When investing in real estate, the goal is to put your money to work today so you have more money in the future. The profit, or return, you make on your investments must be enough to cover the risk you take and the taxes you pay. There are other costs of owning real estate, such as utilities, maintenance, and insurance.
Real estate investing can really be quite simple once you understand the basic factors of the investment, economics, and risk. You buy properties, avoid going bankrupt, and earn money through rent, all so that you can buy even more properties.
But keep in mind that "simple" doesn't mean "easy." If you make a mistake, the consequences can range from minor inconveniences to major disasters.
Four Ways To Make Money by Investing in Real Estate
When you invest in real estate, there are four main ways you can make money:
Real Estate Appreciation
This is what happens when a property rises in value due to a change in the real estate market. For instance, the land around your property could become scarcer or busier (for example, if a major shopping center were to be built nearby). Or, perhaps you made upgrades to the property that make it more attractive to buyers. Real estate appreciation is a tricky game, because it is not easy to predict. It is riskier than investing for cash flow income.
Cash Flow Income
This type focuses on buying a real estate property, such as an apartment building, and operating it. You then collect a stream of cash from tenant rent. Cash flow income can also come from other types of real estate besides apartment buildings, such as storage units, office or retail buildings, and rental houses.
Real Estate-Related Income
This income is common for specialists in the real estate industry, such as brokers. They may make money from commissions on properties they have helped a client buy or sell. Real estate management companies sometimes get to keep a portion of rents in exchange for running the day-to-day operations.
A hotel management company might keep 15% of a hotel's sales for taking care of the day-to-day operations. They may hire cleaners, staff the front desk, mow the lawn, and wash the towels.
Ancillary Real Estate Investment Income
For some, this can be a huge source of profit. Ancillary real estate investment income includes things such as vending machines in office buildings or laundry rooms in rental apartments. In effect, this involves mini-businesses within a bigger real estate investment. They let you make money from a semi-captive collection of customers.
Tips for Your First Property Investment
There are a few ways you can buy your first real estate investment. If you are purchasing a property, you can use debt by taking a mortgage out against a property. The use of leverage is what attracts many real estate investors: it lets them acquire properties they otherwise could not afford.
Using leverage to purchase real estate can be dangerous. In a falling market, the interest expense and regular mortgage payments could drive you into bankruptcy if you aren't careful.
To manage risk and protect yourself, consider holding real estate investments through special types of legal entities rather than in your own name. These include limited liability companies or limited partnerships. You should consult with a lawyer to decide which method is best for you. If the investment goes bust, or someone slips and falls, resulting in a lawsuit, these legal entities can protect your personal assets. That means the worst that could happen is that you would lose the money you've invested. You will have peace of mind knowing that your retirement accounts and other assets should be out of reach.
Pros and Cons of Real Estate Investing
Less risk and volatility than the stock market
Can be a good source of cash flow
Lots of tax deductions
Properties give good long-term return
Not as much potential for aggressive return
Can require a lot of cash
Dealing with tenants and building issues can be difficult
Pros of Real Estate Investing
- Lower risk than the stock market: The housing market isn't subject to as much of the same volatility as the stock market. You don't have the same earning potential, but you can count on a steady incline most of the time.
- Steady cash flow: When you have enough rental properties going, you can count on a stable revenue stream for your business.
- Good tax breaks: You can deduct all sorts of expenses from your taxes. These include mortgage interest, depreciation, property tax, and more.
- Long-term returns will often be positive: Over time, most properties will increase in value.
Cons of Real Estate Investing
- Potential returns aren't as high as the stock market: From 1991 to 2019, the S&P 500 gained over 600%; housing prices increased by only about 160%.
- Real estate investment can be cash heavy: If you really want to get a steady income stream going, then you need enough cash on hand. Whether it's your own money or it's loaned to you, you'll need to be able to pay for building improvements, maintenance, and more.
- Properties are not liquid investments: You can't turn a property into cash quickly like you can when you sell a stock.
- Managing tenants and building maintenance can be a challenge: Whether you hire a property manager or manage it yourself, running a property can be full of unexpected problems. These can include overdue rent, roof leaks, power outages, and more.
The Balance does not provide tax, investment, or financial services advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.