People grow up being told that if they get a solid education, work hard, and save their money they will become wealthy over time. However, saving alone does not create wealth as investments are needed, and one option is to invest in real estate.
There are several real estate investing strategies. There are opportunities to actively invest, just as there are opportunities to passively invest, which allows you to take a hands-off approach while reaping the benefits of owning income property.
What is real estate investing?
Real estate investing is simply investing in, or buying, real estate that is used for wealth generation purposes. Investing in real estate is one of the oldest forms of investing and has been around for quite some time. Real estate is considered one of the five basic asset classes, and it is generally advised that anyone looking to create a balanced portfolio, invest in some form of real estate.
Investing in real estate has many unique benefits. These benefits include ongoing cash flow, appreciation potential, and significant tax advantages. In fact, real estate is considered one of the most tax-advantaged investment vehicles thanks to tax deductions like depreciation.
Different ways to invest in real estate
It is falsely assumed that in order to invest in real estate investors must purchase a property outright, and as most banks require a 20% to 30% down payment when buying, most people feel that investing in real estate is just out of reach.
It is also assumed that investing in real estate forces people into becoming a landlord, a job that many do not have any interest in taking on.
There are several ways to invest in real estate – actively and passively. Here are four of the most prominent ways to invest: real estate investment trusts (REITs), buying properties directly, flipping homes for profit, and investing in real estate development.
REITs
One way to passively invest in real estate is through a real estate investment trust (REIT), which is similar to a mutual fund. Essentially, you are buying stock in a real estate portfolio that is actively managed by a team of professionals. REITs are required to return 90% of profits to their investors by federal regulations. The benefit of buying shares in a REIT is that you can buy and sell these shares at any time, making them a great investment for those looking to preserve liquidity – but they typically offer lower returns than direct investing and come with no tax benefits.
Buying properties
On a smaller scale, a two- to four-unit multifamily property could be purchased. Some investors start out by owner-occupying a small multifamily home, which provides the benefit of highly attractive financing while taking baby steps to becoming a landlord.
Investing in rental property is not limited to residential property. Investors often buy retail, office, industrial, warehouse and other types of asset classes that they rent out for profit.
Buying rental property can be done either actively or passively. Owning and managing rental properties can be time intensive (active), but many investors outsource the day-to-day responsibilities to a third-party property manager (passive), to be freed from obligations such as showing properties, running credit checks on prospective tenants, collecting rent checks, and overseeing repairs and maintenance, just to name a few.
Flipping homes
This is by far the most active form of real estate investing. Some would even argue that flipping homes a business or career rather than an investment strategy. Flipping homes entails purchasing property in need of renovation, then investing in those renovations before selling the property for profit. Most house flips are completed within six to twelve months after purchase, making the workload intensive in the interim. Some investors choose to flip homes personally, while others fund the acquisition and renovations but hire a general contractor to perform the work.
Invest in real estate development
A fourth way to invest in real estate is through real estate development. Real estate development can take many forms, including ground-up development and value-add investing. Ground up development is when an investor buys a vacant lot and builds a new property from the ground up. Value-add investing is when a mediocre property is purchased and then substantial improvements are made to result in better occupancy and/or higher rental rates.
The very first step to becoming a real estate investor is to identify your source of funding.
Many will use their savings to invest in real estate. Once they have invested in property, they can then leverage the equity in that real estate to purchase an additional property –growing their real estate portfolios over time.
Another source of funding is from retirement accounts. This can usually be done with both a 401k, traditional IRA and Roth IRA. However, there are specific guidelines to follow when investing in real estate with your retirement account, so it is important to consult your accountant or retirement advisor.
Few investors purchase property outright. Most will put 20-30% of their own capital into a deal that is then leveraged by debt financing.
Debt financing
Nearly all real estate purchases utilize debt financing. The most traditional form of it is a bank loan. Loans can also be made by insurance companies, pension funds, and private lenders. Individuals can also invest in debt. With real estate debt investments, investors act as lenders to property owners, developers, or real estate companies sponsoring deals. Regardless of the source of debt, the loan issued is secured by the property, and the investor (the bank or otherwise), earns a fixed return based on the loan’s interest and repayment schedule.
After deciding on your source of funding, you should decide if you want to be an active or passive investor.
Active investing
Active real estate investing is when a person is directly involved in the investment process. This involves your time and capital. With active investing, you are fully engaged in the process, either entirely from beginning to end, or heavily during substantial parts of it.
