How To Invest In Real Estate
I am sure we all have that friend or uncle that got rich by investing in real estate. Naturally, this has made you curious about how you too can cash in and make some money as a real estate investor! Real estate has been an asset that has been making investors money for decades. They aren't making any more of it, as the old saying goes. This beginner's guide will help you learn how to invest in real estate.
When your dad or uncle began investing in real estate, it was a lot simpler. The modern real estate investor has an array of options in front of them. Many of these options did not exist just 10 or 20 years ago! As a result, we plan on helping you to understand what real estate investments are out there.
Let's start by covering the most common misconception out there about real estate; it is difficult to invest in real estate.
That was true... a few decades ago. When your dad or uncle purchased his first piece of real estate, he likely had to shell out thousands if not tens of thousands of dollars. As a result, this made it difficult for beginners to start investing in real estate. This was because they weren't sitting on a mountain of cash.
The stock or bond investor had a much easier go of it. They could just call up their stock broker and ask them to invest another few hundred dollars in some shares. Essentially, this is what makes stocks and bonds a low barrier investment. It is easy to go out and buy stocks and bonds.
Small real estate investors now have an array of options in front of them, giving them easy access to deals. Real estate is no longer reserved for the high net worth investors looking to pony up tens of thousands of dollars. You can become a private real estate investor for as little as $500 today. In this article we will show you how to invest in real estate and what options you have as an investor.
What Is Real Estate Investing
We are going to be sharing a number of different real estate investments with you. But first, it is important that we understand what real estate investing actually is! The formal definition, according to Wikipedia, is that real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit.
Just from this definition alone, we can see that there are a number of ways to make money investing in real estate. You are ultimately looking to make money, which is what makes this an investment.
There is always going to be demand for real estate because we will always need somewhere to live. Those who cannot afford or qualify for a mortgage end up renting from a landlord. That landlord is an example of a real estate investor.
Another common misconception; it is difficult or impossible to invest in commercial and industrial real estate. I am here to tell you that this assumption is also false! We will be discussing commercial and industrial real estate investments later on.
For now, all you need to know is that real estate investors are looking to make money. There are a number of different ways to accomplish this, and it doesn't just have to be residential real estate. The modern investor has the ability to invest in both commercial and industrial real estate too!
For most people, the only real estate they own is their own home. Most would agree that owning your primary residence is the first step to becoming a successful real estate investor. In most cases, it does not make sense to be renting a property while owning real estate and renting it out to someone else.
Types Of Real Estate
1. Residential Real Estate
This is the one that most of us are familiar with. The name comes from zoning ordinances. A zoning ordinance is a written law that defines how property in a specific area can be used. Local zoning officials agree on what properties are going to be zoned for residential, commercial and industrial real estate. Once a property is zoned for residential, you cannot build commercial or industrial real estate without an appeal to the zoning board.
Residential real estate is the property that we live on. This includes single family homes, multi family homes, condominiums, townhomes and small apartment buildings. Residential buildings with more than four units are considered to be commercial real estate. As a result, you won't see them in a residential zone unless they have permission from the zoning board. A real estate investor interested in a large apartment building would also have to apply for a commercial loan.
2. Commercial Real Estate
This is a little less familiar for most. Think... dentist office! Commercial real estate must be built in a commercial zone. With commercial real estate, you can generate profit through rental income or capital gain. Commercial real estate includes medical buildings, offices, hotels, malls, farms, garages and more! If they design the building to turn a profit, or if it is an apartment building with more than four units, it's commercial!
Commercial real estate can get expensive quick. If you wanted to go out and purchase an office complex or a warehouse, you could easily be shelling out millions of dollars! As an investor, there are ways to buy commercial real estate without that kind of capital investment. Good news, right?
3. Industrial Real Estate
Finally, we have industrial real estate. They design these buildings to turn a profit, just like commercial real estate. The difference is, nobody wants to be anywhere near these industrial buildings. Commercial real estate can often blend seamlessly with residential, as there aren't usually loud noises or odors coming from a dentist office. An industrial warehouse, on the other hand, could be a huge problem. If they are operating 24/7, nobody would want to live next to it!
The industrial zones are intentionally placed far away from residential when they are planning out the zoning of land. While these buildings have a potential to turn a profit, the barriers to investment are very high. The main reason is because it would be very expensive to go out and purchase a factory or warehouse building.
