What You Need to Know When Investing in Real Estate
Various methods for investing in real estate
Your home is usually the first thing that springs to mind when you think about real estate investing. Of course, real estate investors have many additional possibilities for investing, and they are not just physical assets.
Over the last 50 years or more, real estate has been a popular investment instrument. Here are some of the best possibilities for individual investors, as well as some compelling reasons to invest.
For good reason, real estate has long been regarded as a sound investment. Prior to 2007, historical housing data suggested that prices could continue to rise indefinitely. With rare exceptions, the average sale price of a home in the United States grew every year between 1963 and 2007, when the Great Recession began. Home prices did fall slightly when the COVID-19 epidemic began in the spring of 2020. However, as vaccines became available and pandemic fears faded, home prices surged, reaching all-time highs by 2022.
This graphic from the Federal Reserve Bank of St. Louis depicts average sales prices between 1963 and the first quarter of 2022. (the most recent data available). The areas coloured in light gray are recessions in the United States.
If you invest in rental homes, you will become a landlord, so evaluate whether you will be comfortable in that role. You will be responsible for paying the mortgage, property taxes, and insurance, as well as maintaining the property, finding renters, and dealing with any difficulties as the landlord.
Being a landlord is a hands-on investment unless you employ a property manager to handle the chores. Depending on your circumstances, taking care of the property and the tenants might be a 24/7 job—and not necessarily a pleasant one. However, if you choose your homes and tenants carefully, you can reduce the likelihood of major difficulties. Rent collection is one method landlords make money.
The amount of rent you can charge is determined by the location of the rental. Still, determining the appropriate rent can be tricky because charging too much can drive tenants away, while charging too little will leave money on the table. A frequent technique is to charge enough rent to meet expenditures until the mortgage is paid off, at which point the majority of the rent turns into profit.
The other major source of money for landlords is appreciation.
If the value of your property rises, you may be able to sell it at a profit (when the time comes) or borrow against the equity to fund your next investment. While real estate tends to improve over time, there are no guarantees.
This is especially true during moments of high volatility in the real estate market, such as the current COVID-19 pandemic. From February 2020 to March 2022, median real estate prices in the United States increased by 38%. Many people are asking if prices would drop as a result of the big increase.
Real estate flippers are not the same as buy-and-hold investors, just as day traders are not the same as buy-and-hold investors. Flippers purchase properties with the goal of holding them for a short amount of time—typically three to four months—and then swiftly flipping them for a profit.
There are two techniques to flipping a house:
- Repair and upgrade You take this technique by purchasing a property that you believe will improve in value with certain renovations and updates. Ideally, you finish the job as soon as possible and then sell it for a price that surpasses your whole investment (including the renovations).
- Keep and resell. This method of flipping is unique. Rather than purchasing a house and repairing it, you purchase in a quickly rising market, keep for a few months, and then sell for a profit.
You incur the danger of not being able to sell the property at a profitable price with any type of flipping. This can be difficult because flippers rarely retain enough cash on hand to pay long-term mortgages on houses. Still, if done correctly, flipping may be a profitable method to invest in real estate.
REITs are founded when a corporation (or trust) is formed to use the money of investors to buy, run, and sell income-producing assets. REITs, like stocks and exchange-traded funds, are traded on major exchanges (ETFs).
To qualify as a REIT, the firm must distribute 90% of its taxable income to shareholders in the form of dividends. REITs avoid paying corporate income tax in this manner, whereas a traditional firm would be taxed on its profits, reducing the returns it might give to its shareholders. REITs, like conventional dividend-paying equities, are excellent for investors seeking consistent income while also providing the chance for capital appreciation. REITs invest in a wide range of properties, including malls (which account for roughly 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.
Real Estate Investment Organizations
Real estate investment groups (REIGs) are similar to tiny mutual funds that invest in rental properties. A real estate investment group may be the solution 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 collection of structures, typically apartments, and then allow investors to purchase them through the company, thus joining the group. A single investor can own one or more self-contained residential units. However, the business that runs the investment group administers all of the apartments and handles maintenance, advertising, and finding tenants. The company takes a part of the monthly rent in exchange for this management.
There are various types of investment groups. 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 you'll get enough money to cover your mortgage even if your unit is unoccupied.
The quality of an investment group is totally dependent on the organization that provides it. In theory, it is a safe method to get started in real estate investing, but groups may levy the kinds of excessive fees that have plagued the mutual fund sector. As with any investment, research is essential.
Limited Partnerships in Real Estate
A real estate limited partnership (RELP) is analogous to a real estate investment trust (REIT). It is a legal corporation formed to acquire and hold a portfolio of properties, or sometimes only one. RELPs, on the other hand, have a limited lifespan.
