For many investors, real estate is uncharted territory. Unlike stocks and bonds — traditionally considered “standard assets” — real estate is an “alternative asset,” historically difficult to access and afford… until recently. But just because real estate is an unknown doesn’t mean that it should be avoided as an investment opportunity. When approached correctly, real estate can be a lucrative and reliable way to generate substantial income. Real estate can generate an income stream while supplementing your portfolio’s other asset classes with unique benefits, including cash flow, portfolio diversification, and tax benefits. But, despite obvious upsides, real estate can seem intimidating to outsiders, without an obvious starting point. That doesn’t need to be the case: In this article, we discuss the fundamentals of real estate investing and six different ways that you can get started right away.
So, first thing’s first: What is real estate investing?
What is Real Estate Investing?
Real estate investing is the purchase, ownership, rental, or sale of land and any structures on it for the purpose of earning money. Real estate breaks down into three categories: residential, commercial, and industrial.
- Residential real estate: Residential real estate consists of single family homes, townhouses, condominiums, and multifamily homes that people use as a living space and not a working space. Homes larger than four units are considered commercial property. 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 multifamily. Specific examples of commercial real estate properties include business offices (office), restaurants (retail), farmland (land), and large apartment buildings (multifamily).
- Industrial real estate: 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 on the loan principal. Debt investing provides an investor with regular cash flow. Depending on the number of lenders, there can be one or several types of debt within the capital stack of the investment. Types of debt include senior debt, junior debt, and mezzanine debt. Debt can also be secured or unsecured, which define an investor’s rights in the case of a property’s foreclosure. A loan is a 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 option 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 investment or rental income, a sale provides a large, one-time payment. Depending on the number of owners of a property, equity can be categorized as preferred equity or common equity. Equity ownership can be an active or passive investment depending on the position of the investment in the capital stack.
- Rent: The owner 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 property owners manage their real estate (independently or through a hired manager), they may keep their earnings or share it with a property management company.
Each kind of real estate and investment type 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. Regardless of who performs the underwriting, due diligence plays a vital role in making a decision on an investment, guiding whether an investment opportunity can meet your financial goals.
Many investors value 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 six fundamental ways to invest in real estate with options ranging from active investments, which require high effort, to passive investments, which require low effort.
Active Real Estate Investing
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 analytical and negotiation skills to improve their cap rate and overall return on investment.
Houseflipping 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 resells it a higher price. Houseflipping is generally short-term, because the longer the investor owns the home without leasing it to tenants, the less money they will earn 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 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, tearing down walls to change floor plans, or adding completely new square footage — and then sell the home at a higher price, turning a profit.
While houseflipping is exciting, it also requires deep financial and real estate knowledge to ensure that you can makeover the home within time and budget constraints to ensure a profit in the housing market when finished. The success — and the financial burden — of a house flip falls entirely on the investor. You also need enough cash for a down payment and/or good credit to secure a home loan in order to buy a property before another flipper. 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 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 down payment. 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 an investor in line to buy the home 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 rent payment from tenants. This can provide a steady, reliable income stream for investors, but it also requires a lot of work or delegation 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 checks for prospective tenants and providing 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, emergencies, evictions and record-keeping for the properties. 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 the 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 they cede some control of their properties and lose a portion of their monthly income.
Airbnb is a 21st century technology company that allows residents to list and rent their homes on a night-by-night 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 personal home, your entire personal home while you’re not present (such as when you’re on vacation) or the entirety of a second home that you own. 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.
Passive Real Estate investing
Passive real estate investing offers opportunities to invest in real estate for those with extensive real estate and financial knowledge as well 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 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 are not registered with the SEC, and not publicly traded in 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, and therefore necessarily restricted to those who can afford to invest large amounts 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, so investors can buy and sell them without barriers. 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. Real estate platforms offer investors the ability to invest in single investments or a diversified portfolio of real estate. Many real estate investment platforms carry restrictions such as accreditation requirements and high investment minimums.
For example, Fundrise pools investments and leverages investors’ collective buying power to invest in real estate opportunities that would otherwise be out reach of most individual investors. Through Fundrise, investors can invest in eREITs and eFunds. An eREIT is a non-traded REIT offered only on Fundrise’s tech-driven platform and an eFund is a diversified portfolio of for-sale housing. Unlike other restricted real estate investments, Fundrise’s offerings open investment opportunities to all investors without accreditation or net-worth restrictions. It also gives investors greater liquidity than some other options with quarterly redemption options. Additionally, Fundrise investments carry low fees and a low investment minimum of $500.
Putting it All Together
Real estate investing offers great potential to earn significant returns. It can become a valuable source of cash flow in your investment portfolio when managed wisely. 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.