How To Make Money With Real Estate
Now that you understand the different types of real estate out there, the next logical question is how to make money with real estate! If we go back to our definition of real estate investing, we learned that real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. This definition is a little vague, so let's break down the exact ways that money is made as a real estate investor.
1. Cash Flow
This is the easiest method to understand. Earlier in this article, we talked about how some people cannot afford a mortgage. As a result, they might end up renting from a landlord. There are a few other circumstances where you might see this. If someone is only going to live in the area for a short time, they will likely want to rent instead of own. Finally, if someone has poor credit and cannot qualify for a mortgage, they will have to rent.
As the landlord, you are the real estate investor. You own, maintain and repair the property. Each month, your tenant or tenants write you a check for rent. If your rental income from your tenants exceeds your mortgage payments and other expenses, you will have positive cash flow. As a result, this is the first way to make money as a real estate investor.
2. Asset Appreciation
Real estate is an asset, and like we said earlier they are not making any more of it! Once you understand that, you can see how supply and demand begins to come into play. If you own real estate in a desirable area where people or businesses are looking to move, there is high demand for that real estate. If the area has open land, developers can build new real estate buildings to absorb that demand. Since there will still likely be higher demand than there is supply, or new buildings, the value of the real estate will go up. If more people are looking to buy the same amount of real estate, the value climbs.
This more prominent in certain areas. One example is Los Angeles. Recently, this area was ranked fifth in the country for return on investment for homeowners. This is because thousands of people are looking to move to Los Angeles on a monthly basis, and new construction cannot keep up!
In a nutshell, asset appreciation is buying something and sell it at a higher price down the road. Real estate investors in a hot market, like Los Angeles, will likely experience more of this type of appreciation. A cash flow real estate investor can take advantage of asset appreciation too, allowing you to make money in two different ways! If you owned a duplex in a hot market, you could earn cash flow from the building while the asset was appreciating due to the high demand.
The normal value for this home appreciation is 3% to 5%, according to Zillow. In hot real estate markets, like metropolitan areas, you could see double digit numbers. Invest with caution, however, as this could be a sign of a real estate bubble!
3. Loans To Developers
The third way money is made through real estate is far less common. This is an investor or group of investors loaning money to real estate developers. Remember how we talked about how one way to soak up some of that demand for real estate is to build new homes or apartments? That is exactly what a real estate developer does. If they believe they have found a hot real estate market, they will pool money from investors for a real estate development.
This is yet another way to invest in real estate! By pooling your money with other investors, you can finance real estate development projects and earn interest on the loans. In the past, it was only possible for very high net worth investors to take advantage of this opportunity. Now, investors can take advantage of the internet and take part in these private real estate deals through crowdfunded real estate platforms.
This type of real estate investment is very similar to cash flow investing. These interest payments on the loans are similar to the rent payments from your tenants. The difference is that earning money through loans or debt is passive! As a result, you have to do very little. Once you loan the developer the money, you collect your interest checks. Cash flow investing, on the other hand, is not passive. This is an active real estate investment as you will be the one making repairs and collecting rent checks.
Active Real Estate Investments
The first type of real estate investments we will be discussing are active real estate investments. Active investments require ongoing activity from the investor. An active real estate investor purchases real estate and is actively involved with some aspect of the project. Returns tend to be higher, but there can be a significant amount of work involved!
1. Short Term Rental
If you own real estate, particularly in a desirable area, your first option for renting it out is a short term rental. This could be a vacation rental through a service like Airbnb for example! When people are looking to travel for work or leisure, they often start their search on Airbnb. This can provide travelers with more authentic accommodations than a chain hotel. In fact, there are over 4 million Airbnb listings in the world averaging 500,000 bookings a night! Maybe it is time for you to get in on this trend?
Even if you are not a fan of the short term vacation rentals, you shouldn't rule out short term rentals entirely. Another type of short term real estate rental is 3 to 6 month leases. Let's say a business executive is coming into town to help with operations for a few months. He won't want to live out of a hotel, but he also does not want to furnish an apartment or sign a long term lease. A 3 to 6 month lease would be perfect in this situation! You could offer a furnished unit and charge a premium since it is a short term lease.
In most cases, you will make more money with short term rentals. Here's the thing though... you will be more actively involved. Airbnb hosts have to arrange for cleaning or clean the units themselves every time it turns over. That's a lot of mopping! This is something you will want to consider when exploring the idea of short term rentals.
