Many experts agree: real estate is the best investment you can make.
Why? The short answer is that there’s only so much land. The long answer is more complicated, but it involves steady appreciation, positive cash flow, a competitive seller’s market, and a whole list of tax breaks.
Of course, the one drawback of real estate is that it’s expensive – much more expensive than buying stocks or setting up an index fund. But you can still invest in the real estate market, even if you don’t have five or six figures of cash to put on the table.
There are ways to invest in the real estate market without even buying a physical property, and eligible buyers can potentially purchase a property with no money down. Point is, if you’re determined to get your money working for you, there’s always a way.
Read on for our definitive guide to how to get started as a real estate investor.
- 5 Simple Ways to Start Investing in Real Estate
- How to Buy Your First Investment Property
- The Four Ways to Make Money Investing in Real Estate
- Best Types of Investment Properties for Beginners
- How to Invest in Real Estate with Little Money to No Money Down
Simple Ways to Invest in Real Estate
Below are some of the most popular ways to put your money into real estate. We’ll start with the easiest, least labor intensive option, and proceed to the most time-consuming.
The real estate investment trust, or REIT, is essentially an index fund for real estate. The fund owns a portfolio of properties that might include apartment buildings, commercial/retail properties, shopping malls, or offices. When you buy shares of a REIT, you’re buying a small portion of that portfolio, which entitles you to a proportional share of its profits.
This is probably the easiest way to profit from the real estate market, without actually taking on the responsibilities that come with owning property. You can put a few hundred dollars in, and let it work for you.
The downside is that you won’t actually own any property; if you’re drawn to real estate as a real, substantial investment, as opposed to a paper investment, this doesn’t quite scratch that itch. The other downside is that, if you buy a residential investment property, someone will loan you the money to do it. Not so with a REIT; you’ll have to put your own money on the line.
Rent Out a Room
If you already own a home— or even if you’re a renter— you can dip a toe into the “being a landlord” pool by renting out a single room in your home. If you live in a college or university town, this shouldn’t be difficult at all. With proper vetting, it’s easy to find a dependable, unobtrusive tenant, and once you experience the monthly flow of rental checks, you’ll understand the value of real estate investment.
Of course, the downside is that you’ll have someone living in your home, which will entail the loss of some privacy. But if you’re considering buying a rental, but aren’t sure if you’re up for being a landlord, this is an easy way to find out.
Fix and Flip
House flipping in an enormously popular, and enormously lucrative way to invest in the real estate market. You’re probably familiar with at least the basic outlines of how it works; you buy a home, you fix it up, and you sell it at a price that’s greater than the purchase price plus the money you put into it. Of course, it’s not quite as easy as it sounds.
On the front end, you have to locate properties that are both undervalued and not in terrible condition. If you have to do a gut renovation, you’re probably going to end up losing money, so the ideal flipping candidate will have outdated finishes but “good bones.” Many flippers use scouts to find undervalued properties for them.
Once you have the property, you’ll need dependable contractors to do the repairs and renovations. Cost overruns cut directly into your profits, so this is extremely important. Time is also of the essence, because just owning the property comes with carrying costs; this includes things like mortgage payments (if you went that route), utilities, property taxes, etc. Every month you own the home is costing you money.
And then there are the tax implications, which are in uneasy tension with the carrying costs. The longer you own the home, the more you pay in carrying costs. But when it comes to taxes, especially capital gains, it can actually be advantageous to own the property for more than a year, at which point your profits from the sale will be taxed at the much lower “long term” capital gains rate.
The way the tax code is written, any investment you sell that you’ve owned for less than a year is taxed as regular income, which is likely a much higher rate than the long term capital gains rate. So home flippers get a huge break by holding onto their properties for a year and a day before they sell— the downside being, as we discussed, that every day you own a property costs money.
There’s no easy answer to this conundrum; if you decide to try your hand at house flipping, it’s a problem you’ll have to solve for yourself.
