For many, real estate investing is uncharted territory. Unlike stocks and bonds — often called “standard assets” — real estate is considered an “alternative asset,” historically difficult to access and afford — until recently.
But just because investing in real estate may be an unfamiliar investment opportunity doesn’t mean that it should be avoided. When approached correctly, real estate can be a lucrative and reliable way to generate substantial returns. Real estate can create a consistent income stream while supplementing your portfolio with unique benefits, including appreciation potential, portfolio diversification, and tax advantages.
Despite those obvious upsides, real estate can seem intimidating without an obvious starting point. That doesn’t have to be the case, though. In this article, we discuss the fundamentals of real estate investing, including seven different ways that you can get started right away.
So, first things first: what is real estate investing?
- What is Real Estate Investing?
- Ways to Invest in Real Estate
- Active Real Estate Investing (Doing it Yourself)
- Passive Real Estate investing (The Hands-Off Way)
- Putting it All Together
What is Real Estate Investing?
Real estate investing is the purchase, ownership, lease, or sale of land and any structures on it for the purpose of earning money. Real estate generally breaks down into three categories: residential, commercial, and industrial.
- Residential real estate:Residential real estate consists of single family homes, multi-family homes, townhouses, condominiums, and multi-family homes that people use as a living space and not a working space. Homes that are larger than four units are considered commercial property. Some examples include freestanding homes, townhouses, and condominiums that occupants can own.
- Commercial real estate:Commercial real estate is property that is used for the purpose of business. Commercial real estate is classified as office, retail, land or multi-family. Some examples of commercial real estate properties include business offices (office), restaurants (retail), farmland (land), and large apartment buildings (multi-family).
- Industrial real estate:As the name suggests, these properties serve an industrial business purpose. Some examples include shipping or storage warehouses, factories, and power plants.
In addition to property types, there are three main ways to make money from real estate investments: interest from loans, appreciation, and rent.
- Interest from Loans (or, in the parlance of real estate, “debt”): A real estate loan is an arrangement where investors lend money to a real estate developer and earn money from interest payments. Debt investing provides a regular cash flow for an investor. Depending on the number of lenders, there can be one or several types of debt within the capital stack. Types of debt include senior debt, junior debt, and mezzanine debt. Debt can also be secured or unsecured. This distinction defines an investor’s rights in the event o a property’s foreclosure. A loan is a type of passive investment that is used by private equity firms, REITs and real estate investment platforms.
- Appreciation: As with the ownership of any equity, real estate ownership gives an investor the ability to earn money from the sale of that equity. The appreciation, or increase in value of a property over time, represents the potential profit available to an investor when that property is sold. Unlike debt investments or rental income, a sale provides one large, single return. Equity can generally be categorized as preferred equity or common equity. Equity ownership can be an active or passive investment depending on the position of the investment within the capital stack.
- Rent: An investor who holds equity ownership of a property can earn income by leasing that property. As with the income generated from a debt investment, rental income can provide a regular income stream. Depending on how a property owner manages their real estate (independently or through a hired manager), they may keep all of their earnings or share earnings with a property management company.
Each category of real estate and type of investment carries its own set of risks and rewards. Regardless of the type of real estate that you invest in, it is important to choose investments wisely by running opportunities through a rigorous underwriting process. No matter who performs the underwriting, due diligence plays a vital role in making a decision on an investment determining whether an investment opportunity is financially sound and whether it can meet your financial goals.
Many investors like to use projected rate of return as a key metric when analyzing real estate. However, more seasoned real estate investors will often turn to capitalization rate, or “cap rate,” as a preferred way to assess an opportunity.
Ways to Invest in Real Estate
There are a multitude of ways to invest in real estate with any amount of money, time commitment, and investment horizon. Real estate investment options break down into two major categories: active and passive investments. Here are seven fundamental ways to invest in real estate with options ranging from intense, high-effort to hands-off low-effort.
Active Real Estate Investing (Doing it Yourself)
Active real estate investing requires a great deal of personal real estate knowledge and hands-on management or delegation of responsibilities. Active investors can work as real estate investors part-time or full-time, depending on the nature and number of their investment properties. They usually invest in properties with only one or a few owners, so they bear quite a bit of responsibility in ensuring the success of a property. Because of this, active real estate investors need real estate and financial acumen and negotiation skills to improve their cap rate and overall return on investment.
House-flipping is the most active, hands-on way to invest in real estate. In a house flip, an investor purchases a home, makes changes and renovations to improve its value on the market, and then sells it a higher price. House-flipping is generally short-term, because the longer the investor owns the home without leasing it to tenants, the more their expenses add up. This eats away at returns when they sell it. Investors can repair or renovate the home to increase its sale price or sell when its value in the housing market increases.
If you watch HGTV, then you have probably watched a house get transformed from rags to riches in under 30 minutes and sold for a sizeable profit by house-flipping pros. In these shows, house-flippers buy a home that they believe to be underpriced, add value through renovations — such as replacing countertops or flooring, or tearing down walls to change floor plans — and then sell the home at a higher price to turn a profit.
