Beginner's Guide to Investing in Real Estate
Real estate is one of the five basic asset classes that every investor should consider adding to their portfolios. It offers unique cash flow, liquidity, profitability, tax advantages, and diversification benefits. Real estate investing covers a broad category of operating, investing, and financial activities centered around making money from property or cash flows tied to a tangible property.
There are several ways to make money in real estate, but some can take time to start paying off. Some experts suggest that you start investing when you're young, even in your twenties.
Real Estate Appreciation
Properties tend to increase in value, often due to a change in the market that increases demand for property in its area or because of the effects of inflation. It could also happen because of upgrades you've made to your investment to make it more attractive to potential buyers or renters.
Upgrades don't involve as much time as waiting for real estate to appreciate often does, but they'll cost you and add to the dollars you've invested.
Real Estate-Related Income
Related income is generated by brokers and other industry specialists who make money through commissions from buying and selling property. It also includes real estate management companies that keep a percentage of rents in exchange for running the day-to-day operations of properties.
Ancillary Real Estate Investment Income
Ancillary investment income can be a huge source of profit. It includes things like vending machines in office buildings, or laundry facilities in low-rent apartments. They effectively serve as mini-businesses within a bigger investment, letting you make money from a semi-captive collection of customers.
Cash Flow Income
The purest, simplest form of real estate investing is all about cash flow from rents rather than appreciation. This type of investment focuses on buying a property and operating it so you can collect a stream of cash from rent. Cash flow income can be generated from apartment buildings, office buildings, or rental houses.
The investor/landlord acquires a piece of tangible property, whether it'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. They find a tenant who wants to use this property, and the tenant and landlord enter into a lease agreement.
The tenant is granted access to the real estate and the right to use it under certain terms, for a specific length of time, and with certain restrictions. Some of these restrictions are laid out in federal, state, and local law, while others might be agreed upon in the lease agreement. The tenant pays for the ability to use the real estate.
Rental income can give investors a psychological boost as well. It can be more hands-on than investing in stocks and bonds. Investors have the satisfaction of using their negotiation skills to determine the rental rate. A good operator can generate higher capitalization rates or "cap rates"—the rate of return on the investment based on the net operating income it produces.
Managing Cap Rates on Rentals
You should enjoy a satisfactory rate of return on your capital if you're able to price your rental rates appropriately, after accounting for the cost of the property and any upgrades you've made. This includes:
- Reasonable depreciation reserves
- Property and income taxes
- Other related expenditures
Measure the amount of time required to deal with the investment because your time is the most valuable asset you have.
In exchange for a percentage of the rental revenue, you can establish or hire a real estate property management company to handle the day-to-day operations of your real estate portfolio when your holdings are large enough. This approach transforms investments that you had to actively managed into passive investments that you can simply set up and let someone else deal with.
Residential Real Estate Investing
Investing in properties, houses, or apartments in which individuals or families live can sometimes have a service business component, such as assisted living facilities for seniors or full-service buildings for tenants who want a luxury experience.
Residential leases usually run for 12 months, give or take six months, 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. When a commercial 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 that the tenant doesn't go bankrupt.
But the opposite can also occur. Rather than securing superior, long-term cash flow compared to the prevailing market rate, you could find yourself earning below-market lease rates because you signed long-term leases. You might lock in the rental rates to coincide with the prevailing market rate, only to see the market pick up and rates increase again.
You can change tenants or lease terms and adjust to the market more frequently if you stick to shorter-term leases.
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. Rental rates include a percentage of a store's retail sales in some cases to create an incentive for the landlord to do as much as they can to make the retail property attractive to shoppers.
Mixed-Use Real Estate Investing
Mixed-use investing is a catch-all category for when an investor develops or acquires a property that includes multiple types of investments. 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 upper floors.
The Lending Side of Real Estate
You can also get involved in the lending side of investing by owning a bank that underwrites mortgages and commercial real estate loans. This can include public ownership of stocks. Pay attention to the real estate exposure of the bank loans when an institutional or individual investor is analyzing a bank stock.
Underwriting private mortgages for individuals, often at higher interest rates to compensate you for the additional risk, can include lease-to-own credit provisions.
Investing in mezzanine securities allows you to lend money to a project that you can then convert into equity ownership if it isn't repaid. These arrangements are sometimes used in the development of hotel franchises.
Real Estate Sub-Specialties
Sub-specialties of real estate include 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. This can create significant 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.
You might also consider acquiring tax lien certificates, but they're not appropriate for hands-off or inexperienced investors. They can generate high returns under the right circumstances and at the right time, however. The strategy here is to pay delinquent taxes on a property, which then gives you a right to foreclose in most states, subject to certain rules.
Real Estate Investment Trusts (REITs)
You can also invest in through a real estate investment trust (REIT). An investor can buy REITs through a brokerage account, a Roth IRA, or another custody account. They're effectively corporations that own real estate.
REITs are unique because the tax structure under which they're operated was created back during the Eisenhower administration to encourage smaller investors to invest in projects they otherwise wouldn't have been able to afford.
Corporations that opt for REIT treatment pay no federal income tax on their corporate earnings as long as they follow a few rules, such as distributing 90% or more of their profits to shareholders as dividends.
A downside of REIT investing is that, unlike common stocks, the dividends paid out aren't "qualified," so the owner can't take advantage of the low tax rates available for most dividends. Instead, they're taxed at the investor's personal rate.
The IRS has ruled that REIT dividends generated within a tax shelter such as a rollover IRA generally aren't subject to the unrelated business income tax. You might be able to hold them in a retirement account without much worry of tax complexity, unlike a master limited partnership which is publicly traded.
A Strategic Investment: Your Home
The average person is going to get their first real estate ownership experience the traditional way, by purchasing a home. This isn't an investment in the same way as an apartment building. It's more of a strategic investment. 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.
Outright ownership of a home without any debt against it as you approach retirement is one of the best investments you can make. The equity can be tapped through certain transactions such as reverse mortgages, and the cash flow saved from not having to rent generally results in net savings.
Money saved from free-and-clear home ownership as opposed to making monthly rental payments prompted economists to try to figure out a way for the federal government to tax the cash savings, considering it a source of income even back in the 1920s.
No one can foreclose and evict you from your home as long as you can pay the property taxes in times of personal financial difficulty. There's a level of personal safety and security here that matters. There are times when financial returns are secondary to other, more practical considerations.
The Risks of Real Estate Investing
A substantial percentage of real estate returns are generated due to the use of leverage—borrowing money to finance the acquisition or project. A property is acquired with a percentage of equity, and the remainder is financed with debt. This results in higher returns on equity for the investor, but it can result in ruin far more quickly than a portfolio of fully-paid common stocks if things go poorly.
Most conservative investors insist upon a 50% debt-to-equity ratio or, in extreme cases, 100% equity capital structures. These can still produce good returns if the assets have been selected wisely.
Real estate investing takes years of practice, experience, and exposure to truly understand and master.