There are many forms of active real estate investing, such as wholesaling, property flips, and real estate development. Active real estate investing is incredibly time intensive. Those who do not have much free time may want to consider passive real estate investing as an alternative.
Passive real estate investing
Passive real estate investing, as its name would imply, is a way of generating passive income through real estate. Income is typically generated more slowly, but the income that is generated is consistent and has multiple tax advantages.
There are a few ways to passively invest in real estate. After you invest in a REIT, real estate fund or syndicated deal, there is not much more you need to do but sit back and collect income accordingly.
In a real estate syndication, you invest in a real estate deal alongside a number of others. Each project may have a different minimum requirement; say $10,000 or $25,000 per person. The investors share in the project’s risk (to the extent of their investment) and upside reward, with each being paid out a share of the profits accordingly. Usually the project sponsor will take a small administrative fee, but the sponsor generally falls at the bottom of the equity waterfall – meaning that they are paid last, only after investors have been repaid their equity stake and agreed upon returns above that amount.
One of the benefits of real estate syndication is that you, as an individual investor, are considered a “limited partner,” or LP. The only responsibility of an LP is to provide the capital. Meanwhile, the “general partner,” or GP, takes responsibility for finding and managing deals, and for taking on, and when required, guaranteeing the debt. Typically, the GP brings their real estate expertise in exchange for a share of the profits and is paid out only after the LPs have received their initial capital contribution. This GP/LP structure incentivizes the GP to manage the project diligently; otherwise, they will never make money on the deal since the LP’s must be repaid first. This structure ensures that the GP/LP interests are always aligned.
Identify your target market
Once you have identified your source of capital to invest and narrowed down your preferred approach to real estate investing, you must then identify your target market.
Each state has its own economic forces which in fact creates different markets. There are several reasons to select the geographic location of the property to invest based on opportunity, availability, and active/passive roles. Investing in primary markets, larger cities such as New York, San Francisco, Boston and Los Angeles, is considered a safer investment approach. Real estate in these markets tends to hold its value, even over multiple real estate cycles. However, real estate in primary markets tends to be more expensive and as a result, will often have lower returns (low risk = low returns) than higher risk, secondary, and tertiary markets.
Understand the risks of real estate investing
Although investing in real estate has many benefits, it is certainly not free from risk. There are certain risks associated with investing in real estate such as:
General market risk. If the economy softens, the property could loss value. Investors with highly-leveraged properties could quickly become underwater on their mortgages, and in a worst-case scenario, may default on their loans.
Asset-level risk. There are some risks associated with specific asset classes. For example, some shopping centers might now struggle with high vacancy rates as more consumers move to online shopping. Hotels are also prone to risk, given fluctuations in consumer spending and travel. Industrial and multifamily properties tend to be the least susceptible to risk.
Property-specific risk. Real estate investors always run the risk that something will not turn out as planned. Vacancy may be unusually high, a tenant may stop paying rent, or some unexpected repairs are needed. Those who own rental property for long enough are bound to encounter property-specific challenges from time to time.
Liquidity risk. Real estate, unlike other investment vehicles like stocks and bonds, is inherently illiquid. It is harder to sell real estate. There is a ramp up time needed to sell rental property, compared to securities which can be sold with the click of a button.
Find a property with an upside potential
The underlying zoning. Knowing how a parcel is zoned by the local building authorities is important for redevelopment purposes.
Vacancy rates. A property that has high vacancy could have significant upside potential. It might just need a few adjustments as better management or new leasing agents to get the property fully occupied, generating more cash flow for the investors.
Rental rates. If rents appear low relative to the local market, an investor might be able to increase rents through the implementation of property improvements or bringing in new tenants.
Amenities. Many investors find that integrating new or better amenities to a property such as in-unit laundry, an on-site fitness center, or technology features like Nest or keyless entry systems can result in better revenues. Modest improvements can often turn a lackluster property into one with significant upside potential.
In summary
Given the number of different options and opportunities to invest in real estate, it may feel a bit overwhelming for a first-time investor who is looking to buy their first property. Real estate investing doesn’t need to be complicated, though. There are many ways to invest passively, alongside others – including those who earn their living by investing, owning and operating commercial real estate on behalf of other equity investors.
Real estate investing is about building your wealth and producing a passive cash flow by making your money work hard for you, instead of you working hard for your money. It is a way to generate income for your well-deserved retirement while still being able to tuck some away for a rainy day, or for loved ones down the road.
