NEW YORK (Money Magazine) — Given low prices, low interest rates and anticipated higher inflation, is buying rental real estate now the no-brainer it seems to be? — B.A., Mechanicsburg, PA
Things have definitely been looking up on the real estate front. Figures from S&P/Case-Shiller this week showed that home prices increased 1.2% for the 12 months through July and rebounded roughly 8% from their lows earlier this year.
Meanwhile, existing home sales in August were up 9.3% compared to a year ago and the Zillow Rent Index showed that rents have risen almost 6% nationally over the past year.
If you’re thinking about buying a single-family home, duplex or small apartment building for rental income and capital appreciation — as many people are based on the emails I’ve received — that’s like hitting a trifecta of favorable indicators.
But a no-brainer? Sorry, but I don’t think any investment is ever truly a sure thing. There’s always some sort of risk, even if it’s not readily apparent.
And if you go into an investment with the attitude that profits are virtually assured, you’ll be more prone to overlook potential downsides and get burned. After all, that sort of overconfidence is what got a lot of people in trouble the last time buying real estate seemed like a can’t-lose proposition.
Clearly, the real estate market is better positioned for potential gains than it was before the bubble burst six years ago. But just because we’ve had good news lately isn’t definitive proof that a full-fledged recovery has arrived. We’ve had false starts before.
Even when a turnaround comes — as it inevitably will — it doesn’t mean a sustained surge in prices will follow. A large number of foreclosures still have to work their way through the system. That alone could dampen appreciation potential for some time.
And while many people are under the impression that buying at post-meltdown prices virtually assures outsize gains, that’s far from a given. You’re not the first person to think about capitalizing on a housing recovery. Nor is real estate some obscure investment that exists far outside the mainstream. It’s a huge part of the economy that’s followed by thousands of individual and institutional investors. And that suggests that even if today’s prices are attractive, they’re unlikely to be so absurdly low that you can count on windfall returns.
But the biggest issue that individual investors may be overlooking is diversification, or more accurately the lack of it.
Most people have the financial wherewithal to invest in only one or two properties that are usually in the same city, often in the same neighborhood. Such concentration can be dangerous.
Even if the real estate market thrives overall, problems specific to the area where your property is located — business activity moving to other parts of the city, a shift to a more downscale demographic, whatever — could seriously limit what you can charge in rent, as well as the sales price your property will eventually fetch. In effect, you would be taking the same risk as a stock investor who puts all his money into one or two stocks in the same industry.
My take: Now could very well be a good opportunity to buy rental real estate. But unless your investment portfolio is so large that your real estate investments would represent only a small portion of the value of your total holdings — say, no more than 10% to 15% — I’d pass on buying brick-and-mortar properties. I just don’t think the extra risk you’re taking on by sacrificing diversification is worth the potential upside.
If you’re really intent on investing in rental real estate, I suggest you instead consider real estate investment trusts (REITs) or, better yet, mutual funds that invest in them, which you can find on our MONEY 70 list of recommended funds.
REITs have experienced a pretty big price run-up in recent years. But that shouldn’t scare you off, as long as you invest in a disciplined way — and don’t think of them as no-brainers. 
