Alternative Investment
An alternative investment is a financial asset that does not fall into conventional investment categories like stocks, bonds, or cash. For real estate investors, these often include assets like real estate itself, private equity, or commodities.
Key Takeaways
- Alternative investments are assets outside of traditional stocks, bonds, and cash.
- Real estate is a prominent alternative investment, offering tangible assets and potential for income.
- Key reasons to consider alternative investments include portfolio diversification, potential for higher returns, and acting as an inflation hedge.
- Common types include real estate, private equity, commodities, and hedge funds.
- They often come with lower liquidity and higher complexity compared to traditional investments.
What is an Alternative Investment?
An alternative investment is any financial asset that doesn't fit into the traditional categories of stocks, bonds, or cash. These investments are often less liquid, meaning they cannot be easily converted to cash, and can be more complex than traditional assets. For real estate investors, understanding alternative investments is crucial because real estate itself is considered a major alternative asset class, offering unique benefits and risks compared to public market securities. They are typically chosen to diversify a portfolio and potentially enhance returns.
Common Types of Alternative Investments for Real Estate Investors
While the term "alternative investment" covers a broad range, some types are particularly relevant or accessible to real estate investors.
- Real Estate: This includes direct ownership of residential or commercial properties, investing in Real Estate Investment Trusts (REITs), or participating in real estate syndications. Real estate offers tangible assets and potential for income and appreciation.
- Private Equity: Investing in private companies that are not publicly traded on stock exchanges. This can include venture capital for startups or leveraged buyouts of established businesses.
- Commodities: Raw materials like gold, silver, oil, natural gas, or agricultural products. Investors might buy physical commodities or invest in commodity-linked funds.
- Hedge Funds: These are pooled investment funds that use a variety of strategies to earn active returns for their investors. They often invest in complex assets and employ sophisticated risk management techniques.
Why Investors Use Alternative Investments
Investors, especially those in real estate, often turn to alternative investments for specific strategic reasons.
- Portfolio Diversification: Alternative investments often have a low correlation with traditional assets. This means they may perform differently than stocks and bonds, which can help reduce overall portfolio risk during market downturns.
- Potential for Higher Returns: While not guaranteed, some alternative investments can offer higher returns than traditional assets, especially for illiquidity or complexity.
- Inflation Hedge: Certain alternative assets, like real estate and commodities, tend to perform well during periods of high inflation, helping to preserve purchasing power.
Real-World Example: Investing in a Rental Property
Let's consider a beginner real estate investor purchasing a single-family rental property, which is a common alternative investment.
- Purchase Price: $300,000 for a house in a growing neighborhood.
- Down Payment: $60,000 (20% of the purchase price).
- Monthly Rent: $2,500.
- Monthly Expenses: $1,500 (includes mortgage, property taxes, insurance, and a buffer for repairs).
- Monthly Cash Flow: $2,500 (rent) - $1,500 (expenses) = $1,000. This positive cash flow demonstrates how real estate can generate income outside of traditional stock dividends or bond interest.
Frequently Asked Questions
Are alternative investments only for wealthy investors?
Historically, many alternative investments like hedge funds or private equity were only accessible to accredited investors with high net worths. However, options like direct real estate ownership, crowdfunding platforms, and certain publicly traded REITs make alternative investments more accessible to a broader range of investors today, including beginners.
What are the main risks of alternative investments?
The primary risks include lower liquidity (harder to sell quickly), higher complexity (requiring more specialized knowledge), and often less regulation compared to traditional investments. They can also be subject to higher fees and may not always provide the expected diversification benefits, especially during extreme market conditions.
How does real estate fit into alternative investments?
Real estate is considered a major alternative investment because it is a tangible asset that typically doesn't trade on public exchanges like stocks or bonds. It offers unique characteristics such as potential for rental income, property appreciation, and tax benefits like depreciation. Its value often moves independently of the stock market, making it a good tool for portfolio diversification.
Are alternative investments regulated differently?
Yes, alternative investments are often subject to different regulatory frameworks than traditional securities. Some, like private equity funds or hedge funds, may have less stringent regulatory oversight, which can contribute to their complexity and risk. However, publicly traded alternative investments, such as REITs, are regulated by bodies like the SEC, similar to other public companies.