How to Invest in Real Estate
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Many investors have a real estate position in their portfolio. Adding other real estate investments can help you diversify your portfolio and protect you from stock market volatility.
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Rental properties are the most hands-on option. You buy a piece of residential real estate and rent it out to tenants.
Many rental properties are rented for 12-month periods, but shorter-term rentals through companies such as Airbnb (NASDAQ:ABNB) are becoming quite popular as well.
As the property owner, you are the landlord and are responsible for upkeep, cleaning between tenants, repairs, and paying property taxes.
Depending on the lease terms, you may be liable for replacing appliances and paying for utilities.
You can make money off rental properties from the rental income you receive and price appreciation if you sell the property for more than you paid for it.
You can also benefit from tax write-offs. Under passive activity loss rules, you can deduct up to $25,000 of losses from your rental properties from your normal income if your modified adjusted gross income is $100,000 or less.
Depreciation and interest, could make the property show an accounting loss even when you’re still making money.
When you buy rental property, you may need a down payment of up to 25%.
But if you charge enough rent to cover your mortgage payment, you will get the rest covered by the tenant, plus any price appreciation.
While selling a rental property could take months and more paperwork, a REIT has the advantage of liquidity since they trade on stock exchanges.
If you don’t want to put up with the headache of managing a rental property or don't have a 25% down payment, real estate investment trusts (REITs) are an easy way to start investing in real estate.
REITs are publicly traded trusts that own and manage rental properties.
They can own anything including: medical office space, malls, industrial real estate, and office or apartment buildings.
REITs have high dividend payments because they are required to pay out at least 90% of their net income to investors. If the REIT meets this requirement, it will not have to pay corporate taxes.
Real estate investment groups
Investing in a real estate investment group (REIG) is one way to keep the profit potential of private rental properties, while getting more upside than a REIT trading at a premium.
REIGs purchase and manage properties and then sell off parts of the property to investors.
A REIG will buy an apartment building, and investors can buy units within it.
The operating company retains a portion of the rent and manages the property. The company finds new tenants and takes care of all maintenance.
The investors will also pool some of the rent to keep paying down debt and meet other obligations if some units are vacant.
If you choose to flip houses, be smart and figure out a way to sit it out when the market gets too hot.
It may seem counterintuitive, but it will save you money in the long run.
Flipping houses is the most difficult and risky, but it can be the most profitable.
The two most common ways to flip houses are to buy, repair, and sell, or buy, wait, and sell.
The key is to limit your initial investment with a low down payment and keep renovation costs low.
Let’s say you manage to buy a house for $250,000 with 20% down, or $50,000. You do another $50,000 of renovations and then list the house for $400,000.
You use the $400,000 to pay off the $200,000 loan and then have $100,000 in profit on a $100,000 investment. It is a great return if you can get it.
The problem is, housing markets are not known for being volatile.
Keeping renovation costs to a minimum may sound easy, but it may be nearly impossible if you don’t have direct construction experience.
Materials prices continue to rise, there are worker shortages everywhere, and almost no houses are for sale on the cheap.
It is the worst possible time for house-flippers: Everything is expensive, and the market could turn at any moment.
Real estate limited partnerships
Real estate limited partnerships (RELPs) are a form of REIG. RELPs are structured in a similar way to hedge funds, where there are limited partners (investors) and a general partner (the manager).
The general partner is often a real estate business that takes on all liability.
RELPs are a more passive investment in real estate. Usually, the general partner sets up the partnership and recruits investors to be limited partners.
Investors receive a K-1 to report income on their taxes, but they don’t have much influence in operations.
RELPs can be very profitable if you find a good general partner.
The general partner must without much oversight, manage the property and reliably report financials back to you.
Real estate mutual funds
Real estate funds invest in REITs and real estate operating companies (REOCs). REOCs are like REITs, but they don’t have to pay dividends, so they grow much faster.
Real estate mutual funds or exchange-traded funds (ETFs) are the simplest ways to invest in real estate.
You allow a manager or even an index to choose the best real estate investment while you simply collect dividends.
Even if you’re a stocks-only investor, consider using real estate funds to get diversification while keeping your liquidity profile.
Why should you invest in real estate?
Here are a few advantages and cons of investing in real estate:
Advantages of investing in real estate
If you invest in a physical property, you can control your investment, and have a totally passive investment that you don’t need to manage.
It can be a source of steady monthly passive income payments.
Can reduce your overall volatility through diversification and lower price movements.
It can lead to long-term wealth through the use of leverage.
Disadvantages of investing in real estate
In a recession, prices can collapse and take down your entire portfolio.
With the amount of leverage required, even small price drops can wipe out your whole investment.
If you choose to flip houses or personally own rental properties, it can turn into a career and use up significant free time.
Up-front costs can make initial investments quite difficult. You need to save enough for the down payment and to cover cash flow shortages when there are vacancies.
Real estate investing may seem intimidating.
Not everyone has the time or ability to flip houses or handle having a tenant.
There are options available for every level of investor, with each catering to different goals, skill levels, and time constraints.
The most important thing to do is get started today and let your investment start compounding.
How to get started in real estate
If you choose to invest in real estate, follow these steps to get started:
Save money: Real estate has some of the most expensive barriers to entry of any asset classes.
Pay off your high-interest debt and have some significant savings.
Choose a strategy: If you choose to buy REITs or funds, you can do online research about your options to help you get started.
If you want to buy physical property, decide on a market.
Assemble a team: Work with an agent when you get started. If you become successful, you may eventually need investors.
Do deal analysis: Whether you’re investing in residential or commercial real estate, do research on any investment.
For instance, with rental properties, you will need to analyze what future rent payments could be, what expenses you may be liable for, and forecast what you could sell the property for.
Close the deal: The final step is to close on your property, or make the buy in your brokerage account.