Real Estate Investing: What You Should Know
- April 30, 2021
- by Michael
If you find real estate investments confusing or are yet to begin your investment journey, here’s a guide to help you get a head start! I was a landlord for several years, including during the great recession which gave me a lot of real world experience in this area.
Real estate investing can start with a small home or condo and grow into a duplex, four-plex, commercial space or even larger buildings. Some experts say not to consider your primary residence as an investment. However looking at it as an investment, at least partially, can help you get a better return over the years.
1. How To Invest?
There are many ways in which you can earn money through real estate investments.
Non Direct Ownership Methods
Traditionally, people invest in real estate by either directly owning property or owning one with a number of partners. However, there are other options for getting into real estate without actually owning a property or having a mortgage.
For example, you can choose to invest in exchange-traded funds that include real estate holdings. There is a special type of these called REITs (real estate investment trust) which trade like a stock but offer good dividends. Generally REITs are not great in terms of tax treatment (lots of dividends and returns of capital). Rather than a taxable brokerage account a better place to hold a REIT is in a tax deferred account like an IRA, 401(k) or Roth IRA.
There are also crowdfunding platforms where you can invest in small slices of properties and spread out your risk. These are more risky than REITs but could offer higher returns.
Another way to invest is through platforms that allow investors to purchase notes representing real estate loans. If you’re already an accredited investor, you can invest in commercial real estate projects that give you excellent returns.
One of the most popular methods of getting an immediate return on real estate is through rent. The easiest way to start is to rent out a spare room in your current place. Having rent paying roommates can help pay off a mortgage and earn steady cash while living in your own property. Honestly I can say for all my real estate adventures this was the easiest and most satisfying way to get ahead.
Some new-age investors are renting out spare rooms via Airbnbs. While that is questionable in terms of legality city by city, the extra cash flow it generates is very appealing to some. This can work really well homes that have an attached apartment.
Buying a duplex and living in half while renting out the other half is also a good option. You are there all the time to keep an eye on things. You can do the maintenance yourself. I wish I would have done this when I was younger vs going with single family homes, but oh well.
The next step up from renting out rooms is to purchase a single family home, duplex, or apartment building and rent it out to others. Keep in mind, at this point you are running a small business.
When renting out a place you don’t live in there are a few extra things to budget for:
- Property Manager - they take care of advertising, screening tenants and collecting the rent. You can do this yourself but it takes work and expertise to get it right.
- Vacancy - the place will not always be rented out in between tenants.
- Wear and Tear - the deposit should cover this.
- Maintenance - landscaping, gutters, heating system checkups, unexpected problems like clogged pipes or pests, etc.
- Utilities - water, possibly electricity, and always pay for garbage!
Keep in mind when you become a landlord (even renting out a spare room) you may need extra insurance and a professionally drafted rental agreement contract. Tenants have all kinds of legal protections which you will need to learn about or run the risk of being stuck with a squatter.
In terms of a cash return, 5% of the property value is considered good when renting out a place. It can be much higher if you use leverage (say 25% down payment). Major repairs or unexpected economic down turns (where rent actually drops) can eat into it.
Keep in mind that landlords are on the opposite side of the rent spiral. As rents gradually go up over the years increases your cashflow. For landlords inflation is a good friend because it translates into more profit (assuming you have a fixed rate loan, or the property is paid off).
If you purchase a home thinking its value will appreciate predictably based on the past few years, you might be in for a surprise. Many investors buy homes with a plan to sell them a few years later at a hefty profit. This approach can work but must be considered carefully. The real estate market is very dynamic. Things outside of your control will send prices soaring or plummeting at any given time. In reality your return due to appreciation comes down to luck and market timing. 2006 wasn’t such a good time for that. 2010 was a great time. A few years can make a huge difference in your actual returns.
For a long term real estate investor you can expect the home to at least keep pace with inflation. A home’s value is partially based on replacement cost which inflation factors into. Location is arguably a more important factor, so when choosing an investment property consider the location carefully.
If you put time and money into a property by fixing it up that can generate a nice return, but with a rental that extra value may be taxed when you sell.
Owning a rental that operates at a loss on paper can provide short term tax benefits if you have other income to offset. Keep in mind that any expense associated with the rental is tax deductible. Major remodels need to be depreciated over a number of years. The main expense that comes into play for claiming a loss is interest on the mortgage. However, as the mortgage gets paid down the benefit gets smaller and smaller. Eventually the rental should start turning a profit on paper. At that point the rental becomes a small tax drag that needs to be budgeted for.
