How to Invest in Real Estate
The recent volatility in the financial markets probably has you wondering if there are other ways to invest without so much turbulence.
Stocks are an excellent long-term investment, but there’s no doubt they can also be incredibly unpredictable.
One way to broaden your investment base is by holding at least some of your equity portfolio in real estate. The returns are comparable with stocks, and often more consistent.
That brings up the obvious question of how to invest in real estate. Surprisingly, there are several ways it can be done, some without even getting your hands dirty.
Why Invest in Real Estate?
Most investment advisors recommend the typical investor hold most of their portfolio in equities. While those are generally considered to be stocks, real estate also qualifies as an equity investment. After all, just as is the case with stocks, real estate represents ownership in the underlying investments.
But real estate does something else that’s important in any portfolio – it diversifies your allocations. Rather than having 100% of your equity portfolio invested in stocks, you can add real estate to the mix, giving you long-term capital appreciation from a different direction.
That point alone is worth a deeper discussion. Strictly speaking, stocks are financial assets. That is, they’re tied to the financial markets. When there’s turbulence in the financial markets, stocks go down with the rest of the pack.
By contrast, real estate tends to be a more slow-moving investment. Its cycles are longer, which means it may continue to perform well even when stocks and other financial assets are not. This will give you an opportunity to continue earning positive returns on your equity portfolio, even when the financial markets aren’t cooperating.
Advantages of Investing in Real Estate
Real estate has two big advantages over stocks: leverage and depreciation.
With a small amount of capital, often 20% or less, you can control a much larger investment. For example, with a $50,000 capital contribution, you can own a $250,000 property.
A 5% annual capital appreciation rate – which will be $12,500 on a $250,000 investment – will translate into a 25% return on your $50,000 of invested capital.
Such returns are possible because you can leverage 80% or more of a real estate investment. By contrast, leverage on stocks is limited to a 50% margin.
Real estate’s other advantage is depreciation. Depreciation is what’s known in accounting circles as a “paper expense.” While it’s deductible for tax purposes, it doesn’t result in an out-of-pocket cost. For that reason, your actual income from real estate will be reduced for tax purposes but without a corresponding reduction in your real net income.
With all the advantages of investing in real estate can bring to your portfolio, let’s look at the best ways to participate.
Ways to Invest in Real Estate
Here are 5 great ways to invest in real estate:
- Home Ownership
- Real Estate Investment Trusts (REITs)
- Real Estate Crowdfunding Platforms
- Buying Rental Property
- Fix and Flip Properties
Owning Your Own Home
There’s some debate as to whether owning your own home is mostly about having a place to live, or is it more about having an investment. Probably the best answer is both. And that’s a big part of the homeownership advantage. Your home can provide shelter and a sense of permanence while building equity and investment value over the long term.
In fact, the family homestead offers two ways to earn long-term returns:
- Capital appreciation, from the slow, but steady (and sometimes not so slow) rise in the value of the property. At an average annual rate of 3%, the value of a home can double in less than 25 years. At 5%, it will only take 15 years. And at 7%, it’ll double in just ten years.
- The paydown of your mortgage balance. Even if you think a 30-year mortgage will go on for what seems like forever, your outstanding mortgage balance is still gradually declining each and every year. And at the end of 30 years, it’s completely gone, and you’ll have 100% equity in your home.
This is also another example of the leverage advantage enjoyed by real estate. You can buy an owner-occupied home with a down payment of as little as 5% – and sometimes even less, all the way down to zero. If your home is appreciating at 5% per year, that will be like earning a 100% return on your equity each year.
Over the long term, the returns are obvious.
But let’s say you purchase a $300,000 home with a 5% down payment – $15,000. After 30 years, the house will be fully paid for, and at 5% appreciation, it will quadruple in value.
Your $15,000 initial investment in the home will grow to an investment worth $1.2 million.
