Real estate can be a great investment choice for people looking for recurring passive income and a way to build long-term wealth. The first thing most people think of when investing in real estate is buying a house to rent out. However, today there are plenty of other ways to invest in real estate without spending a lot of time or money.
In this article, we will discuss everything there is to know about investing in real estate, including the different ways to invest in real estate, important steps to follow, and what to expect with your first real estate investment.
Types of Real Estate Investments
The purpose of real estate investing is to generate income through recurring rents or appreciation in property value. Investing in real estate can involve buying and selling property, leasing and managing, and adding value or improving property to increase the overall value of the asset.
Residential real estate is property where people live. Types of residential property include single-family homes, small multifamily property of four units or less, townhomes, condominiums, and co-operatives.
Although the majority of residential real estate is occupied by homeowners, some cities such as Boston, Miami, and Glendale, California have more renter-occupied households than owner-occupied.
Commercial real estate is property specifically intended to generate income for investors. Types of commercial property include office, retail, apartments, and leisure and hospitality.
Traditionally, commercial real estate was only owned by large institutional investors and experienced private investors. Over the last few years, a growing number of individual investors have been investing in commercial real estate, attracted by the stable cash flows and higher yields that commercial property offers.
Industrial commercial real estate has been one of the most resilient sectors amid the pandemic, according to a recent report from CBRE.
Property types in the industrial sector seeing strong demand include e-commerce warehouses and distribution centers, and alternative special purpose investments such as data centers, student housing, life sciences, and self-storage properties.
Special purpose properties such as these generate high yields, stable income, and portfolio diversification for investors while historically offering downturn protection during recessions.
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Ways to Invest in Real Estate
It used to be that most people begin investing in real estate by purchasing a single-family rental home.
There are some advantages to buying a residential property, such as ease-of-financing and the fact that almost everyone knows how a house 'works.' However, there are some drawbacks as well, like getting repair calls in the middle of the night or chasing down residential tenants for the monthly rent.
Today, there are a variety of ways to invest in real estate to earn recurring passive income and property appreciation over the long term, some without having to deal directly with tenants.
Remote real estate investors are people who invest in rental property outside of the market they live in. In many urban real estate markets, the price of housing is so high that it can be nearly impossible to find an affordable rental property to invest in.
After researching potential homes to purchase, investors make an offer, close on the transaction, and hire a local property management company to take care of the property and the tenants. Each month the investor collects passive income from the cash flow the rental property generates.
Real estate flipping (also known as wholesale real estate investing) is a real estate investing strategy where an investor locates a property with a below-market value, makes any needed repairs and updating, then quickly sells or flips the property for a profit.
Countless books, podcasts, and television shows have glamorized real estate flipping. Unfortunately, as with most get-rich-quick techniques, flipping real estate for a profit is not as easy as it looks. That being said, real estate investors with a high tolerance for risk and an in-depth knowledge of neighborhoods in a real estate market may find real estate flipping a good money-making opportunity.
Real estate investment trusts (REITs) are another good way to passively invest in real estate. Shares of publicly-traded REITs trade on the major stock exchanges, and investors can select REITs that focus on specific property types such as communications, industrial, data centers, malls, residential, and self-storage.
Another benefit to investing in REITs - and in commercial real estate in general - is that real estate historically has a low correlation to the broader stock market. According to Nareit, "defensive" property types that have generally shown the lowest historical correlations with the broad stock market include health care, infrastructure, data centers, and self-storage.
Online real estate crowdfunding investing platforms such as CrowdStreet, Fundrise, and RealtyMogul give investors a way to pool money with other people to invest in commercial real estate assets such as new single-family home developments, multifamily projects, retail shopping centers, and self-storage properties.
Some advantages to online real estate platforms include participating in large commercial real estate projects that are difficult for an individual to do alone, and low minimum investment requirements beginning at $500. However, oftentimes the best opportunities on an online platform are reserved for accredited investors with an annual income of at least $200,000 and a net worth of $1 million, not including their primary residence, or more.
Rent an unused room
House hacking by renting an unused room is a way to invest in real estate that many people overlook. Renting out a room can generate incremental cash flow that is then used to pay down a mortgage quicker and build home equity faster.
Once equity reaches a certain level, a homeowner can obtain a cash-out refinance to pull money out of the house to reinvest in more real estate. Some real estate investors repeat this process over and over again, using the 'rinse, wash, and repeat' strategy for investing in income-producing real estate.
Steps to Making Your First Real Estate Investment
Investing in real estate can generate recurring passive monthly income while building wealth through property appreciation over the long term. However, not every property is right for renting and creating income.
By employing a methodical approach to real estate investing, the process of buying your first investment property can be painless and potentially very profitable.
Define your goals
Before you begin investing in real estate, ask yourself what you expect to get from the investment and when. While many people would like to earn a return as quickly as possible, that is not always the case with investment real estate.
A report from Harvard Extension School reveals that the real estate market historically moves in an 18-year cycle. This suggests that real estate investors who have the goal of buying-and-holding for the long term may generate larger investment returns compared to investors with a shorter investment timeframe.
Understand your financing options
Financing investment real estate is different from buying a home to live in. Lenders view loans on real estate purchase for investment use as higher risk. Down payments are larger, and fees and interest rates are usually a little more than with an owner-occupied property. Because of this, prudent real estate investors often make down payments of between 20% - 25%.
Conventional loans are among the most common mortgages for residential real estate. Banks and other private lenders originate the home loan, then sell it to government-sponsored entities such as Fannie Mae and Freddie Mac.
Loans sold to Fannie and Freddie are also known as "conforming loans" because they must meet the lending guidelines established by these enterprises. In general, a borrower will need a minimum credit score of 620, a low debt-to-income ratio, and a good employment history.
