People grow up being told that if they get a solid education, work hard, and save their money they’ll become wealthy over time. But often, even those who follow this regiment fail to create the life they’ve dreamed of living. They’re tied down to their 9-to-5, stressed out, and lack freedom in their day. So, what’s the alternative?
The fact of the matter is even those with well-paying 9-to-5 jobs find it difficult to grow their income by saving alone.
One option is to invest in real estate. There are many real estate investing strategies, which we’ll get into below. There are opportunities to actively invest, just as there are opportunities to passively invest, which allows you to take a hands-off approach while reaping the benefits of owning income property. Read on to learn more about how to become a real estate investor.
What is real estate investing?
Real estate investing is simply investing in, or buying, real estate that is used for income generating purposes. Investing in real estate is one of the oldest forms of investing, having been around since the early days of human civilization. Real estate is considered one of the five basic asset classes, and it is generally advised that anyone looking to create a balanced portfolio invest in some form of real estate.
Investing in real estate has many unique benefits relative to investing in other asset classes. These benefits include ongoing cash flow, appreciation potential, and significant tax advantages. In fact, real estate is considered one of the most tax-advantaged investment vehicles thanks to tax deductions like depreciation.
Different ways to invest in real estate
Many people falsely assume that in order to invest in real estate, they must purchase a property outright, and because most banks require at least 20% down when buying investment property, most people feel that investing in real estate is not within reach.
Some people also assume that investing in real estate forces them into becoming a landlord, a job that many people don’t have any interest in taking on.
But in fact, there are many ways to invest in real estate – both actively and passively. Here we take a look at four of the most prominent ways to invest in real estate: through real estate investment trusts (REITs), by buying rental properties directly, by flipping homes for profit, and by investing in real estate development.
One way to passively invest in real estate is through a real estate investment trust (REIT), which is similar to a mutual fund. Essentially, you’re buying stock in a real estate portfolio that is actively managed by a team of professionals. According to federal regulations, REITs are required to return 90% of profits to their investors. The benefit of buying shares in a REIT is that you can buy and sell these shares at any time, making them a great investment for those looking to preserve liquidity – although typically they offer lower returns than direct investing and come with no tax benefits.
Buy Rental Properties
Another way to invest in real estate is by buying rental properties. At a smaller scale, you could purchase a two- to four-unit multifamily property. Some investors start out by owner-occupying a small multifamily home, which provides the benefit of highly attractive financing while taking a baby step into becoming a landlord.
Investing in rental property does not need to be limited to residential property. Investors often buy retail, office, industrial, warehouse and other types of asset classes that they rent out for profit.
Regardless of the type of real estate you purchase, buying rental property can be done either actively or passively. Owning and managing rental properties can be time intensive (active), but many investors outsource the day-to-day responsibilities to a third-party property manager (passive) to be freed of obligations like showing properties, running credit checks on prospective tenants, collecting rent checks, overseeing repairs and maintenance, etc.
Flipping homes is by far the most active form of real estate investing. Some would even argue that flipping homes is not an investment strategy, but rather, a business or career. Flipping homes entails purchasing property in need of renovation, then investing in those renovations before selling the property for profit. Most house flips are completed within six to twelve months after purchase, making the workload intensive in the interim. Some investors choose to flip homes personally, while others fund the acquisition and renovations but hire a general contractor to perform the work.
Invest in Real Estate Development
A fourth way to invest in real estate is through real estate development. Real estate development can take many forms, including ground-up development and value-add investing. Ground up development is when an investor buys a vacant lot (or buys a lot with a building that they then demolish) and builds a new income property from the ground-up (as the name implies). Value-add investing is a form of real estate development in which a mediocre property is purchased and then substantial improvements are made to result in better occupancy and/or higher rental rates.
Step by Step Guide to Become a Real Estate Investor
Step 1: Identify your source of funding
One of the first steps someone needs to take prior to investing in real estate is identifying the capital that they’ll use to invest. Many people will use their savings to invest in real estate for the first time. Once they’ve invested in property, they can then leverage the equity in that real estate to purchase additional property – and that’s how most investors grow their real estate portfolios over time.
Another way to invest in real estate is by drawing on your retirement accounts. This can usually be done with both a 401k, traditional IRA and Roth IRA. However, there are specific guidelines to follow when investing in real estate with your retirement account, so it’s important to consult with your accountant or retirement advisor before going this route.
In any event, it’s important to identify your source(s) of funding. Knowing how much capital you have available to invest will steer the direction (asset class, location, size of property etc.) of your first real estate investments.
Few investors purchase property outright. Most will put 20-30% of their own capital into a deal that is then supplemented by debt financing. Read on to learn more about equity and debt financing.
Types of Real Estate Funding
Real estate development projects usually have general partners (GPs) and limited partners (LPs) who, collectively, put the equity into the deal. GPs play an active role in the project, whereas LPs invest but then take a backseat on decision-making. Equity is then paired with debt financing. Typically, the more equity in a deal, the better rates and terms someone can get on debt.