How to Screw Up a Perfectly Solid Long-term Real Estate Investment
I have to throw in an important caveat here. The above example will only work if you’re committed to paying off your mortgage. But if you’re in the habit of taking home equity lines of credit and refinancing your home to get cash out every few years, your debt will grow over the years. That will offset the equity buildup that would otherwise take place.
The hoped-for windfall at the end of 30 years will be greatly reduced, or even eliminated if you get carried away with stripping out the equity.
Real Estate Investment Trusts (REITs)
REITs are like mutual funds that hold commercial real estate. A single trust can hold dozens or even hundreds of properties. Investments can include office buildings, retail shopping centers, large apartment complexes, warehouse space, and many other different types of income-generating properties.
One of the major advantages with REITs is that they can provide both steady income and long-term capital appreciation. Rents collected on the properties in excess of operating expenses are returned to investors in the form of dividends. In fact, REITs are required by law to distribute at least 90% of their profits to investors in the form of dividends. And since at least some of that income is reduced by depreciation expense, it will at least partially escape taxation.
Capital appreciation distributions are possible when properties held in the trust are sold at higher prices. Given that most properties are sold in more than one year, investors will get the benefit of lower long-term capital gains tax rates.
REITs have an excellent long-term investment performance. They out-earned stocks over a recent 38-year time frame, returning 12.87% versus 11.64% for stocks from 1978 to 2016. The difference may “only” be about 1.23%, but that can make a substantial difference over 20 or 30 years.
- Learn More: Read my post on How to Invest in REITs.
Real Estate Crowdfunding Platforms
Real estate crowdfunding is a relatively recent investment trend, having come about primarily in the past ten years. It’s part of the peer-to-peer (P2P) investment model that’s becoming more popular with each passing year. Real estate sponsors come to the platforms to offer their real estate deals, while investors fund them through investments.
Perhaps the most unique feature of real estate crowdfunding platforms is that they provide you an opportunity to invest in a single specific property or to select from several. As an investor, you can hold fractional shares in individual properties, or you can fund the entire investment, in some cases.
Real estate crowdfunding is something like the wild West of P2P investing. Because you’re investing in individual properties, and commercial properties at that, this type of investing is considered higher risk. For that reason, many platforms require you to be an accredited investor to participate. That means you’ll need an annual income of at least $200,000, or a net worth of at least $1 million exclusive of your primary residence.
However, not all real estate crowdfunding platforms require you to be an accredited investor. You can even invest in some for as little as $500 per investment.
Real estate crowdfunding is an excellent way to invest if you prefer to choose individual real estate investments. But be aware that this type of investing is not particularly liquid. Since the investments are not traded on public exchanges, you’ll normally need to hold your investment for a few years before earning your full return, or even getting your capital back.
Recommended Real Estate Crowdfunding Platforms
Some prominent real estate crowdfunding platforms include:
- Fundrise. You can invest with as little as $500 or $1,000 and invest in either growth or income. There is no requirement to be an accredited investor, so anyone can invest.
- CrowdStreet. This platform requires you to have a larger investment – ranging from $10,000 to as much as $250,000 – as well as being an accredited investor.
- Roofstock. This is another popular real estate crowdfunding platform that’s also available to non-accredited investors. You can begin investing with as little as $5,000, investing primarily in single-family investment properties.
Learn More: Read my guide on the Best Real Estate Crowdfunding Platforms.
Buying Rental Property
This is perhaps the most classic way to invest in real estate. When we think of real estate investing, rental properties quickly come to mind – and for a good reason.
Rental property has similar advantages to an owner-occupied home in that you’ll get the benefit of both long-term capital appreciation and the paydown and eventual payoff of the mortgage on the property. But it has an even bigger advantage since your tenants will pay the monthly operating expenses through the payment of rent.
While it can be a tight squeeze when you first invest in a rental property, eventually rising rents should enable you to begin earning a monthly profit on your investment. As time goes on, and rents go even higher, your cash flow should improve. And once the property is paid off, your net rental income will certainly take off.
