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Real estate adds diversification, but how should you invest?

By all measures, the real estate sector, along with the rest of the economy, is roaring again. Just look at median home prices of existing homes. In July they were $244,100, a 5.3 percent rise from the same period a year before, according to the National Association of Realtors.

That, plus historically low interest rates, has made investors take notice.

"I used to have people say, 'I need a 6 percent yield on my investments to retire,'" said Michael Berry, a certified financial planner and CPA based in Seattle. "I don't know where you're going to find it these days, except in real estate."

A couple looks over their home renovation progress in Arlington, VA.
Brooks Kraft LLC | Corbis | Getty Images

Indeed, the average yield of stocks in the Standard & Poor's 500 index is 2.29 percent, and the 10-year Treasury note yields just 1.69 percent. But real estate can yield more than that, while also adding important diversification to a portfolio.

Diversification factor

Real estate has a low correlation to stocks and bonds. Because it's a lagging economic indicator — it rises and falls well after the rest of the economy — it moves differently than stocks or bonds. What's more, real estate markets are unique. The factors that can sink home prices in one market can have no bearing on another, though not always.

"Global real estate is an enormous part of the global economy, so it should have a role in an investor's portfolio," said CFP Daniel Kern, chief investment strategist with TFC Financial Management in Boston.

He recommends a 5 percent to 10 percent allocation over your overall portfolio.

Owning your own home is not real estate investing, financial advisors stress. "It's best to view [a primary residence] as an expense," said Tony D'Amico, a CFP and the CEO of Fidato Group, a registered investment advisor.

Easiest way in

For most investors, buying a real estate investment trust, which can purchased in either a mutual or exchange-traded fund, is the easiest way to go.

REITs pool investor assets to buy or finance a portfolio of properties. REITs typically specialize in certain industries, such as shopping malls, apartment buildings, hotels or hospitals.

"It's pretty wide economic exposure," said Kern of TFC Financial Management.

"In some areas, we're getting back to 2006 levels for home flipping, and that's cause for concern." -Daren Blomquist, senior vice president with ATTOM

In exchange for favorable tax treatment, REITs must pass on 90 percent of their taxable income to shareholders in the form of dividends. The average REIT now yields 3.87 percent, according to the National Association of Real Estate Investment Trusts, a trade group. In the past 12 months (through July), REITs returned 21.5 percent, well ahead of the 5.61 percent of the S&P 500 during that time period.

But REITs aren't always the stellar performers they are today. As a group, they declined by 37.73 percent in 2008, a bit worse than the S&P 500.

"In 2008 they moved very much in tandem with equities," Kern said. "Maybe it's not perfect exposure to real estate, but there's an argument to be made that you get a little diversification."

Becoming a landlord

Others aren't satisfied to let others be the landlords. They want to do it themselves.

Take Joan and Chris Davies of Seattle, clients of CPA Berry. They love to travel and own an apartment facing the yacht-studded Adriatic Sea in Dubrovnik, Croatia. The Davies, both 62, spend most of their winters in Dubrovnik. While they are away, they rent out their Seattle house. And when they're stateside, they rent out the Dubrovnik property.

"For us, asset utilization is the name of the game," said Chris Davies.

They've done so well renting the Dubrovnik home that they founded a company, AbsolutelyDubrovnik, to help other property owners in the seaside town rent out theirs, for which they collect a fee.

"If we didn't have a travel business and didn't rent out our own properties, we'd have less money to travel," Davies added.

Jose Luis Pelaez | MNPhotoStudios | Getty Images

Anyone who wants to become a landlord must understand the amount of work involved, said Jeanne Fisher, a CFP with ARGI Financial Group and the daughter of a real estate developer.

"[Real estate] provides really great monthly cash flow, but you have to work for that," Fisher said. "There are two ways to invest, you're either going to invest the money or you're going to invest the time."

Someone who's handy and doesn't mind calls from tenants at all hours can maximize the income from properties. Otherwise, it's best to work with a management company, though could eat into profits.

Fisher advises her clients to buy only in markets they know well, so they can pounce on properties that may be undervalued. For her part, Fisher likes to put down as little of her own money as possible. "Even if someone came into my office and said, 'I have all the cash in the world,' I still think it makes financial sense to use leverage," she said. "It's is an incredible tool in this low-rate environment because you're using someone else's money."

In it for the short haul

Another way to invest in real estate is by flipping homes, something that's making a comeback. In the second quarter of 2016, flipping accounted for 5.5 percent of all sales of single-family homes and condos, reaching a six-year high, according to ATTOM Data Solutions, the parent company of RealtyTrac. Individual investors are leading the charge, according to Daren Blomquist, senior vice president with ATTOM, causing some to worry that the real-estate market may be overheated.

"In some areas, we're getting back to 2006 levels for home flipping, and that's cause for concern," Blomquist said.

When done right, flipping has its appeal, said Berry, the Seattle-based CPA. "If you can go in and refurbish an existing property and sell it like a new property, then you can avoid all the cumbersome cost of taking a piece of raw land and building on it," he said.

Like renting, flipping requires capital, time and know-how, said ATTOM's Blomquist.

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To protect yourself from another housing bust, it's important to understand the market and what buyers are looking for. Demand for flipped homes tends to come from first-time buyers. But in some locations, landlords looking for rentals are driving the demand, according to Blomquist.

"They don't want to put all that work into fixing up a property," he said. "They want to buy a turnkey property and start renting it out to somebody right away."

No matter how you choose to add real estate to your portfolio, know what you're getting yourself into. Even if the sector isn't as overheated as it was in 2006 and 2007, the market is bound to take a breather. Be sure you're ready to ride out a few bad years before jumping in.

— By Ilana Polyak, special to CNBC.com