2. Long Term Rental
The next option for those who own real estate is to offer a long term rental of the property they own. Many real estate investors exclusively follow this strategy. Instead of doing short term vacation rentals or short term leases, they do single or multi-year leases. They would rather have a long term tenant so they are less actively involved. If you have a good tenant in a well maintained piece of real estate that you own, it truly can feel like passive income! While you will need to go in and clean, patch and paint between tenants, it won't happen as often as the turnover of a short term rental.
The next type of active real estate investment is far more speculative than others. What we mean by speculative is that it is a high risk, high potential return investment. In a nutshell, you could make a killing or lose your shirt on the investment.
Wholesaling is appealing to new real estate investors because it does not require a lot of upfront cash. With wholesaling, you are the middleman in the real estate transaction. The investor, or wholesaler, finds a distressed home and puts it under contract with the intent of selling it to someone else.
A distressed property is one where the owners cannot maintain them. This could be failure to keep up with financial obligations or maintenance of the properties. Wholesalers are specifically looking for homes where the owners cannot keep up with the financial obligations. This often results in a property going into foreclosure due to non payment of the mortgage or taxes. You may also find a wholesaler looking for a property that has not been maintained. The idea is to sell it to a flipper, a different type of real estate investor. Real estate investors are always on the hunt for distressed properties!
Let me give you a simple explanation of what wholesaling looks like. Let's say your friend is looking to sell his boat because he can't afford to maintain it. Money is tight, so he gives you a really good deal of $10,000. You put it under contract and agree to pay that price at some point in the future. Now, you go out and try to find someone who will buy the boat from you at a higher price. You find someone who will pay you $12,500 and you pocket the difference of $2,500. It was never really your boat! You just found a better offer.
Flipping real estate is another high risk form of real estate investing. The reason behind this is because a flipper is usually looking to buy and sell a property in a short window of 6 to 12 months. If the real estate market tanked in the meantime, the flipper would be caught holding the bag! Flipping real estate is almost like a game of hot potato. You are looking to grab it and pass it to the next guy as fast as possible, without getting burned!
There are actually two different types of real estate flippers out there. The first type of flipper is looking to make money off of sweat equity. By making repairs on the property himself, he can improve the resale value of the property. You would be amazed what a fresh coat of paint and new carpets would do for the value of a home!
Let me give you an example. Let's say someone who owned an excavating company purchased a home with a bad foundation. Since the price of a foundation is around $60,000 they were able to negotiate and get that taken off the asking price. The home sells for $100,000 as a result. Since this person owns the business, they can have all the work done for a total cost of $35,000. Now, that house has a brand new foundation worth $60,000. The flipper turns around and sells the house for $160,000 pocketing the $25,000.
The other type of flipper isn't actually doing anything to the property. They are merely buying a piece of real estate in a hot market with the intention of selling it for a higher price down the road. Remember earlier how we said you can earn money as a real estate investor through asset appreciation? This type of flipper is looking to do exactly that... but in a very short window. They typically want to make a return of 10% or more in a 6 to 12 month timeframe, making this a high risk venture. The other type of flipper can establish a margin of safety, as they are building in sweat equity making the repairs on their own. Even if the housing market went down, they could probably get out around breakeven.
5. Owner Occupant
The final type of active real estate investment is being an owner occupant. As an owner occupant, you are living in the building you are renting out. This can have a number of different advantages. First of all, it can be a lot easier to secure a mortgage from a bank. Second of all, many owner occupants have found that their tenants are better behaved when the landlord lives next to them. Third and finally, you are able to keep an eye on the property and make sure nothing is in need of repair.
Nothing is more annoying than a tenant calling you about something weeks or months after the problem started. Maybe the sink was leaking, but now the kitchen cabinets need replacement due to mold! If you live right next door, your tenant might be more likely to keep you informed on these quick fixes rather than ignore them.
As an owner occupant, you could offer your other unit or units as a short term rental or a long term rental. It might be easier to do short term vacation rentals if you live right next door! All you have to do is grab your cleaning supplies and head on over. It is also a safe bet that having the owner next door will deter the desire to party your guests may have.
