals, just on a bigger scale. From complying with fair housing rental regulations to insurance, to making sure the property complies with building codes and common-sense safety guidelines, property management dominates your wallet and your time. It’s a very complicated asset. But because it’s a physical asset, people think it isn’t complicated. People way underestimate the number of issues that come up.

One way to test your tolerance for being a landlord is to buy a duplex or a small apartment building, with the aim of living in one unit and renting the others.

A nascent rebound seems to be buoyed by millennials who are edging into the market as owner-occupants. Thin on cash, 20-somethings are finding they can gain a toehold into homeownership by buying a small, multiunit property, such as a duplex or three-apartment building. Their plan is to live in one unit and rent out the others. Although this arrangement can stretch down payment dollars, it also demands a Himalayan learning curve: first-time homeownership simultaneous with first-time landlord.

The most important consideration for potential first-time landlords is to not assume today’s rising rental rates will lift future cash flow. Today’s tight rental market will be eased as projects under construction enter the market. That means rents will level off, so it’s best to work cash flow and return numbers using conservative projections.

Key cash-flow factors include not only predictable costs, such as property taxes, but also variables that can affect the appeal of the units to potential renters. For example you may think including heat and water in the monthly rent will attract renters. But the actual cost of heat and water is quite different for a single occupant compared with a unit shared by three roommates. The more water and heat they use, the less money you keep.

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Denver, Colorado - Phill Foster and Company

www.phillfosterco.com