While house-flipping is exciting, it also requires deep financial and real estate knowledge to ensure that you can make over the home within time and budget constraints to ensure a profit in the housing market when the home is sold. The success — and the financial burden — of a house flip falls entirely on the investor. You need enough cash for a down payment and/or good enough credit to secure a home loan in order to buy a property before another flipper does. It’s a high-pressure and high-stakes real estate investment that makes for great TV, but a good investment opportunity only for certain knowledgeable investors.
Another property-flipping option is wholesaling. Wholesaling is when an investor signs a contract to buy a property that they believe is underpriced and then sells it quickly to another investor at a higher price for a profit. Most often, wholesalers seek out properties in need of renovations and sell them to house-flippers who are willing to perform the renovations. An investor will sign a contract to buy a property and put down an earnest-money deposit. Then, they quickly try to sell the home to a house-flipper at a premium, earning a small profit. Essentially, a wholesaler gets a finder’s fee for brokering a home sale to a house-flipper. However, unlike traditional brokers, a wholesaler uses their position as the homebuyer to broker the deal.
Wholesaling is a risky venture, also requiring real estate and financial expertise. It demands due diligence and access to a network of house-flippers in order to find a buyer within a timeframe to sell at a profitable price. Otherwise, like house-flipping, you risk not earning a profit or, worse, losing money.
Rental properties also require hands-on management, but unlike house flips, they have a long-term investment horizon. Any type of property (residential, commercial, or industrial) can be a rental property. Property owners earn regular cash flow usually on a monthly basis in the form of rental payment from tenants. This can provide a steady, reliable income stream for investors, but it also requires a lot of work or delegation of responsibilities to ensure that operations are running smoothly.
First, you must find tenants for your property. This may be easy or difficult depending on your property type and available resources for finding tenants. You are also responsible for performing background screenings for prospective tenants (if you want to) and providing legally sound lease agreement contracts with tenants. For each month that you do not have a tenant, you miss out on income from your investment.
Once you have tenants, you have a litany of resultant duties. As the landlord, you are responsible for rent collection, property maintenance, repairs, evictions, record-keeping for the properties and ensuring legal compliance on all matters. Depending on the number of rental properties that you own, property management can be a part-time or full-time job.
Some real estate investors who don’t want to handle the management of a property contract a property management company for a fixed or percentage fee. This takes some weight off an investor’s shoulders, transforming the real estate into a more passive investment. However, this trade off also means that an investor cedes some control of their properties and lose a portion of their monthly income.
Airbnb is a tech company that allows residents to rent out their homes on a nightly basis, usually as an alternative to a hotel. Airbnb rentals are similar to rental properties, but they are confined to residential properties and usually only available for short-term periods. Unlike traditional rentals, Airbnb lets you rent out a portion of your home, or your entire home. Property owners earn money by renting their property by the night, which can provide regular or irregular cash flow, depending on the demand of the property within its specific market. Property owners are responsible for furnishing and maintaining the home for renters.
Airbnb rentals require much less expertise and supervision than traditional rentals for several reasons. Airbnb itself facilitates the booking of the rental property and creates the contract agreement between the property owner and renter. Because Airbnb manages several components of the rental process, Airbnb rental properties can be a part-time job or side hustle.
While Airbnb rentals can be a lucrative solution to the spare bedroom in your home, before listing, make sure that short-term rentals are allowed in your area. Homeowner associations have the power to ban short-term rentals, and in some cities, such as New York, there are existing bans against types of short-term rentals. And, make sure that you’re prepared to handle any possible headaches that may come up under Airbnb’s hosting policies.
Passive Real Estate investing (The Hands-Off Way)
Passive real estate investing offers opportunities to invest in real estate for everyone: those with extensive real estate and financial knowledge and those with limited or no expertise. Passive real estate investors typically provide only capital and allow professionals to invest in real estate on their behalf. As with stocks and bonds, passive investors bear responsibility only for their investments.
Private Equity Fund
A private equity fund is an investment model where investors pool their money together into a single fund to make investments. They are usually limited liability partnerships with a designated manager or management group. While the manager actively manages the equity fund’s investments, investors are not necessarily required to be directly involved on a regular basis. However, as an investor it is important to have the financial and real estate knowledge necessary to understand the risks and potential returns of each investment, because minimum investments are generally quite high.
Access to private equity funds is generally limited to accredited and institutional investors with high net worth. Investment minimums can vary, but are usually not less than $100,000. Private equity funds typically use a “two and twenty” model, in which they charge a 2% annual management fee and an additional 20% fee on any profits that the fund earns. Private equity funds are generally illiquid as well, and therefore necessarily limited to investors who can afford to tie up large amounts of money for long periods of time.