The general partner is an experienced property management or real estate development firm. After that, outside investors are sought to offer money for the real estate project in exchange for a stake in the company as limited partners. The partners may get periodic dividends from the RELP's profits, but the true return comes when the properties are sold—hopefully at a significant profit—and the RELP dissolves afterwards.
Mutual Funds for Real Estate
Real estate mutual funds generally invest in REITs and REIT operating firms. They enable you to obtain diversified exposure to real estate with a minimal amount of funds. They give investors with a far greater asset selection than buying individual REITs, depending on their strategy and diversification aims.
These funds, like REITs, are fairly liquid. Another key benefit to individual investors is the fund's analytical and research material. This can include information about purchased properties as well as management's assessment of the viability and performance of specific real estate investments and the asset class as a whole. To optimize profit, more speculative investors can invest in a family of real estate mutual funds, tactically overweighting specific property types or areas.
Why Should You Invest in Real Estate?
Real estate can improve an investor's risk-return profile by providing competitive risk-adjusted returns. In general, the real estate market has moderate volatility, particularly when compared to equities and bonds.
When compared to more traditional forms of income return, real estate is also appealing. This asset class often trades at a yield premium to US Treasuries and is especially appealing in a low-interest-rate environment.
Diversification and safeguarding
Another advantage of investing in real estate is the opportunity for diversity. Real estate has a low and, in some circumstances, negative correlation with other main asset classes, which means that when equities fall, real estate often rises. This indicates that adding real estate to a portfolio can reduce volatility while increasing return per unit of risk. The better the hedge, the more direct the real estate investment: Less direct publicly traded vehicles, such as REITs, will mirror the overall performance of the stock market.
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 more indirect kinds of investment provide some level of protection. REITs, for example, require a minimum percentage of profits (90%) to be distributed as dividends.
Hedging Against Inflation
The capacity of real estate to hedge inflation arises from the positive link between GDP growth and demand for real estate. As economies grow, the demand for real estate rises, resulting in greater rents and higher capital values. As a result, real estate tends to retain capital purchasing power by passing some inflationary pressure on to tenants and incorporating some inflationary pressure in the form of capital appreciation.
The Influence of Leverage
With the exception of REITs, investing in real estate provides an investor with one weapon that stock market investors do not have: leverage. Leverage refers to the utilization of debt to fund a larger purchase than you have sufficient cash for. If you wish to buy a stock, you must pay the full purchase price at the time you make the order—unless you are purchasing on margin. Even still, thanks to that magical financing method, 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 may be able to acquire a mortgage with as little as 5% down. This means you can control the entire property and its equity simply by paying a percentage of the overall value. Of course, the size of your mortgage influences how much ownership you have in the home, but you have power over it the moment the papers are signed.
This is what motivates both real estate flippers and landlords. They can get a second mortgage on their homes while also making down payments on two or three other properties. Whether they rent things out to pay the mortgage or wait for a good chance to sell for a profit, they have ownership over these assets despite having only paid a small portion of the total worth.
How Can I Expand My Real Estate Portfolio?
Aside from directly purchasing properties, regular investors can acquire REITs or funds that invest in REITs. REITs are pooled investments that own and/or manage real estate or mortgages.
Why is real estate regarded as an inflation hedge?
Home prices typically rise in lockstep with inflation. This is because the costs of homebuilders rise with inflation, which must be passed on to new home buyers. Existing home prices climb in lockstep with inflation. If you have a fixed-rate mortgage, your regular monthly payments become more affordable when inflation rises. Furthermore, as a landlord, you can raise the rent to keep up with inflation.
Why Do Interest Rates Affect Home Prices?
Because real estate is such a vast and expensive asset, loans are frequently required to finance its purchase. As a result, rising interest rates make new mortgage payments more expensive (or on existing adjustable-rate loans like ARMs). This may deter buyers, who must consider the cost of carrying the property on a month-to-month basis.
Real estate can be a good investment that can give a consistent income and help you create wealth. Still, one disadvantage of real estate investing is illiquidity: the difficulty in changing an asset into cash and cash into an asset.
A real estate deal can take months to close, as opposed to a stock or bond transaction, which can be finished in seconds. Even with the assistance of a broker, finding the proper counterparty can take several weeks. Naturally, REITs and real estate mutual funds provide superior liquidity and market pricing. However, they come at a higher price in benefits of volatility and diversification, as they have a considerably larger link to the general stock market than direct real estate investments. Keep your expectations realistic, like with any investment, and do your homework and research before making any decisions.