2. Are You Making A Legally Sound Investment?
When you own property you are exposed to liability (lead based paint issues, dogs getting out and biting others, correctly handling tenant issues, etc). A landlord rider policy on the home insurance can help with some of this.
Another way to manage liability risk is to run everything through an LLC (limited liability company) or a limited partnership. So instead of owning the property in your name, the LLC owns it. The tenants pay the LLC. The legal agreement is between the tenants and the LLC, etc. This can make your taxes more complicated and incur annual business fees but it can also help prevent a catastrophic claim against your other assets.
Now, LLCs don’t protect you automatically from consequences, so it is better to keep a check on what you’re signing up for. The ideal thing to do is to consult with a lawyer with considerable expertise in real estate.
Lawyers are aware of the risks involved in investing in real estate and will offer you valuable advice on keeping yourself secure.
Moreover, you should maintain your books systematically from the start. You can hire a bookkeeper in the beginning to keep your financial records. This is especially true if you go the LLC route.
You should be mindful of the tax consequences of running your rental properties through an LLC, so talking to a CPA who knows this area is also a smart move.
As you can see, when you own rentals you start to need other experts (lawyers, accountants, property managers, maintenance people). It can really start to add up, but if you do it right these folks can help you sleep better at night and avoid huge negative surprises down the road.
3. How To Conduct Market Research For Real Estate Investments?
The best investors always look at the market and assess it before investing in real estate. Whether you invest in a commercial project or a personal home, you need to find out what’s happening around you. The best way to learn about the local market is to keep an eye on nearby home listings and what similar properties are renting for. Plus, you can have a word with realtors about the market (they will be eager to help you).
As part of your research you will want to know:
- What it will cost for home insurance plus a landlord rider.
- Also consider flood, earthquake or other insurance as applicable.
- What utilities will cost - electricity, water, gas, and garbage.
- What similar nearby properties sold for.
- What amenities are nearby (shopping, freeway, parks, schools, bus lines).
- Any negatives nearby like a sewage treatment plant, noisy train yard, bodies of water subject to flooding, etc.
- What property management companies charge in the area.
- What are the typical costs to a seller when selling a property (closing costs) and tax laws concerning selling a property?
- When touring properties see our Property Walkthrough Checklist for ideas of what to look for.
4. How To Manage Expenses?
An important aspect of investing in real estate is to keep a check on your expenses. Such expenses may include property taxes, maintenance of the property, insurance and income taxes you will pay on any profit.
Even if you feel like you’re making a lot of profit on a cash basis month to month, rentals come with hidden risks. For example a massive surprise repair bill can quickly send you into the red.
If you’re thinking of managing costs as they come, it might land you in financial trouble. If you have a loan on the property and run out of cash it is game over. At that point the bank could foreclose and you would be forced to sell (on their terms) and you could end up losing everything you invested.
Each property should have a budget with lines for the following:
- loan payments
- annual insurance
- annual taxes
- vacancies (when in between tenants)
- turnover cost (repainting, repairs, cleaning)
- a “slush fund” for unexpected expenses
Just like it is smart to keep an emergency fund for personal finances, having an emergency fund for your rentals is also a good idea.
The initial stages of a real estate investment are not very profitable. However, if you’re able to keep your expenses to a minimum as well as make intelligent decisions during the course of your investment, you can expect to earn a good return over the years.
5. What is your overall strategy?
Investing in any real estate project is quite different from traditional investment options. Consider the realities of investing in real estate as part of your plan.
Going in it makes sense to have an exit strategy that outlines when you will sell out completely, or upgrade to a larger property.
How many properties do you want to invest in ultimately? Are you investing in these real estate properties to earn a side profit or transition into a full-time earning opportunity? Do you plan to sell them all by a certain age? Do you plan to leave them to your kids?
If you plan to manage your rentals on your own it can easily turn into a full-time job. However, if you’re managing your rentals alongside a day job, you might want to hire a property manager to take care of it for you.
Investing in real estate is a fantastic option since it can provide returns above many traditional alternatives. Real estate is something you can see and exercise control over vs stocks or bonds. Many people prefer to invest in real estate because it is tangible. However, it is not for the faint of heart. Being a landlord requires a lot of work, potentially new skills, and a bit of luck to make big gains. The trick for any sound investment is patience and planning. If you plan well and manage your expenses properly, your chances of success will increase greatly.