Rental real estate also has a depreciation advantage. You can depreciate the property improvements, offsetting net income with a paper expense. However, it’s important to understand that as you depreciate the value of the property, your investment tax base declines. That means the capital gain on sale will be that much larger.
But that may not be a problem. Since rental property is a long-term investment, you’ll get the benefit of lower long-term capital gains tax rates.
Investing in Rental Properties is Not for the Faint of Heart!
I do have to warn you, however, that investing in rental properties does require a strong knowledge base before you get started. The learning curve will be even steeper if you are a beginner.
For example, investing in rental properties usually requires a larger down payment – something on the order of 20% of the purchase price or more. You’ll also be dealing with tenants. Some tenants may pay their rent late, damage the property, or even skip out in the middle of the night. The risks are even greater if you invest in out-of-state rental properties.
But if you have sufficient capital, at least some experience in repairing and renovating real estate, and more than a little bit of patience, rental properties can be one of the very best investments you can make.
- Learn More: Read my post on Investing in Rental Properties.
Fix-and-flip isn’t new, but it’s turned into the “TV version” of investing in real estate, thanks to the many fix-and-flip TV shows now available on HGTV and other networks. It seems simple enough, or at least that’s how they make it look on TV. The real-life version, however, is something very different.
The basic concept is you purchase a property that’s in serious disrepair. That’s an important component, because the poor condition enables you to purchase it for substantially below its fully improved market value.
You might buy a property in a $300,000 neighborhood for $200,000. If you can restore the property to the standard of the surrounding community for $40,000, you can sell it for $300,000, and bank $60,000 profit.
Fix-and-Flip is Anything But Simple
It looks simple on TV, but in real life, it’s anything but. First, you have to know your market area – as in really know your market area. That means you know the difference between a property that’s selling for a discount versus one that is truly undervalued.
Second, you have to know what’s involved in renovating the property. In fact, you’ll need to be able to do much of the work yourself. Otherwise, you’ll pay a fortune to contractors. You’ll also need to know what in a property can be repaired, and what might make a house a real candidate for condemnation. Misjudge the difference, and you can lose your life savings.
Third, fix-and-flip requires a lot of capital. Unless you have a commercial loan arrangement with a bank (which is very difficult to get for this purpose), you’ll need to pay cash for the properties you purchase. It’s rare that you’ll be able to get common mortgage financing on properties that are in real need of extensive renovations. As well, you’ll need additional capital to pay for both the needed renovations and the expenses of maintaining the property until it’s sold.
If you have the bankroll, the expertise, and the nerves needed to make fix-and-flip deals work, it can be lucrative. But just be aware that the market has become very crowded, and one of your biggest problems will be finding suitable properties at the right price. In many markets, even handyman specials are selling for very close to full market value.
What Makes Fix-and-Flip Unique Among Real Estate Investing
There’s one more thing to understand about fix-and-flip: it’s more of an occupation, and less of an investment – if it’s even an investment at all. Fix-and-flip is very hands-on, and you’ll need to be ready to put in both the time and effort to make it work. It can very easily rise to the level of a full-time occupation.
Should You Invest in Real Estate?
As I said at the beginning, there are multiple ways to invest in real estate. Since it’s one of the very best long-term investments – and a perfect equity diversification away from stocks – you should choose at least one investment and commit to it.
Owning your own home is the default choice for many. But even if you do, and especially if you don’t, add a REIT or two to your investment portfolio or IRA. They work just like mutual funds and exchange-traded funds, but they add commercial real estate to your portfolio.
If you have a higher net worth, and you’d like to get involved in individual commercial real estate deals, investigate the opportunities in real estate crowdfunding. There are so many different platforms now that you can choose the specific investments you want to make.
And if you have the capital and you’re prepared to deal with tenants, investing in rental properties can be one of the very best real estate investments of all.
Finally, consider fix-and-flip only if you have a very large bankroll, plenty of hands-on skill, and a willingness to risk losing everything. If you can overcome those hurdles, it can be an excellent occupation – but not so much an investment.