Asset-based loans use the property itself as collateral for the loan, along with a borrower's credit score, income, and employment history. Loans based on the underlying value of the property can be a good alternative to a conventional mortgage, because the lender is more concerned about the cash flow the property generates than a borrower's credentials.
Asset-based lenders will analyze the property's debt service coverage ratio (DSCR) to see if the property generates enough cash flow to comfortably pay for the mortgage and normal operating expenses.
A home equity line of credit (HELOC) loan is a loan for a fixed amount that is secured by the property. The amount you can borrow is normally capped at 85% of the equity.
For example, if your property has an appraised value of $200,000 and your current loan balance is $130,000 you could obtain a home equity loan of $59,500 ($200,000 - $130,000 = $70,000 x 85%).
Repaying a home equity loan is made in equal monthly payments over a fixed term, just as with a mortgage. If a borrower defaults on a home equity loan the lender can foreclose on the property.
Qualifying for a mortgage on a second home can be easier than applying for an investment property loan if you plan on living in the property for at least part of the time.
There are two conditions for obtaining a second home mortgage: 1) You must live in the property for at least 14 days per year, and 2) You must reside in the property for at least 10% of the days the property is rented out.
For example, if you rent the house out for 330 days per year (or about 11 months) you must live in the house for 33 days in the year. If you are able to negotiate this with a tenant, you may be able to qualify for a second home loan.
The average 401(k) account balance in the U.S. is $106,478, according to Business Insider. This makes a retirement a potentially good source for funding your first real estate investment. While you cannot buy real estate with a normal 401(k), you may be able to roll your IRA into a self-directed IRA to invest in rental property.
With a self-directed IRA for real estate, you may be able to invest in rental property directly, put money into a real estate crowdfunding investment, or participate in a private equity commercial real estate investment such as self-storage.
House hacking can be a good real estate investing strategy to use for purchasing a small multifamily property with two, three, or four units.
According to QuickenLoans, if you live in one of the units and rent the other ones out you may be able to qualify for conventional, FHA, or VA financing. Down payments range from zero down to 20% for a four-unit property.
The key to house hacking is to use the income you receive from the rental units to pay down the mortgage as quickly as possible. Once you have built up some equity, refinance the loan and use the cash you pull out to invest in more investment real estate.
Hire an expert team
Investing in real estate is a team effort. But as Robert Kiyosaki advises, "Choose your partners wisely. A bad team member is one of the most dangerous things you can have."
Key trusted members of a real estate team should include:
- Business partners, mentors, or personal advisors.
- Real estate agent with proven experience working with real estate investors.
- Real estate attorney, accountant or CPA, lender, and property manager.
- Service providers including escrow officer, home inspector, handyman, plumber and electrician, HVAC technician, and general contractor.
Find the right property
Now that you know what you expect from your real estate investment, how to finance it, and have a team in place, the next step is to find the right property. For example, single-family rental homes are generally easier to finance, but small multifamily and commercial self-storage properties can have more cash flow due to the multiple income streams.
Geography is another important consideration when looking for the right rental property. Over the last couple of years, smaller secondary and tertiary real estate markets in states such as Florida and South Carolina have benefited from in-bound migration as both residents and businesses leave larger, high-tax urban areas.
Decide on your marketing strategy
Key components of a marketing strategy to find investment real estate include:
- Creating a monthly marketing budget with measurable results, such as leads generated.
- MLS leads from the real estate agent who is part of your team.
- Referrals from other team members such as your handyman, escrow officer, or lender.
- Driving and walking for dollars in the target neighborhoods you have targeted for investment.
- Direct mail to property owners who may be willing to sell, such as out-of-state owners, owners delinquent on their taxes, rental property owners evicting a tenant, and pre foreclosure properties.
Drawbacks to Investing in Real Estate
While there are plenty of benefits to buying your first real estate investment, there are also some potential drawbacks to be aware of as well. If any of the following four things is a 'deal killer,' you may want to think twice before investing in real estate:
Even with passive income real estate, you will need to spend some time monitoring your investment. After you have found your first real estate investment, there will still be monthly property management reports and financial statements to review, occasional reports to your lender, and putting together year-end reports for your accountant.
Significant capital needed
Directly investing in rental property means making a down payment of around 25%. According to Zillow, the typical home value in the U.S. is $276,717 (as of March 2021). Based on that figure, your upfront costs to acquire a property could be around $75,000, including the down payment, closing costs, and due diligence items such as inspecting the property.
A liquid asset is one that is easy to sell, such as stocks and bonds. On the other hand, an illiquid investment is one that can take some time to sell for a fair price, including a crowdfunding investment or a rental property.
However, illiquid assets are not necessarily something to avoid. Over a long enough holding period, real estate can have less volatility while generating passive cash flow for the buy-and-hold real estate investor.
Another potential drawback to investing in real estate is that month cash flow will not always be consistent. There may be months where repairs are above budget, or it takes longer than expected to fill a vacancy. That is why real estate investors set up reserve accounts, to make sure funds are available to cover short-term periods where the cash flow is negative.
The two main ways investors make money from a real estate investment are recurring cash flow from the monthly rent payments (after operating expenses and the mortgage have been paid) and appreciation in property value over the long term. While owning investment real estate is potentially very profitable, it will take some work. Fortunately, there are plenty of good options for investing in real estate today for both active and passive investors. Special purpose properties such as self-storage can generate higher yields and stable income, while offering downturn protection during a recession.
To learn more about how to make your first (or next) real estate investment while eliminating all the time and risks associated with going it alone, contact us here at Reliant for more information on how to invest passively in our self-storage fund.