How Much of Your Portfolio Should Be in Real Estate?

Looking for a good return on your investment? That 12 percent jump in home prices from April 2012 to April 2013 makes real estate sound pretty good.

If you own a home that has appreciated in recent months, perhaps you're thinking it's time to buy an investment property. If you prefer a more hands-off approach, you may be considering putting your money in a real estate investment trust, or REIT.

Financial and real estate experts have varied views about the best way to invest in real estate, but all agree that it's important to have a diversified portfolio. Here's their advice about how much property should be in your portfolio.

Why Real Estate?

In spite of the recent housing crisis, real estate historically has been a safe, sound, solid investment, says Theresa Bradley-Banta, founder and CEO of Theresa Bradley-Banta Real Estate Consultancy in Denver and author of "Invest in Apartment Buildings: Profit Without the Pitfalls."

"Real estate tends to go up in value, can provide cash flow from rental income, and offers tax benefits and incentives," she says. "Also, over time, equity value increases as the loan is paid down and appreciation can be forced by making improvements to the property."

Another way to look at real estate is through the lens of how the sector compares to other investments in your overall portfolio. Frank Armstrong, president and CEO of Investor Solutions in Miami, agrees that real estate should be part of your investment portfolio. "Real estate is a great asset class with little correlation to the stock market, which means that it can over time reduce portfolio risk and increase returns in a properly structured portfolio."

That said, like any asset class, real estate isn't immune to the market's roller coaster, as we all learned just a few short years ago.

"Real estate is a cyclical, interest-rate-sensitive investment," says Keith Newcomb, a certified financial planner and portfolio manager with Full Life Financial in Nashville, Tenn. "For all the good times, there will also be bad times. Fortunately, there are usually signs along the way."

Direct or Indirect Investment

Your first decision as a novice real estate investor should be to choose whether you want to be a passive or active investor -- whether you want to own actual property or pool your money with other investors into more hands-off investments.

A benefit -- and a risk -- of direct ownership in a property is that you have a say in the management, maintenance, and sale, says Bradley-Banta: "With direct ownership, an investor has a much greater opportunity to build wealth." The more active leadership role investors take, the better their potential returns -- provided the investors are well-educated about real estate investing.

While some direct investors hold on to their properties for long-term growth and income, others opt to flip properties when market conditions are right.

Newcomb says real estate does best when you're able to purchase it at distressed prices from a forced seller, although financing can be harder to obtain in a declining market. Buying without financing in a down market -- if you can swing it -- can be the most profitable real estate investing scenario. On the other hand, when the real estate market is doing well and interest rates start to rise, Newcomb says, "the party has already peaked and may be nearing its end. At these times, it is best to keep the cash raised from reducing real estate holdings on hand and wait for the upcoming buying opportunity to unfold."

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It's important to remember that direct real estate ownership is much more burdensome than buying professionally managed REIT common or preferred stocks, ETFs, or mutual funds, Newcomb says. As a landlord, you're responsible for maintenance and repairs, and your income stream is dependent on keeping your properties occupied with tenants who pay their rent on time.

And there are sure to be times when that's not how it goes: Landlords need to be financial prepared for those periods when the residence is unoccupied. A good rule of thumb for property investors, Newcomb says, is never to own more direct real estate than you could afford to hold with zero real estate income for an extended period of time.

The case for passive investments

Armstrong is less bullish on becoming a landlord; he recommends passive real estate investing.

"By now, we should have learned that speculating in houses carries a load of undiversifiable and unrewarded risk," says Armstrong. "When the housing market crashed, it took far too many individual investors with it. Additionally, it's a huge time sink to manage individual properties. Even if you don't lose your shirt, it may not be worth the effort and aggravation to be a landlord."

Armstrong suggests that a maximum of 20 percent of your risk assets be divided between domestic and foreign REITS, preferably index funds and ETFs.

REITs can own a wide variety of properties such as apartments, offices, hospitals, storage facilities, and retail sites -- areas where an individual may not otherwise be able to invest.

Another benefit of REITs is that, as an investment, they're more liquid than physical real estate. Selling a property isn't as easy as selling shares of a REIT. Therefore direct ownership should be viewed as a more long-term investment.

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Michele Lerner is a contributing writer to The Motley Fool.