Passive Real Estate Investments
The second type of real estate investments we will be discussing are passive real estate investments. A passive investing strategy does not require your time or attention. In fact, the only time you should have to do anything is when you rebalance the portfolio or file your taxes! Passive investments often yield lower returns than active, but they are not a burden on your time. Here are a few options for how to invest in real estate using a passive strategy.
1. Crowdfunded Real Estate
The first passive real estate investment is one of the newest ones. Thanks to the internet, people from all over the world can pool their money together and invest in in real estate projects. Crowdfunding has really changed the way the world operates. Investors can now source funds from thousands if not millions of people all over the world. Let's take a tech start up for example. Instead of needing to raise $100,000 from 10 investors, they could instead raise $1,000 from 1,000 smaller investors! This is only now possible thanks to the internet and crowdfunding.
This type of project funding has disrupted real estate investing as well. Private real estate deals were traditionally reserved for high net worth investors. Now, small retail investors can pool their money together with others and get access to these private real estate offerings! Crowdfunded real estate sites like Fundrise allow investors to start investing with as little as $500.
Fundrise pools money from investors and separates the investments into different plans based on your investment objective. For example, you can invest in a growth oriented plan, an income oriented plan or a blended plan. Fundrise takes this money and invests it in a variety of different real estate projects. This could be new construction or renovation of existing real estate.
It is important to note that Fundrise is not the only crowdfunded real estate option out there! There are a number of different options available to investors, Fundrise is just the most well known. This new form of real estate investing has been extremely disruptive and has spread like wildfire. Below, you will see a number of projects that Fundrise investors are currently backing.
The next type of passive real estate investment is the REIT or Real Estate Investment Trust. Real estate has traditionally been a high barrier investment due to the amount of money required to start investing. In the past, investors had been able to overcome these barriers by investing in REITs offered on public exchanges like the NYSE or NASDAQ.
These investment vehicles are large pools of real estate split up into millions of shares and sold to hundreds or thousands of investors. These products allow common everyday investors to gain access to real estate markets. While they allowed the average retail investor to gain exposure to the real estate market, they were not the perfect solution for a few reasons.
First of all, one of the main reasons why investors buy real estate is to diversify assets. They don't want all of their money in stocks or bonds or precious metals. They want to spread money across different assets. Since a REIT trades on a stock exchange like a stock, the two assets are heavily correlated with each other. That means if one goes up, the other one likely does too. If one goes down, so does the other. This defeats the purpose of investing in different assets.
The second issue with REITs is that not all of them are created equally. Some REITs, like the Vanguard REIT, are low in fees and overall a good investment. Other REITs can be loaded with fees! For example, a lot of REITs have front load fees. These are fees you pay before you even begin investing! The REIT makes sense for some investors, but it is not a one size fits all. Thankfully, there are other real estate investments out there!
3. Fully Managed Portfolio
Another option for passive real estate investment is to hire a property manager. If you like the returns of active real estate investment, but you don't like the work involved, a property manager might be the perfect solution. A property manager takes care of a lot of the headaches involved with renting. For example, they often collect the rent checks and lease out the units. On top of that, they are typically the primary point of contact. If an issue arises, they call the property manager and not the landlord!
Here is the problem though... it is not cost effective to hire a property manager if you only own one or a handful of units. It only becomes cost effective when you own multiple buildings or units, say 10 or more. As a result, those who want to start owning and renting real estate will have to manage their units until a property manager is cost effective. Otherwise, they will be losing money! That is not a good investment.
4. Private Funds
The final form of passive real estate investment is private real estate funds. High net worth investors pool their money together for some type of real estate investment. This type of deal is typically reserved for accredited investors. This is a person or entity who is allowed to invest in deals that are not registered with financial authorities.
In the United States, to be an accredited investor you must have a net worth of over $1,000,000 excluding the value of your primary residence. The other way to qualify as an accredited investor is to have income of at least $200,000 per year for the last two years or $300,000 combined income if married.
The reason why this requirement is in place is because regulators consider these investments to be higher risk. This is because they are not registered with financial authorities. These authorities expect accredited investors to do their own research and due diligence on investments. The income and net worth requirements are in place to protect small investors who do not have the capability to offset a large financial loss. These income and net worth limitations make private funds out of reach for the average retail investor.