A Vacation Rental
Buying a vacation rental can be a comfortable median between the previous options on this list and being a full time landlord. Owning a property in, say, a skiing hotspot like Vail, CO, or a beach hotspot like the Florida Keys means you’ll be renting it during the high season and, most likely, letting it go vacant during the rest of the year. That has a few implications for your investment prospects.
First, the high season will command extremely high rents, and you’ll probably have no problem finding renters. That being said, if you do, for whatever reason, struggle to find a tenant for a season, your losses are going to be rapid and steep. You should also keep in mind that vacation tenants have very high standards, so you’ll want to continually update your property, and provide very responsive service. You may even want to consider hiring a professional property management company, especially if the property is going to be vacant during the offseason.
Unoccupied dwellings need to be regularly monitored; even small accidents like fallen tree branches or frozen pipes can quickly mushroom into serious problems if they aren’t detected early. And larger problems like storms or break-ins can be catastrophic.
Most vacation communities have property managers or caretakers who’ll look after rental properties during the offseason, but they aren’t free. You’ll want to carefully do the math before you take the plunge into this kind of investment, to make sure the financials work.
Housing hacking is when you own a multi-unit property, live in one of the units, rent out the other units, and use those rents to pay the mortgage on the property. This essentially means you’re living rent-free, and your tenants are paying your mortgage.
The financial potential of this kind of setup is obvious. In the U.S., the average person pays 37% of their income toward housing, so you can cut out more than ⅓ of your expenses simply by buying a multifamily house and having your tenants cover your mortgage!
The main drawback is that you’ll be an on-site landlord. That means that if a tenant’s smoke alarm needs a new battery or if someone’s toilet gets clogged at 4 in the morning, there’s going to be a knock at your door.
Even if you hire a professional property manager to handle issues like this, you’ll still rub shoulders with your tenants every day, and you can bet they’ll let you know if they’re having any problems. That’s well within their rights as paying tenants, of course; but you could quickly find out that being a landlord is a full-time job, and then some.
You also need to run the numbers to ensure your expenses are truly covered by the tenants. If you buy a rundown property with outdated capital expenditures and don’t account for repairs, your amazing investment can turn into a money pit of despair.
That’s why we’re going to cover the four ways you make money in real estate.
How to Buy Your First Investment Property
Let’s get into the nuts and bolts of property investing – the money. Where will it come from? Where should it go? How much will you owe the bank and the IRS?
We’ll get into all those questions below.
The Four Ways to Make Money
So let’s say you’ve decided to buy an investment property. How does it generate income? Novice investors might be surprised to learn that cash in hand— i.e. rent checks— is just one of the ways that your investment property can make you money. Let’s look at the four ways to make money off your investments.
Let’s not overlook cash flow. To calculate your cash flow, you simply add up all the cash you took in from your investments that month, and subtract all your expenses. What’s left is your cash flow. As long as your expenses don’t exceed your income, this should be a steady source of income.
Pro tip: Don’t spend that money on indulgences! Either reinvest it or save it for repairs.
Some people think rental income is “passive” income, but anyone who’s ever been a landlord will tell you that there’s nothing passive about it. Appreciation, however, is essentially passive wealth generation. Regardless of your circumstances, your property is likely appreciating in value, year after year, making it more and more valuable. And you don’t have to do a thing.
Is this always steady and predictable? No, of course not. There are down years, like after the 2007 financial crash. But on a long enough time table, buying and holding real estate tends to result in steady appreciation.
You can also think of this as equity-building. Equity is simply the difference between a property’s value and the amount owed on it. As you pay down your mortgage, and the property’s value increases, that gap— your equity— grows larger and larger.
Equity is real wealth; you can convert home equity to a line of credit, or do a simple cash out refinance, and walk away with money in your pocket.
It’s probably not much of a secret at this point that the U.S. tax code incentivizes home ownership. There are a lot of tax benefits available to property owners, from the depreciation deduction, to a long term capital gains rate that’s much lower than the tax rate for regular income, to devices like the 1031 exchange, which allow you to essentially trade on investment for another, while deferring capital gains taxes entirely.
Best Types of Investment Properties for Beginners
Convinced that investing in real estate is the way to go? Then your next decision should be what kind of property to buy. Here are a few suggestions for each signature approach.