Nearly all real estate purchases utilize debt financing. The most traditional form of debt financing is a bank loan. Loans can also be made by insurance companies, pension funds, and private lenders. Individuals can also invest in debt. With real estate debt investments, investors act as lenders to property owners, developers, or real estate companies sponsoring deals. Regardless of the source of debt, the loan issued is secured by the property and the investor (the bank or otherwise) earns a fixed return based on the loan’s interest and repayment schedule.
Step 2: Create an Investment Strategy
As alluded to above, there are two distinct investment strategies: active investing and passive real estate investing.
Active real estate investing is when a person is directly involved in the investment process. It involves YOUR time, YOUR capital, and as a result, YOUR risk. With active investing, you are fully engaged in the process, either entirely from the beginning to the end, or heavily in parts of the process.
There are many forms of active real estate investing, such as wholesaling, property flips, and real estate development.
Wholesaling is when a person ties up a piece of real estate, through a purchase and sale agreement, option or otherwise – and then sells the rights to that property to someone else. In this case, you aren’t actually investing in or exchanging real estate. You’re purchasing and selling contracts associated with a piece of real estate, usually for an assignment fee.
Then there are property flips. Investors often find an off-market deal, purchase the property at a discount and then turn around and sell immediately for a profit. This can be lucrative, but it also requires a lot of work. Finding properties to flip is the biggest challenge, and is incredibly time intensive, particularly for someone who doesn’t have much real estate experience or lacks local connections.
At the other end of the spectrum are major real estate renovation or development projects. These tend to be the most complicated of real estate investments and, in many cases, can be among the most lucrative. There are a lot of moving parts, from negotiating land contracts to permitting, design and construction. Once the project is built, or rehab complete, you still need to lease the space before generating cash flow. These projects tend to have a lot of unknowns. You really need to have an experienced team in place in order to be successful with this real estate investing approach.
An alternative form of active real estate investing is to “buy and hold” property. Buy and hold investors tend to collect cash flow over time, build equity in their property, and then often pass the portfolio on to a family member or sell through what’s known as a 1031-exchange (a process that involves investing the proceeds of the sale into another real estate asset to defer paying capital gains tax). In the event that a buy-and-hold investor wants to sell their portfolio entirely, they can do so with the benefit of paying long-term capital gains tax instead of the short-term capital gains tax that other active real estate investors often face.
Passive Real Estate Investing
Passive real estate investing, as its name would imply, is a way of generating passive income through real estate. You’ll typically generate income more slowly, but the income that is generated is consistent and has multiple tax advantages (more on this to come).
There are a few ways to passively invest in real estate. We’ve already discussed REITs above.
Another approach is to buy into a real estate investment fund, a process often referred to as syndication. Don’t let the fancy name throw you off – most people have participated in a syndication at one point or another. If you’ve ever purchased an airline ticket, you’ve participated in a syndication. You paid for your seat, as do others. In total, revenue generated by each ticket sale is used to pay the airline, pilot, government fees, etc.
Real estate syndication is not dissimilar. You invest in a real estate deal alongside a number of others. Each project may have a different minimum requirement, say $10,000 or $50,000 per person. The investors share in the project’s risk (to the extent of their investment) and upside reward, with each being paid out a share of the profits accordingly. Usually the project sponsor will take a small administrative fee, but that sponsor usually falls at the bottom of the equity waterfall – meaning they are paid last, only after investors have been repaid their equity stake and agreed upon returns above that amount.
One of the benefits of real estate syndication is that you, as an individual investor, are considered a “limited partner”. The only responsibility of an LP is to bring the capital. Meanwhile, the “general partner,” or GP, takes responsibility for finding and managing deals, and for taking on and, when required, for guaranteeing the debt. Typically, the GP brings their real estate expertise in exchange for a share of the profits and is paid out only after the LPs have received their initial capital contribution. This GP/LP structure incentivizes the GP to manage the project diligently; otherwise, they will never make money on the deal since the LP’s must be repaid first. This structure ensures that the GP/LP interests are always aligned.
Similarly, a real estate fund will pool investors’ resources and then can deploy that capital across an array of real estate projects depending on the goals of the fund.
After you invest in a REIT, real estate fund or syndicated deal, there’s not much more you need to do. Sit back, relax, and collect income accordingly.
Step 3: Identify your target market
Once you’ve identified your source of capital to invest, and once you’ve narrowed down your preferred approach to real estate investing, then you must identify your target market for investing.
Investing in primary markets (i.e., larger cities like New York, San Francisco, Boston and Los Angeles, amongst others) is considered a safer investment approach. Real estate in these markets tends to hold its value, even over multiple real estate cycles. However, real estate in primary markets tends to be more expensive and as a result, will often have lower returns (low risk = low returns) than higher risk, secondary and tertiary markets.
Many investors, especially those who have been priced out of primary markets, opt to invest in secondary and tertiary markets. Real estate in these markets tends to be more affordable, meaning lower barriers to entry. Yet real estate in secondary and tertiary markets tends to be more susceptible to market swings, making it potentially riskier. With higher risk comes the potential for higher returns, so investing in these markets may appeal to those with a higher risk tolerance.
