Maximizing Real Estate Returns in Texas: Investment Strategies & Ownership
With Texas's changing property tax landscape, real estate is becoming an increasingly attractive asset class. Discover if and how real estate may fit within your investment portfolio.
Governor Abbott recently signed one of the most significant property tax cuts in American history, officially using $18 billion of the state’s budget surplus to tamp down on property taxes throughout Texas.1 The legislations was approved by an 80% majority on November 7, leading to a substantial reduction in the cost of investing in and managing real estate assets in the coming years.2 With lower annual costs come higher potential annual returns, igniting renewed interest in real estate investing for many Texans. With real estate becoming an increasingly attractive asset class, it's essential to consider which investment method and financial planning considerations align best with your portfolio.
The Pros and Cons of Real Estate as an Asset Class
Real estate, as an asset class, offers both advantages and challenges. On the positive side, it has the potential for substantial growth and tax benefits, provided you make wise investment choices. Tax advantages of traditional real estate investments can include deductions for things like property maintenance, upgrades, repairs, state-specific tax credits, as well as advertising and administrative costs.3 On the other hand, one of the most significant potential drawbacks in real estate investing is the issue of liquidity constraints. If a substantial portion of your wealth is tied up in real estate, it can complicate liquidity and cash flow planning, wealth transfer and equitable distribution among beneficiaries. Additionally, it’s important to be mindful of what sources of investment dollars to use and understand the respective tax implications to maximize net ROI when investing in real estate.
For example, real estate can be purchased through a self-directed Roth IRA (SDIRA) so that property appreciation and income can potentially occur tax-free, as long as you are at least age 59 ½ and it has been at least five years since you first contributed to a Roth when a distribution from the Roth IRA occurs.4 This approach can have very favorable tax benefits; however, there are many rules to know and follow with SDIRAs to avoid unintended tax consequences.
Utilizing Ownership Structures for Real Estate Investment
Owning real estate in various ways, such as through partnerships or Limited Liability Companies (LLCs), can offer significant advantages, especially regarding estate planning. When it comes to estate planning, the structure of your real estate ownership plays a crucial role in determining how tax-efficient the ultimate transfer will be.
For example, suppose you set up an LLC where non-voting units own 98% of the property's value and only 2% is owned by voting interests. In that case, you create an opportunity to apply substantial discounts to the property's overall value. Non-voting interests typically have limited decision-making capabilities and, therefore, lower value in the eyes of potential buyers. In some cases, this can result in a discount of up to 30% to 40% of the market value. Leveraging this structure allows you to transfer non-voting interests to a trust for your children and grandchildren, taking advantage of discounted values.
The Role of Liquidity in Real Estate Investment
Addressing the issue of liquidity is essential when incorporating real estate into your family's wealth plan. Liquidity allows for a smoother wealth transfer process and ensures that assets can be divided fairly among heirs when necessary. In scenarios where real estate forms a significant part of your family's wealth, you may want to consider asset classes that provide liquidity precisely when needed.
Choosing asset classes with complimentarily strengths becomes increasingly important for estate planning. Real estate ownership has the strength of high growth potential but the weakness of low liquidity. As such, life insurance can be a strong supporting asset for a sizable real estate portfolio. Instead of selling real estate to create liquidity for estate taxes, life insurance creates liquidity at the precise moment it is needed.
How to Invest in Real Estate: 4 Popular Ways
Investing in Rental Property Ownership
Rental property ownership remains one of the most direct and common ways to invest in real estate. In this case, you can determine how much rent you collect every month, when you collect, and your chosen tenants. This gives you a lot of control over the outcome of your investment.
However, owning and managing a rental property remains a high-cost, high-risk endeavor. Larger properties can become full-time jobs, even when a property management company is involved. Moreover, a single reckless tenant or natural disaster can cause a property to become a money pit.
- Direct control
- Ongoing income
- Property appreciation
- Tax benefits
- Low liquidity
- Potentially reckless tenants
- Landlord responsibilities & property maintenance
- Future unknowns (changes to neighborhood, real estate market, insurance rates, tax codes, etc.)
Investing in Property “Flipping”
Property “flipping” is the practice of buying a distressed or indebted property, renovating it, and quickly selling it for a profit. In many cases, this can be a profitable endeavor. But it does come with its risks.
The potential payoff includes a one-time return at the time of sale, often requiring the investor to put in additional resources after the initial purchase to update or improve the property. Selling the property and recouping the upfront investments often hinges on timing. If “flippers” cannot find a buyer, the entire investment can quickly become a loss.
Additionally, due to the short timelines typically involved with property flipping, short-term capital gains may be an important factor to discuss with a knowledgeable advisor and CPA for accurate tax projections.
- Direct control
- Potential for fast return on investment
- Unanticipated costs
- Capital gains taxes
- Unpredictable contractors & material delays
- Rapidly changing market conditions
Investing in Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts are privately managed trusts comprised of different investment properties. Investors can invest in the trust rather than individual properties with the intent of pooling resources to maximize profits. Each of the properties within the REIT is managed by a professional company, minimizing the work investors have to do.
Most REITs will have low entry points, which makes them great for beginning investors or as a diversification method for a portfolio. Considerations for REITs include the lack of control over what is included within the investment, as you cannot choose which properties will be part of the trust, and the inability to contribute “sweat equity” to help save in renovation or management expenses.
Liquidity considerations will vary depending on whether the fund is publicly traded or non-traded. Publicly traded REITs tend to be highly liquid and trade like a stock. While non-traded REITs are less liquid, this does enable managers to maintain the long-term strategy without as high of cash reserves for redemptions.
Both public and non-traded REITs file with the SEC, which adds a degree of transparency but also additional costs to ensure they are operating in compliance with regulations.
- Liquidity (publicly traded REITs)
- Potential for steady income
- Liquidity (non-traded REITs)
Investing in Private Equity
Private equity is becoming a preferred real estate investment vehicle for accredited investors. Private equity funds, when rigorously vetted and managed by professionals, allow for sharing the investment with other partners and can provide almost direct exposure to a specific project. Investing more directly in a project with fewer layers of administration could potentially lead to higher returns than publicly traded real estate investment alternatives. Investors gain proximity to the source of wealth creation through private equity investing. Like REITs, they require less active involvement from investors while maintaining the benefits of asset protection and tax advantages.
- Higher potential returns
- More direct exposure
- Access to unique investment opportunities
- Higher Risk
- Limited Information
Investing in Real Estate with Granite Harbor Advisors
In summary, when considering real estate investment as part of your comprehensive wealth plan, weighing the benefits and challenges of the different ownership structures, addressing liquidity concerns, and exploring opportunities to further maximize your returns and minimize risks, such as with private equity, will be crucial to identifying the best option for you.
Houston-based Granite Harbor Advisors offers asset management, financial planning, and high-net-worth financial services geared toward bettering your future. To understand if and how real estate fits into your overall portfolio allocations, schedule a call today to speak with one of our knowledgeable advisors. From evolving private equity opportunities to community connections throughout the greater Houston area, we are here to provide robust expertise and fiduciary-level financial advice.