Investing in real estate is one of the oldest forms of investing, having been around since the early days of human civilization. Predating modern stock markets, real estate is one of the five basic asset classes that every investor should seriously consider adding to his or her portfolio for the unique cash flow, liquidity, profitability, tax, and diversification benefits it offers. In this introductory guide, we'll walk you through the basics of real estate investing, and discuss the different ways you might acquire or take ownership in real estate investments.
First, let's start with the basics: What is real estate investing?
What Is Real Estate Investing?
Real estate investing is a broad category of operating, investing, and financial activities centered around making money from tangible property or cash flows somehow tied to a tangible property.
There are four main ways to make money in real estate:
- Real Estate Appreciation: This is when the property increases in value. This may be due to a change in the real estate market that increases demand for property in your area. It could use be due to upgrades you put into your real estate investment to make it more attractive to potential buyers or renters. Real estate appreciation is a tricky game, though.
- Cash Flow Income (Rent): This type of real estate investment focuses on buying a real estate property, such as an apartment building, and operating it so you collect a stream of cash from rent. Cash flow income can be generated from apartment buildings, office buildings, rental houses, and more.
- Real Estate Related Income: This is income generated by brokers and other industry specialists who make money through commissions from buying and selling property. It also includes real estate management companies who get to keep a percentage of rents in exchange for running the day-to-day operations of a property.
- Ancillary Real Estate Investment Income: For some real estate investments, this can be a huge source of profit. Ancillary real estate investment income includes things like vending machines in office buildings or laundry facilities in low-rent apartments. In effect, they serve as mini-businesses within a bigger real estate investment, letting you make money from a semi-captive collection of customers.
The purest, simplest form of real estate investing is all about cash flow from rents rather than appreciation. Real estate investing occurs when the investor, also known as the landlord, acquires a piece of tangible property, whether that's raw farmland, land with a house on it, land with an office building on it, land with an industrial warehouse on it, or an apartment.
He or she then finds someone who wants to use this property, known as a tenant, and they enter into an agreement. The tenant is granted access to the real estate, to use it under certain terms, for a specific length of time, and with certain restrictions -- some of which are laid out in Federal, state, and local law, and others of which are agreed upon in the lease contract or rental agreement. In exchange, the tenant pays for the ability to use the real estate. The payment he or she sends to the landlord is known as "rent".
For many investors, rental income from real estate investments has a huge psychological advantage over dividends and interest from investing in stocks and bonds. They can drive by the property, see it, and touch it with their hands. They can paint it their favorite color or hire an architect and construction company to modify it. They can use their negotiation skills to determine the rental rate, allowing a good operator to generate higher capitalization rates, or "cap rates."
From time to time, real estate investors become as misguided as stock investors during stock market bubbles, insisting that capitalization rates don't matter. Don't fall for it. If you are able to price your rental rates appropriately, you should enjoy a satisfactory rate of return on your capital after accounting for the cost of the property, including reasonable depreciation reserves, property and income taxes, maintenance, insurance, and other related expenditures. Additionally, you should measure the amount of time required to deal with the investment, as your time is the most valuable asset you have -- it's the reason passive income is so cherished by investors. (Once your holdings are large enough, you can establish or hire a real estate property management company to handle the day-to-day operations of your real estate portfolio in exchange for a percentage of the rental revenue, transforming real estate investments that had been actively managed into passive investments.)
What Are Some of the Most Popular Ways for a Person to Begin Investing in Real Estate?
There is a myriad of different types of real estate investments a person might consider for his or her portfolio.
It's easier to think in terms of the major categories into which real estate investments fall based on the unique benefits and drawbacks, economic characteristics and rent cycles, customary lease terms, and brokerage practices of the property type. Real estate properties are ordinarily categorized into one of the following groups:
- Residential real estate investing - These are properties that involve investing in real estate tied to houses or apartments in which individuals or families live. Sometimes, real estate investments of this type have a service business component, such as assisted living facilities for seniors or full-service buildings for tenants who want a luxury experience. Leases usually run for 12 months, give or take six months on either side, leading to a much more rapid adjustment to market conditions than certain other types of real estate investments.
- Commercial real estate investing - Commercial real estate investments largely consist of office buildings. These leases can be locked in for many years, resulting in a double-edged sword. When a commercial real estate investment is fully leased with long-term tenants who agreed to richly priced lease rates, the cash flow continues even if the lease rates on comparable properties fall (provided the tenant doesn't go bankrupt). On the other hand, the opposite is true - you could find yourself earning significantly below-market lease rates on an office building because you signed long-term leases before lease rates increased.
- Industrial real estate investing - Properties that fall under the industrial real estate umbrella can include warehouses and distribution centers, storage units, manufacturing facilities, and assembly plants.
- Retail real estate investing - Some investors want to own properties such as shopping centers, strip malls, or traditional malls. Tenants can include retail shops, hair salons, restaurants, and similar enterprises. In some cases, rental rates include a percentage of a store's retail sales to create an incentive for the landlord to do as much as he, she, or it can to make the retail property attractive to shoppers.
- Mixed-use real estate investing - This is a catch-all category for when an investor develops or acquires a property that includes multiple types of the aforementioned real estate investments. For example, you might build a multi-story building that has retail and restaurants on the ground floor, office space on the next few floors, and residential apartments on the remaining floors.
You can also get involved on the lending side of real estate investing by:
- Owning a bank that underwrites mortgages and commercial real estate loans. This can include public ownership of stocks. When an institutional or individual investor is analyzing a bank stocks, it pays to pay attention to the real estate exposure of the bank loans.
- Underwriting private mortgages for individuals, often at higher interest rates to compensate you for the additional risk, perhaps including a lease-to-own credit provision.