Step 4: Understand the Risks of Real Estate Investing
Although investing in real estate has many benefits, it is certainly not foolproof. There are certainly risks associated with investing in real estate. These risks include:
- General market risk. If the economy softens, property values could depreciate. Investors with highly-leveraged properties can quickly become underwater on their mortgages, and in a worst-case scenario, might default on their loans.
- Asset-level risk. There are some risks associated with specific asset classes. For example, many highly adept investors purchased shopping centers years ago and now struggle with high vacancy rates as more consumers move to online shopping. Hotels are also prone to risk, given fluctuations in consumer spending and travel. Industrial and multifamily properties tend to be least susceptible to risk.
- Property-specific risk. Real estate investors always run the risk that something will not work out as planned with a property. Vacancy may be unusually high. A tenant might stop paying rent. The heating system may unexpectedly need to be replaced. Those who own rental property for long enough are bound to encounter property-specific challenges from time to time.
- Liquidity risk. Real estate, unlike other investment vehicles like stocks and bonds, is inherently illiquid. It is harder to sell real estate, especially commercial real estate. There is a ramp up time needed to sell rental property, compared to securities which can be sold with the click of a button.
Step 5: Find a property with a lot of upside potential
Ideally, investors will find real estate that presents significant upside potential. There are a few key features to look for when trying to identify whether a property has upside potential, including:
- The underlying zoning. Knowing how a parcel is zoned by the local building authorities is important for redevelopment purposes. For example, a single-story retail building may be zoned for 5-story mixed-use commercial development. This means it could be a great candidate for redevelopment into four-stories of residential or office above a single story of retail.
- Vacancy rates. A property that has high vacancy could have significant upside potential. It might just need new management or better leasing agents to get the property fully occupied, thereby generating more cash flow for the new investor.
- Rental rates. If rents appear unusually low relative to the local market, an investor might be able to increase rents through the implementation of property improvements.
- Amenities. Many investors find that integrating new or better amenities into a property (such as in-unit laundry, an on-site fitness center, technology features like Nest or keyless entry systems etc.) can result in better revenues. Modest improvements can often turn a lackluster property into one with significant upside potential.
Website Resources to Find Investment Properties:
- CoStar is one of the nation’s leading platforms for investment properties. There are many reasons people use CoStar, from finding investment properties to conducting market research. CoStar is often used by brokers looking for comps when creating property valuations. The platform also provides valuable lease information, including rental rates and property vacancy rates. CoStar uses a subscription-based model and requires a monthly fee.
- LoopNet is an online commercial listings platform, giving users easy access to active for sale and for lease listings across the U.S. and Canada. It is a marketplace for those looking to buy property that is for sale, and for those looking to actively market and sell a property. More generally, it’s a platform for property buyers and sellers to connect. The site is primarily used by commercial brokers and investors as a tool for finding opportunistic property buyers and sellers.
- CREXi, much like LoopNet, allows for the handling of the property sale process from first listing to close. The site also offers for sale and for lease listings for multifamily apartments, retail, office, industrial, and more asset classes across the entire United States. Despite not having as many listings as LoopNet, CREXi can still be used for many of the same purposes.
- Ten-X is an online platform that not only provides access to investment properties for sale, but also provides end-to-end services for those who want to purchase commercial real estate directly through the website. Ten-X is one of a new breed of online commercial real estate purchasing platforms. In many ways, Ten-X Commercial acts as a middle man between buyers and sellers. It essentially serves as an online broker for those wondering how to find investment properties.
Is real estate investing right for you?
Before taking the plunge, people should take a long, hard look as to whether real estate investing is right for them. Ask yourself the following:
- How much time do you have? Active real estate investing is incredibly time intensive. Those who don’t have as much free time might want to consider passive real estate investing as an alternative.
- What level of risk are you willing to accept? Real estate investing, both active and passive, can be riskier than investing in the S&P 500, bonds, or mutual funds. It’s definitely riskier than keeping your cash in a high-yield savings account. That said, those with a higher risk tolerance will often find real estate investing to be a great way to earn cash flow and build equity over time.
- What else are you invested in? Most people will want to have a diversified investment portfolio. Anyone who saves via a 401k, Roth IRA or other traditional retirement account will have the bulk of their assets tied up in securities. Investing in real estate is a good option for those looking to diversify their portfolios.
Given the different ways to invest in real estate, it might feel overwhelming for the first-time investor looking to buy their first property. Real estate investing doesn’t need to be complicated, though. There are many ways for people to invest passively, alongside others – including those who earn their living by investing, owning and operating commercial real estate on behalf of other equity investors.
Remember: at the end of the day, real estate investing is about generating passive cash flow and building wealth. Instead of working hard for your cash, investing in real estate is a way to put your cash to work for you while you sleep. It’s how savvy investors set themselves up for financial freedom so they can live comfortably into retirement, with a sizeable nest egg to pass on to future generations when the time comes.