When someone talks about investing, most people instantly think of stocks and bonds. They are after all considered to be the most standard assets. Real estate however, is considered as an alternative asset. This is mainly because real estate is very hard to access and afford, until the last 20 or so years.
That being said, just because real estate investing seems like dark waters to most people, doesn’t mean it’s not an opportunity worth trying. When real estate is approached carefully and during the right time, it can create incredible returns for investors. Additionally, real estate can also be relied upon as a consistent income stream.
Like with most investments, it’s not all sunshine and rainbows with real estate. In this guide, we will try to give you a simple and quick understanding of real estate investing. We will also try and provide you with the tools to get started right away.
So before we go over the basics of real estate investing and how it works, let’s quickly familiarize ourselves with a few tricky meanings:
Residential real estate: It consists of single and multi-family homes, townhouses and condominiums which people use only as a living space. Homes which are larger than four units are considered commercial property.
Commercial real estate: This is the type of property used for business only. Offices, restaurants (retail), farmland (land) and as stated above large multi-family homes, can be used for business.
Industrial real estate: Nothing surprising here as these properties are used only for industrial businesses. Perfect examples would be factories, warehouses and power plants.
Appreciation: Like every equity, the ownership of real estate, gives the investor the ability to earn money from its sale. The appreciation, or property value increase over time, stands for the potential profit of an investor when the property is inevitably sold. The sale will provide one large, single return.
What is real estate investing and how does it work?
Houses, apartments, industrial buildings, offices and hotels make up the real estate industry. This might come as a shock, but this industry is worth more than $35 trillion. So how does one invest and more importantly profit in the real estate industry?
Let’s imagine we buy a house for the not so small amount of $500 000. Our goal would be to rent this house to tenants and secure ourselves a passive income stream. Usually a $500 000 property would require a 20% payment which makes $100 000. That leaves us with an 80% mortgage, which amounts to $400 000. In total, that leaves us with $100 000 of equity and $400 000 of debt.
Now that we own our every own rental property, we will have to find our tenants. A nearby house rents for $2500/month so we’ll match that. $2500 for 12 months, equals $30 000 in gross rental income. After we have a passive income we can look at our total returns:
Our Gross Rental Income
- – Expenses
- -Mortgage Interest
- + Change of property value over time
Let’s say for good measure we have to pay the property tax, the insurance and minor operating and maintenance costs. That’s roughly $5000/year. The biggest cash hole would be the mortgage interest. If our $400 000 mortgage has an 4.5% interest rate, that makes $18 000/year. That would take our total returns to $7000.
If we look at the $7000 return, it might not seem like all that much. However, $7000 divided by our initial $100 000 investment, equals to 7$ annual return in cash flow. There’s more than just the cash flow however. A land owner typically benefits from potential appreciation in both the rent and property values. The industry’s unwritten rule is that there is 3% appreciation per year. If we assume that’s true, we’re making 7% in rent and 3% in appreciation. That leaves us with a 10% annual return in the long run.
If this still doesn’t look like much, let’s compare our 10% annual return with the stock market. The historical stock market returns are usually between 6 and 8% a year. The truth is that real estate has outperformed stocks in the last 30 to 40 years. Not every person however, has the time or money to become a landlord.
So now that we have a general idea of how we can earn money from real estate, let’s go in-depth into the ways to invest:
There are a large number of ways to invest in real estate with different amounts of money, time commitment and investment horizon. That’s largely breaking up real estate investing into two major categories: Active and Passive investments. We’ll go over a few ways to invest ranging from full-time, all in efforts to low hands-off effort.
Active Investing
This is where investing requires a lot of knowledge around real estate and hands-on management of delegation and responsibilities. Active investors can choose to work either full or part-time in accordance with their own time availability and the number of their investment priorities. Active investors usually choose to investment in a property with no more than two owners. This means they share a lot of the responsibility in ensuring the property’s success. That’s why active investors usually require real estate and financial acumen and negotiation skills to improve their cap rate and return of investment.