- Investing in mezzanine securities, which allows you to lend money to a real estate project that you can then convert into equity ownership if it isn't repaid. These are sometimes used in the development of hotel franchises.
There are sub-specialties of real estate investing including:
- Leasing a space so you have little capital tied up in it, improving it, then sub-leasing that same space to others for much higher rates, creating incredible returns on capital. An example is a well-run flexible office business in a major city where smaller or mobile workers can buy office time or rent specific offices.
- Acquiring tax-lien certificates. These are an esoteric area of real estate investing and not appropriate for hands-off or inexperienced investors but which -- under the right circumstances, at the right time, and with the right sort of person -- generate high returns to compensate for the headaches and risks involved.
Real Estate Investment Trusts (REITs)
On top of all of this, you can actually invest in real estate through something known as a real estate investment trust, or REIT. An investor can buy REITs through a brokerage account, Roth IRA, or another custody account of some sort. REITs are unique because the tax structure under which they are operated was created back during the Eisenhower administration to encourage smaller investors to invest in real estate projects they otherwise wouldn't be able to afford, such as building shopping centers or hotels. Corporations that have opted for REIT treatment pay no Federal income tax on their corporate earnings as long as they follow a few rules, including a requirement to distribute 90% or more of profits to shareholders as dividends.
One downside of investing in REITs is that, unlike common stocks, the dividends paid out on them are not "qualified dividends", meaning the owner can't take advantage of the low tax rates available for most dividends. Instead, dividends from real estate investment trusts are taxed at the investor's personal rate. On the upside, the IRS has subsequently ruled that REIT dividends generated within a tax shelter such as a Rollover IRA are largely not subject to the unrelated business income tax so you might be able to hold them in a retirement account without much worry of tax complexity, unlike a master limited partnership.
(If you're interested in learning more about these unique securities, start by checking out Real Estate Investing Through REITs, which covers REIT liquidity, equity, how to use REITs to your real estate investing advantage, and much more.)
Investing in Real Estate Through Home Ownership
For all the real estate investing options available to investors, the average person is going to get his or her first real estate ownership experience the traditional way: By purchasing a home.
I've never viewed the acquisition of a home quite the same way most of society does. Instead, I prefer to think of a person's primary residence as a blend of personal utility and financial valuation, and not necessarily an investment. To be more direct, a home isn't an investment in the same way an apartment building is. At its very best, and under the most ideal of circumstances, the safest strategy is to think of a home as a type of forced savings account that gives you a lot of personal use and joy while you reside in it.
On the other hand, as you approach retirement, if you take a holistic view of your personal wealth, outright ownership of a home (without any debt against it) is one of the best investments a person can make. Not only can the equity be tapped through the use of certain transactions, including reverse mortgages, but the cash flow saved from not having to rent generally results in net savings -- the profit component that would have gone to the landlord effectively stays in the homeowner's pocket. This effect is so powerful that even back in the 1920s economists were trying to figure out a way for the Federal government to tax the cash savings over renting for debt-free homeowners, considering it a source of income.
This is a different type of investment, though -- something known as a "strategic investment." Were the economy to collapse, as long as you could pay the property taxes and basic upkeep, no one could evict you from your home. Even if you had to grow your own food in a garden, there's a level of personal safety there that matters. There are times when financial returns are secondary to other, more practical considerations. Whatever you do, though, don't sacrifice your liquidity to try and build equity in your real estate investments too quickly, as that can lead to disaster (including bankruptcy).
If you are saving to acquire a home, one of the big mistakes I see is new investors putting their money into the stock market, either through individual stocks or index funds. If you have any chance of needing to tap your money within five years or less, you have no business being anywhere near the stock market. Instead, you should be following an investment mandate known as capital preservation. Here are the best places to invest money you're saving for a down payment.
Which Is Better - Real Estate Investing or Investing in Stocks?
One of the most common questions I encounter involves the relative attractiveness of investing in stocks versus investing in real estate. The short version is that it's somewhat akin to comparing vanilla and chocolate ice cream. They are different, and as your net worth grows, you may even find that both have a role to play in your overall portfolio. Your personality will also inform your decision, as some people are more temperamentally geared toward stock ownership or real estate ownership, respectively.
Risks of Real Estate Investing
A substantial percentage of real estate returns are generated due to the use of leverage. A real estate property is acquired with a percentage of equity, the remainder financed with debt. This results in higher returns on equity for the real estate investor; but if things go poorly, it can result in ruin far more quickly than a portfolio of fully-paid common stocks. (That's true even if the latter declined by 90% in a Great Depression scenario, as no one could force you to liquidate).
That's why the most conservative real estate investors insist upon a 50% debt-to-equity ratio or, in extreme cases, 100% equity capital structures, which can still produce good returns if the real estate assets have been selected wisely. Billionaire Charlie Munger talks about a friend of his prior to the 2007-2009 real estate collapse. This friend, a very rich landlord in California, looked around at the high valuations on his properties and said to himself: "I'm wealthier than I would ever need to be. There's no reason for me to take risks for the sake of more." This friend sold many of his properties and used the proceeds to pay off the debt on the remaining ones that he thought the most attractive. As a result, when the economy collapsed, the real estate markets were in turmoil, people were losing their properties to foreclosure, and bank stocks were collapsing -- he didn't have to worry about any of it. Even as rents dropped due to tenant financial difficulties, it was all still surplus cash and he was armed with funds that kept replenishing themselves, letting him take advantage of buying up the assets everyone else was forced to sell.
Stop trying to get rich so quickly, and be content to do it the right way. You'll have much less stress in your life, and it can be a lot of fun.
Some Final Thoughts on Real Estate Investing
Of course, this is only the beginning of your journey to understanding the topic, as we've barely scratched the surface. Real estate investing takes years of practice, experience, and exposure to truly appreciate, understand, and master.