Why Should You Invest In Real Estate
Real estate has a number of advantages over other types of investments out there. Beyond the reasons we will discuss, another common statement is that you can't live in a stock or a bond! This is entirely true. At the end of the day, a real estate investment can provide you with much needed shelter if you need it. This is not something a traditional investment like a stock, REIT or a bond can offer you
The first reason why people invest in real estate, as mentioned earlier, is diversification. A well balanced investment portfolio contains a collection of different assets. Each one is going to perform differently as a result. Most investors own a portfolio of stocks and bonds, but some branch out into other assets like real estate! By adding a completely separate asset to your portfolio, you lower your exposure to each one and diversify!
Don't put all your eggs in one basket! I am sure you have heard that saying... Let's say for example an investor has some of his money in stocks and bonds and some money in real estate. First of all, stocks and bonds do not always behave the same way. There are times when bonds are offering better returns and stocks are offering better returns. By owning both, you get exposure to the upside of both! Adding real estate to the mix allows you to have a more diverse blend of assets. Maybe the stock market has tanked and bond yields are lousy, but your tenant is still paying rent!
As you can see, the ultimate goal here is to have your money in different places that are doing different things. Stock, bonds and real estate do not directly correlate. The only correlation typically seen is a correlation between the stock market and REITs. That is simply because a REIT is basically a real estate stock. It sells on the same exchange as stocks, making it just as vulnerable to panic selling. You can control what you do, but you can't control the actions of people around you. If they begin a selling frenzy, the price is bound to plummet.
2. Tax Advantages
This has been a debate for a long time; why do real estate investors get so many tax breaks and advantages? The truth is, real estate investors have a significant advantage over other types of investors out there. The reason behind it is understandable too. Since real estate investors are helping to provide housing and prevent housing shortages through development, they are benefitting local economies. That decrepit old house on the street might not get fixed up if these tax incentives are not in place. In general, it is in everyone's best interest to incentivize real estate investors.
Will the tax laws change in the future? Probably. All we know for sure is that real estate investors have a lot of tax deductions available to them. If you have ever invested in stocks, bonds or other traditional investments, you have likely found that there are very few tax deductions. You will find that is not the case with a real estate investment. If you are searching for tax benefits, real estate could be the answer for you.
A third reason to invest in real estate is because it allows you to use leverage. For those who are not familiar, in business terms leverage is using debt as part or all of the deal instead of equity. Investing with 100% debt is high risk, but having enough equity in the deal can improve your margin of safety. For most other investments out there, leverage is extremely dangerous. Borrowing money to buy stocks, also known as buying on margin, was a major contributor to the stock market crash of 1929.
Real estate, on the other hand, allows you to use what most would agree is a healthy amount of leverage. As long as you have enough equity in the deal, say 20% or more, that should keep you out of trouble. The interesting thing about real estate is that this leverage allows you to be in control of the asset for as little as 3.5% down. While most would not recommend having this little equity in a property, it is possible.
Let me walk you through an example of why this is so important. You are going to want to pay attention, because this could potentially make you a lot of money. Let's say you purchased a piece of real estate that was $250,000 with 20% down. Your investment, or equity, is $50,000. All of the sudden, the planning board announces they are building a gigantic park on your block and the local school district was ranked #3 in the state. Since those are two important things potential homebuyers are looking for, this increases the value of your property. All of the sudden, your house is worth $275,000.
You probably think you got a 10% return on your investment, right? Your house is worth $25,000 more, so your return is 10%... wrong! Here's the thing, your investment in this property was $50,000. Since the house is now worth 10% more, you just earned a return of 50%. You are controlling the asset and capturing 100% of the appreciation. You could theoretically sell this house tomorrow for $300,000 and pull $75,000 out of the deal. That is how leverage can work to your advantage with real estate.
I hope this beginner's guide has helped you learn the basics of how to invest in real estate. If you are a traditional investor who sticks to stocks and bonds, you are now aware of some of the potential benefits of owning real estate.
The good news is that there has never been an easier time to invest in real estate. In the past, real estate was a high barrier investment because it required thousands or tens of thousands of dollars upfront. Now, there are options such as crowdfunded real estate platforms that allows you invest in private deals for as little as $500.
At the end of the day, we will always need somewhere to live and they aren't making any more land. As populations grow around the world, the demand for real estate will increase. Knowing how to invest in real estate can be a very valuable skill. Real estate has been making money for investors for hundreds of years, and odds are it will continue to do so in the future.