House-Flipping
House-flipping is the most active and quick form real estate investing there is. Basically, house-flipping is when an investor purchases a property, usually a small or medium sized home and renovates it to sell for a higher price. This is a very short-term for of investing, because if the home remains vacated, the investor is not making money and the expenses usually begin to build up. House-flipping can also be done without any renovations as the investor can simply buy a property and sell it when the market offers a higher price.
House-flipping professionals even have their own shows. You can check out you tube clips from professional house-flippers as they manage to transform a home from a teenager man-cave to a perfect home for a new family in less than 30 minutes. These professionals buy a property which they think is underpriced and renovate sufficiently enough to have a profit after the immediate sale.
This seems like a very exciting way to invest in real estate as investors quickly change projects. However, house-flipping requires deep financial and real estate knowledge. Investors need to be able to make the home within the time limit and with a fixed budget in order to make maximum profits. The success and the financial burden also falls entirely on the investor.
There is another form of house-flipping called wholesaling. Wholesaling has the investor sign a contract to buy a property which he believes is undervalued. The investor quickly gets in touch with other investors and sells the contract for a higher price. In this practice, investors usually seek out properties who are in a desperate need of renovations. After signing the contract, the investor puts down an earnest-money deposit and quickly tries to sell it to a house-flipper at a premium for a small profit. Basically, a wholesaler takes a “finder’s fee” from a house-flipper.
Wholesaling is quite risky and requires a lot of real estate and financial expertise. The wholesaler must also be well-connected to a network of house-flippers to use the short time window for maximum profit. Much like the house-flipper, if the wholesaler doesn’t work quick enough, he risks making no profit or even losing money.
Rental Properties
Rental properties require hands-on management, but they do possess a long-term investment horizon. Residential, commercial and even industrial properties can all be given out for rent. This secures the owners a monthly steady and reliable income. However, it takes a lot of work or delegation of responsibilities to ensure that everything goes well.
Tenants are required for investors to gain income and depending on the property type, they can be hard to find. Additionally, a landlord is required to perform background screenings for tenants if he is to provide a legally sound lease agreement with them. Every month without a tenant, is a month without income from the investment.
When tenants are present, the landlord has a litany of resultant duties. He is responsible for rent collection, maintenance, repairs, evictions, record-keeping and ensuring the appropriate legal compliance on all matters. If the land lord has more than a few properties, the effort required might turn from a part-time job, to a full-time one.
Of course most investors do not want to deal with property management. That’s why they secure the services of a property management company for a fixed percentage fee. If the investor can afford it, this takes a huge weight off his shoulders and transforms the real estate into a more passive investment. The tradeoff is losing some control of the properties and a portion of the monthly income.
Airbnb
Airbnb is a tech company which allows residents to rent their homes on a nightly basis. This became very popular after hotel prices went up and service levels did not. Airbnb rentals are very similar to rental properties, but they are generally confined to residential properties and are only available for short-time periods. Airbnb also lets residents rent out parts of their home or the entirety of it. This form of investing can result in an irregular cash flow for owners. Airbnb is by no way responsible for the state of the property and owners are entirely responsible for maintenance for the renters.
That being said, Airbnb rentals require far less expertise and supervision than traditional rentals. The company facilitates the booking of the property and creates the contract agreement between the property owner and the renter. Airbnb managed a huge portion of the whole process and that makes Airbnb rental properties a part-time job or even a side hustle.
This form of renting can be a great solution to the spare room in your house, but before listing, make sure that your area allows short-term rentals. In America, Homeowner associations possess the power to ban short-term rentals and some cities like New York, have an effective ban against short-term rentals.
Passive Investing
This form of investing allows opportunities for everyone: those with deep knowledge and those with almost no experience. In most cases, passive investors provide a substantial sum of money to qualified professionals in order to take care of their investments. This form is investing is very popular with stocks and bonds, since the passive investors are only responsible for their own investments.
Private Equity Funds
This is an investment model which has investors pool their money into one single fund in order to invest. The partnerships are usually limited liability with a designated manager. The manager actively manages the equity fund’s investments and investors are not required to be active on a regular basis. This form of investing however, requires the investor to fully understand the risks and potential returns of each investment, mainly because minimum investments are generally quite high.
