Your home is usually the first thing that comes to mind when you consider real estate investing. Real estate investors, of course, have many more alternatives when it comes to investing, and they aren’t all physical assets.
Important Points to Remember
Being a landlord of a rental property is one of the most lucrative methods for real estate investors to make money.
Flippers purchase undervalued property, renovate it, and resell it for a profit.
Real estate investment trusts (REITs) allow investors to have exposure to the real estate market without having to own, run, or finance assets.
Over the last 50 years or more, real estate has been a popular investment instrument. Here are some of the most popular options for individual investors, as well as some compelling reasons to invest.
You’ll become a landlord if you invest in rental homes, so think about whether you’ll be comfortable in that role. You’ll be responsible for paying the mortgage, property taxes, and insurance, as well as maintaining the property, finding renters, and dealing with any issues as the landlord.
Rent collection is one method landlords make money. The amount of rent you can charge is determined by the location of the rental. Even yet, determining the appropriate rent can be tricky because charging too much would drive tenants away, while charging too little will leave money on the table. A frequent technique is to charge just enough rent to meet expenditures until the mortgage is paid off, at which point the majority of the rent is profit.
The other major source of income for landlords is appreciation. If the value of your property rises, you may be able to sell it for a profit (when the time comes) or use the equity to fund your next investment. While real estate does have a tendency to appreciate, no assurances can be made.
Prices in the Past
Real estate has long been seen as a safe haven for money, and with good reason. Prior to 2007, historical housing data suggested that prices could rise indefinitely. Between 1963 and 2007—the commencement of the Great Recession—the average sale price of homes in the United States grew every year, with few exceptions.
The average sales prices between 1963 and 2019 are shown in this graph from the Federal Reserve Bank of St. Louis (the most recent data available). Recessions in the United States are indicated by light grey shading.
The Federal Reserve Bank of St. Louis is the source of this information.
Of course, the greatest major real estate collapse prior to the COVID-19 epidemic occurred during the Great Recession. The consequences of the coronavirus outbreak are still unknown. Home sales are projected to fall dramatically as a result of closures, social isolation, and devastating jobless figures. While this does not necessarily imply that home values would rise in lockstep, it will, at the very least, alter the way individuals buy and sell real estate in the medium term.
Real estate flippers are a different species from buy-and-rent landlords, much like day traders are different from buy-and-hold investors. Flippers buy homes with the purpose of holding them for a short time—usually three to four months—before flipping them for a profit.
When it comes to flipping a house, there are two main methods:
- Repair and modernize. With this strategy, you purchase a home that you believe will appreciate in value after a few repairs and renovations. In an ideal world, you’d finish the project as quickly as possible and then sell it for more than you paid for it (including the renovations).
- Hold for a while and then resell. This method of flipping works in a unique way. Instead of buying a house and renovating it, you buy in a hot market, hold for a few months, and then sell for a profit.
With either sort of flipping, there’s a chance you won’t be able to sell the house for enough money to make a profit. This can be difficult because most flippers don’t have enough cash on hand to pay long-term mortgages on their properties. Even yet, if done correctly, flipping may be a profitable way to invest in real estate.
When a corporation (or trust) is founded to use investors’ money to buy, operate, and sell income-producing properties, it is known as a real estate investment trust (REIT). REITs, like stocks and exchange-traded funds, are purchased and sold on major exchanges (ETFs).
To be classified as a REIT, the company must distribute 90% of its taxable income to shareholders in the form of dividends. REITs avoid paying corporate income tax in this way, whereas a traditional firm would be taxed on its profits, reducing the amount of money available to give to shareholders.
REITs, like conventional dividend-paying equities, are suitable for investors seeking consistent income, however they also provide the possibility of capital appreciation. REITs invest in a wide range of properties, including malls (which account for nearly a quarter of all REITs), healthcare facilities, mortgages, and office buildings. REITs have the advantage of being very liquid when compared to other types of real estate investments.
Groups of Real Estate Investors
REIGs (real estate investment groups) are similar to tiny mutual funds that invest in rental properties. A real estate investment group may be the answer for you if you want to own a rental property but don’t want the headache of being a landlord.
A firm will buy or construct a set of structures, usually apartments, and then allow investors to purchase them through the company, thus becoming members of the group. One or more self-contained residential units can be owned by a single investor. The investment group’s operating firm, on the other hand, runs all of the units and is responsible for upkeep, advertising, and finding tenants. The corporation receives a percentage of the monthly rent in exchange for this management.
Investment groups come in a variety of shapes and sizes. The lease is in the investor’s name in the normal version, and all of the units pool a portion of the rent to protect against vacancy. This implies that even if your apartment is vacant, you will be able to pay your mortgage.