For House Hackers: a Small Duplex or Quadplex
This is the ideal property for someone interested in house hacking. The idea is simple: buy a duplex, live in one half, and rent out the other half.
A true house hacker might want to aim for a triplex or a quadplex, though; a duplex might not generate enough passive income to cover the entire mortgage. Anything above 4 units, however, is getting close to a large-scale landlord situation.
For Vacation Rental Owners: a Property with a Granny Flat/Guest House
Let’s be honest: it’s going to be tough to own a property in a fantastic vacation destination, and not want to stay there during high season, at least for a little while. Looking for a property with a small additional property on the premises at least gives you that option, without cutting off your income entirely.
Or consider buying a tiny home and putting it on your property. And keep in mind that, if you don’t stay in one of the units, you essentially have two properties to rent, at slightly different price points.
For Bargain Hunters: a Retail Property
In October 2020, several months into the pandemic and with no end in sight, large swaths of the commercial real estate markets have hit record lows. If you’re looking for value, it’s hard to find an asset that’s more distressed— with better prospects for a quick turnaround in the near future— than a retail property.
For the Long-Term Planner: Land
A lot of people forget that when you buy property, the land brings as much or often more value than whatever’s built on top of it. So if you’re in this for the long run, buying a strategically located plot of land can offer amazing value.
Land is also a great approach if you don’t yet know if you’re buying to own, or buying to sell; the beautiful thing about owning a plot of land is that you can resell it, or you can build your dream home on it.
How to Invest in Real Estate with Little Money
A lot of prospective investors think they can’t get in the game because they simply don’t have enough money on hand. But that’s not always true— there’s often a way to get financing, no matter your credit score or history. Let’s look at some of the most popular options.
The Federal Housing Administration (FHA) guarantees mortgages at very generous terms; some buyers can put as little as 3.5% down. Even buyers who’ve dealt with bankruptcies or foreclosures can qualify for an FHA loan, though they may have to put 10% down.
Investors should keep in mind that one of the requirements of the FHA loan is that it has to be the buyer’s primary residence.
If you served in the military, or are an eligible spouse of someone who did, you can get a loan guaranteed by the VA at extremely advantageous terms. VA loans require no down payment, and have no minimum credit score requirement.
For eligible investors considering fix-and-flips, the VA also offers rehab and renovation loans.
These loans, guaranteed by the USDA, can come with zero down payment and interest rates as low as 1%. The only catch? They’re targeted at rural and suburban areas, so you won’t be able to secure a USDA loan if you want to buy in a city.
USDA loans are for owner-occupied properties, and they also offer home improvement loans and grants.
This setup is often called “lease to own” or a “land contract.” This is an agreement, often over a mortgage-like term of 30 years, in which the buyer makes monthly payments; at the end of the term, they’ll become the owner of the home.
While this sounds a lot like a traditional mortgage, many experts consider this setup to be exploitative and unethical. For example, some of these agreements come with open-ended eviction clauses, so the owner can kick out the occupant on short notice, and keep all the payments they’ve made, as lease-to-owners don’t accrue equity with their payments, as they would in a traditional mortgage.
This kind of arrangement can work, if there are proper protections written into the agreement. But investors should be wary and bring a real estate lawyer to review the contract.
Hard money loans
If you’re a house flipper, a traditional mortgage might not make much sense— if you’re selling in less than a year, why would you ask for a 30-year mortgage?
Hard money loans are the solution to this problem. Also called bridge loans, this is simply money from a private lender that’s used for a short-term investment project. They come with a much higher interest rate than a conventional loan, and carry a much shorter term, but they can be a lifesaver for investors who want to get in and get out.
A lot of investors think they can’t afford to start investing in real estate, but once you see all the potential options, you realize you can’t afford not to. No matter your budget, there are ways to buy into the market, at whatever scale and level you prefer.
Of course, if you put aside dumb luck, the quality of your investment is going to be equivalent to your understanding of the market. That is, if you really understand the dynamics of your local market, you’ll be able to spot the opportunities— and profit from them.
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