Not many investors however have access to private equity funds. Access is usually granted only to accredited and institutional investors with a very high net worth. An investment minimum below $100 000 can rarely be seen. Private equity funds also operate on the “2 and 20” model. This means they charge a 2% annual management fee and an additional 20% fee on any profits the fund earns. The funds are also illiquid, which means that investors need to be able to let go of large amounts of money for a long period of time.
Opportunity Funds
This investment model is used mainly in the United States. A large group of investors pool their resources together into a single fund in order to invest in Qualified Opportunity Zones. Opportunity Zones are census tracts of low-income communities, nominated by state governors and certified by the US Department of Treasury. Both Opportunity Zones and Opportunity Funds are part of the Opportunity Zone program. It was created in order to encourage investors to help with the development of economically distressed neighborhoods across the United States.
In accordance with the law, the Opportunity Funds must invest at least 90% of their assets into property or businesses only within Opportunity Zones. In the case of real estate, the program was designed to promote the neighborhood development so only a few types of real estate are allowed. Typically, only new buildings are built and old, unused ones are redeveloped.
Opportunity Funds also receive enormous capital gains tax incentives for their investments. An Opportunity Fund allows investors to defer taxes on realized capital gains invested into an Opportunity Fund until Dec. 31st, 2016. If the investment is held for five years before the said date, investors can expect a 10% reduction in tax liability on their deferred capital gains. 7 years equals to a 15% reduction and 10 years have any gains earned from the investments be permanently excluded from capital gains taxes.
So in general, these investments are long-term and in order to gain the full tax advantages of the Opportunity Fund, investors must invest before Dec 31st, 2019 and hold their investment for at least 10 more years. This form of investing is perfect for hands-off investors who seek to maximize capital gain tax savings. Unfortunately, not many investors can afford to tie up their money for such long periods of time.
Real Estate Investment Trusts or REITs
A REIT is a company which makes debt or equity investments in commercial real estate. In most cases, REITs offer a portfolio of real estate to different investors. The investors later purchase shares of the company and earn income from the debt and equity investments in the form of dividends. Much like mutual funds, REITs were originally created in order for ordinary investors to gain public access to real estate investments. REITs are required by law to earn at least 75% of their gross income from real estate and additionally distribute at least 90% of its taxable income between its shareholders each year.
Nowadays, REITs are private, publicly-traded and public non-traded.
Private REITs are not registered with the SEC and are not publicly traded on the stock market. They are very similar to equity funds by being usually limited to high net worth investors with very high minimums. The fees are also usually quite high, mostly around 15%. Another issue for most investors is that private REITs are illiquid.
Publicly-traded REITs are both registered with the SEC and are traded on the public stock market. They are highly liquid and there is no investment minum other than the share price. This allows investors to buy and sell them with ease. Since public REITs offer the greatest access, they also tied to the public markets and therefore are subjects to the most volatility.
The public non-traded REITs are a hybrid between the two above. They are registered with the SEC, but are not traded on the stock market. Their investment minimums vary and they can be both open and restricted. In most cases, they are illiquid and have high investment fees, but there are exceptions.
Online Real Estate Investment Platforms
These platforms pool together investments and invest in opportunities which would otherwise be difficult to find or reach as a solo investor. They offer investors the ability to invest in either single investments or diversified portfolio of real estate. While some limit themselves to offering only debt investments, others offer both equity and debt investments. Depending on the platform, the focus can be centered in only a single city or in an entire country. Most of these platforms also carry restrictions like accreditation requirements and very high minimum investments.
Finishing thoughts
The last 40 years have shown that real estate has a very respectable track record. With real estate investing, you can earn significant profits and diversify your portfolio. With experience and proper management, real estate investments can offer a reliable cash flow. As with most investments, real estate requires knowledge about both the risks and rewards. Different forms of investing, require different amounts of time, capital, knowledge and patience.
There is something for every investor in real estate, as long as you are willing to learn, grow and adapt to the many potential opportunities this market has to offer.
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