The quality of an investment group is totally dependent on the firm that provides it. In principle, it’s a safe method to get into real estate investing, but it’s possible that groups will collect exorbitant fees similar to those seen in the mutual fund business. Research is crucial, as it is with any investment.
Limited Partnerships in Real Estate
A real estate limited partnership (RELP) is a type of real estate investment trust that is comparable to a real estate investment trust. It’s a company created to buy and hold a portfolio of properties, or perhaps just one. RELPs, on the other hand, have a limited lifespan.
The general partner is an experienced property manager or a real estate development firm. The real estate project’s financing is then sought from outside investors in exchange for a share of ownership as limited partners. The partners may get periodic dividends from the RELP’s properties’ income, but the true return comes when the properties are sold—hopefully at a profit—and the RELP dissolves afterwards.
Mutual Funds for Real Estate
Real estate mutual funds generally invest in real estate investment trusts (REITs) and real estate operating companies (REOCs). They allow you to obtain diversified real estate exposure while investing a little amount of money. They offer investors a far greater asset selection than can be obtained by purchasing individual REITs, depending on their strategy and diversification aims.
These funds, like REITs, are extremely liquid. The fund’s analytical and research material is also a substantial benefit to regular investors. This can contain information on newly acquired assets as well as management’s assessment of the viability and performance of individual real estate investments and the asset class as a whole. To enhance returns, more speculative investors can invest in a family of real estate mutual funds, tactically overweighting certain property types or geographies.
What Are the Benefits of Investing in Real Estate?
Real estate can improve an investor’s risk-and-return profile by providing competitive risk-adjusted returns. In comparison to equities and bonds, the real estate market has a low level of volatility.
When compared to more traditional sources of income, real estate is very appealing. This asset class often trades at a yield premium to US Treasuries, making it particularly appealing in a low-rate environment.
Protection and diversification
Another advantage of real estate investing is the opportunity for diversification. Real estate has a low, and in some cases, negative, correlation with other main asset classes, which means that when equities fall, real estate rises. As a result, adding real estate to a portfolio can reduce volatility and increase return per unit of risk. The better the hedge, the more direct the real estate investment: Publicly traded entities with a lower degree of directness, such as REITs, will reflect the general stock market’s performance.
Some analysts believe that now that REIT equities are included in the S&P 500, REITs and the stock market will become more connected.
Direct real estate also has less principal-agent conflict, or the amount to which the investor’s interest is dependent on the integrity and competency of managers and debtors, because it is supported by brick and mortar. Even the most indirect kinds of investment are covered by some form of insurance. REITs, for example, must pay out a minimum percentage of income as dividends (90 percent).
Hedging Against Inflation
The potential of real estate to hedge against inflation arises from the positive link between GDP growth and real estate demand. As economies grow, demand for real estate rises, resulting in higher rents and, in turn, higher capital values. As a result, real estate tends to preserve capital purchasing power by passing some inflationary pressure onto tenants while also incorporating some inflationary pressure in the form of capital appreciation.
The Influence of Leverage
With the exception of REITs, real estate investing provides an investor with a weapon that stock market investors do not have: leverage. Unless you are buying on margin, if you wish to buy a stock, you must pay the whole price at the time you place the order. Even still, thanks to that magical financing mechanism, the mortgage, the percentage you can borrow is still considerably lower than with real estate.
A 20% down payment is required for most conventional mortgages. However, depending on where you reside, you might be able to get a mortgage with as little as 5% down. This means that by paying a part of the whole value, you can gain control of the entire property and its equity. Of course, the degree of ownership you have in the property is affected by the size of your mortgage, but you have control over it from the moment the papers are signed.
This is what motivates both landlords and real estate flippers. They can get a second mortgage on their residences and put down payments on two or three more properties. Whether they rent them out to pay the mortgage or hold onto them until they can sell them for a profit, they have control over these assets despite having only paid a small portion of the total worth.
Real estate can be a good investment that can give a consistent income and help you create wealth. Still, illiquidity, or the difficulty of changing an asset into cash and cash back into an asset, is a disadvantage of real estate investing.
A real estate deal can take months to finish, unlike a stock or bond purchase, which can be completed in seconds. Even with the assistance of a broker, finding the proper counterparty can take several weeks. REITs and real estate mutual funds, on the other hand, provide better liquidity and market pricing. However, because they have a considerably stronger link to the general stock market than direct real estate investments, they come with higher volatility and fewer diversification benefits.
Keep your expectations realistic, and do your homework and research before making any decisions, just like you would with any other investment.