An Opportunity Fund is an investment model where investors pool their money together into a single fund to make investments in Qualified Opportunity Zones. Opportunity Zones are census tracts of low-income communities that have been nominated by state governors and certified by the US Department of Treasury. Opportunity Zones and Opportunity Funds fall under the Opportunity Zone program, which was created to encourage private investments in the development of economically distressed neighborhoods across the US.
By law, an Opportunity Fund must aim to invest at least 90% of its assets into property or businesses within Opportunity Zones. For real estate, the Opportunity Zone program was designed to promote the improvement of neighborhoods, so the types of allowed real estate investments is limited. Real estate investments are limited to the construction of new buildings, the redevelopment of previously unused buildings, or the Opportunity Fund must invest more in improvement than it paid to buy the property within 30 months of buying it.
Opportunity Funds investors can receive substantial capital gains tax incentives for their investments. An Opportunity Fund allows an investor defer taxes on realized capital gains invested into an Opportunity Fund until December 31, 2026. If the investment is held for at least five years prior to December 31, 2026, investors can expect a 10% reduction in tax liability on their deferred capital gains. If the investment is held for at least seven years prior to December 31, 2026, investors can expect a 15% reduction in tax liability on their deferred capital gains. And, if the investment is held for at least ten years, any capital gains earned from the investments should be permanently excluded from capital gains taxes.
Opportunity Funds are long-term investments that may or may not be illiquid. To receive the full tax advantages of an Opportunity Fund, investors must invest before December 31, 2019 and hold their investment for at least 10 years. They’re ideal for hands-off investors who want to maximize capital gain tax savings, but they’re generally limited only to investors who can afford to tie up their money in investments for long periods of time.
A real estate investment trust (REIT) is a company that makes debt or equity investments in commercial real estate. Generally, REITs offer a portfolio of real estate to investors. Investors buy shares of the company and earn income from its debt and equity investments in the form of dividends. Similar to a mutual fund, REITs were created as a way to give ordinary investors public access to real estate investments. By law, a REIT must earn at least 75% of its gross income from real estate and invest at least 75% of its assets in real estate. Additionally, it must distribute at least 90% of its taxable income to shareholders each year.
Today, REITs can be categorized according to investor access in three ways: private REITs, publicly-traded REITs and public non-traded REITs.
Private REITs aren’t registered with the SEC, and aren’t publicly traded on the stock market. Private REITs are similar to private equity funds in many ways. They are usually limited to accredited investors with high net worth, and while minimums are subjective, they are usually quite high. Private REITs also generally carry high fees, sometimes as much as 15%. Additionally, they are generally illiquid, which restricts access to those who can afford to invest large sums of money for long periods of time.
Publicly-traded REITs are registered with the SEC and traded in the stock market. Unlike most real estate investments, these are highly liquid with no investment minimum other than the price of the share, so investors can buy and sell them easily. While public REITs offer the greatest access, because they are correlated to the public markets, they are one of the real estate investments subject to the most volatility.
A public non-traded REIT is somewhat of a hybrid between a publicly-traded REIT and a private REIT. They are registered with the SEC, but not traded on the stock exchange. They can be open or restricted and their investment minimums can vary. They are usually illiquid and can carry high investment fees, but this is not always the case.
Online Real Estate Investment Platforms
Online real estate platforms pool investments and invest in real estate investment opportunities that would otherwise be difficult to find or out of reach on an individual level. Real estate platforms offer investors the ability to invest in single investments or a diversified portfolio of real estate. Some offer only debt investments and others offer both debt and equity investments. And, some focus on a specific city or region and other invest across the country. Many real estate investment platforms carry restrictions such as accreditation requirements and high investment minimums, but not all of them.
For example, Fundrise pools investments from thousands of investors of all sizes and leverages their collective buying power to invest in real estate investment opportunities that would otherwise be out reach of most investors on an individual basis. Our real estate team with more than $7.5 billion of experience acquires and manages our investments building nationally diversified portfolios of private real estate on behalf of our investors. Unlike other restricted real estate investments, Fundrise is open to everyone with no accreditation or net worth restrictions. It also gives investors access to greater liquidity than some other private market options through a quarterly redemption, subject to certain restrictions and limitations. Additionally, Fundrise investments carry low fees and a low investment minimum of $500.
Putting it All Together
Real estate has a track record of strong performance. Real estate investing offers the potential to earn significant returns and add meaningful diversification to your portfolio. When managed wisely it can become a valuable source of cash flow in your investment portfolio. As with any investment, real estate investments require you to understand and weigh the risks and potential rewards before beginning. Depending on which way you choose invest in real estate, you’ll need varying amounts of time, beginning capital, knowledge, and patience.
If it fits with your goals, available resources, and personality, fast-paced, high-risk house flipping ventures may be what makes most sense with you. If you don’t have extensive knowledge and experience to venture into house-flipping, or if you don’t have a strong desire to become a landlord, you can still access the diversification benefits and earning potential of real estate. There are passive investment options, such as Fundrise, that can help you unlock real estate without the ongoing obligations that fall on the shoulder of active investors.