Making Money from Real Estate Investing
How to Make Money By Investing in Real Estate
When it comes to making money in real estate investing, there are only a handful of ways to do it. Though the concepts are simple to understand, don't be fooled into thinking they can be easily implemented and executed. Grab a notebook and pencil, because, in the next ten minutes, I'll walk you through a brief overview to help you understand the basics of real estate and how successful real estate investors work to maximize their earnings.
The Three Primary Ways to Make Money from Real Estate Investments
There are three primary ways investors make money from real estate:
- An increase in the property value.
- Rental income collected by leasing out the property to tenants.
- Profits generated from business activity that depends upon the real estate.
In a nutshell, that is it. Of course, there are always other ways to directly or indirectly profit from real estate, such as learning to specialize in more esoteric areas like tax lien certificates, but those three items account for a vast majority of the passive income, and ultimate fortunes, that have been made in the real estate industry. By learning how to take advantage of them for your portfolio, you can add another asset class to your overall asset allocation, increasing both diversification and, if implemented prudently, reducing risk.
1. Making Money from an Increase In the Property Value of Your Real Estate Investments
First, it's important you understand that property values do not always increase. This can become painfully evident during periods like the late 1980s and early 1990s, and the 2007-2009 real estate collapse. In fact, in many cases, property values rarely beat inflation. For example, if you own a $500,000 piece of real estate and inflation is 3%, your property might sell for $515,000 ($500,000 x 1.03%), but you aren't any richer than you were last year. That is, you can still buy the same amount of milk, bread, cheese, oil, gasoline, and other commodities (true, cheese may be down this year and gasoline up, but your standard of living would remain roughly the same).
The reason? The $15,000 gain wasn't real. It was nominal.
This happens because the government has to create money when it spends more than it takes in through taxes. All else equal, over time, this results in each existing dollar losing value and becoming worth less than it was in the past.
One of the ways that the savviest real estate investors can make money in real estate is to take advantage of a situation that seems to crop up every few decades: When the rate of inflation is projected to exceed the current rate of long-term debt, you might find people willing to gamble by acquiring properties, borrowing money to finance the purchase, and then waiting for inflation to increase. That way, they can pay off the mortgages with dollars that are worth far less. This represents a transfer from savers to debtors.
You saw a lot of real estate investors making money this way in the 1970s and early 1980s as inflation began to spiral out of control before Paul Volker took a 2x4 to its back and brought it under control by drastically raising interest rates.
The trick is to buy when cyclically adjusted cap rates are attractive or when you think there is a specific reason that a particular piece of real estate will someday be worth more than the present cap rate alone indicates it should be. For example, talented real estate developers can look at the right project, at the right time, at the right price, and quite literally create the future rental income to support a valuation that might otherwise appear rich based on present conditions because they understand economics, market factors, and consumers.
In my old hometown, I watched a terrible old hotel on a great piece of land get transformed into a bustling shopping center with office buildings pumping out considerable rents for the owner. Absent those cash flows, present or net present value; you are speculating to some degree or another, no matter what you tell yourself, no matter which banks approve your loans, and no matter what society around you says. You will require either substantial inflation in the nominal currency (if you're using debt to finance the purchase) to bail you out or some sort of low probability event to work out in your favor.
2. Making Money from Rental Income Generated by Your Real Estate Investments
Making money from collecting rents is so simple that every six year old who has ever played a game of Monopoly understands on a visceral level how the basics work. If you own a house, apartment building, office building, hotel, or any other real estate investment, you can charge people rent in exchange for allowing them to use the property or facility. Of course, simple and easy are not the same thing. If you own apartment buildings or rental houses, you might find yourself dealing with everything from broken toilets to tenants who operated meth labs.
If you own strip malls or office buildings, you might have to deal with a business that leased from you going bankrupt. If you own industrial warehouses, you might find yourself facing environmental investigations for the actions of the tenants who used your property. If you own storage units, theft could be a concern. Real estate investments are not the type you can phone in and expect everything to go well.
The good news is that there are tools available that make comparisons between potential real estate investments easier. One of these, which will become invaluable to you on your quest to make money from real estate is a special financial ratio called the cap rate, which is short for "capitalization rate." If a property earns $100,000 per year and sells for $1,000,000, you would divide the earnings ($100,000) by the price tag ($1,000,000) and get 0.1, or 10%. That means the cap rate of the property is 10%, or that you would earn an expected 10% on your investment if you paid for the real estate entirely in cash and no debt.
Just as a stock is ultimately only worth the net present value of its discounted cash flows, a real estate is ultimately worth a combination of 1.) the utility it generates for its owner and 2.) the net present cash flows it generates relative to the price that was paid for the investment. Rental income can be a margin of safety that protects you during collapses. Certain types of real estate investments are better suited for this purpose. To go back to our earlier discussion of the challenges of making money from real estate, office buildings, to provide one illustration, typically involve long, multi-year leases.
Buy one at the right price, at the right time, and with the right tenant and lease maturity profile, and you could sail through a real estate collapse collecting above average rental checks that the companies leasing from you have to provide still (due to the lease agreement they signed) even when lower rates are available elsewhere. Get it wrong, though, and you could be locked in at sub-par returns long after the market has recovered.
3. Making Money from Real Estate Business Operations
The final way of making money from real estate investments involves special services and business activities. If you own a hotel, you might sell on-demand movies to your guests. If you own an office building, you might make money from vending machines and parking garages. If you own a car wash, you might make money from time-controlled vacuum cleaners. These types of investments almost always require sub-specialty knowledge; e.g., there are men and women who spend their entire career specializing in designing, building, owning and operating car washes.
For those who rise to the top of their field and understand the intricacies of a particular market, the opportunity to make money can be endless.
More About Making Money In Real Estate
For more information about how to make money in real estate, read The Complete Beginner's Guide to Real Estate Investing.