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How To Invest In Real Estate

Hanna KielarJanuary 08, 2020

Investing in real estate is a great way to build wealth. Industrialist Andrew Carnegie famously said, “Ninety percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.”

However, according to a recent RealtyShares survey, only 15% of Americans have a real estate investment outside of their primary home. So why don’t more people invest in real estate? For many, it’s fear. They ignore the tremendous possibilities and instead focus on the things that can go wrong. But for others, it’s a lack of understanding and lack of education on what it takes to be a great real estate investor.

Learning how to invest in real estate is a big commitment. It’s important to put in the time to understand exactly what it takes to become successful. When done properly, a real estate investment can be a very profitable endeavor.

What Is Real Estate Investment?

Before you make the jump and decide to purchase your first investment property, it’s important to understand the basic principles of real estate investing.

As a real estate investor, there are two things you look for. The first is appreciation and the second is potential rental income. When you purchase any property, you’re hoping that its value increases (or appreciates) over time. Unfortunately, during the great recession, housing prices across the United States fell by an average of 33 percent. This meant a significant loss of wealth for many investors. Luckily, the market turned around and prices have rebounded dramatically.

The next major factor to pay attention to is rental income. When you purchase a home and rent it out, you collect rent payments each month. While appreciation on a home is only realized when you choose to sell the property, rental income is realized every month you have a tenant in your home.

Owning physical property isn’t the only way to invest in real estate. Next, we’ll talk a little more about some of the different types of real estate investments.

4 Ways To Invest In Real Estate

1. Buy Rental Properties

The first option for buying a real estate investment is through a rental property. The primary goal of any rental property is to collect rent every month that’s greater than the monthly expenses on the home. Ideally, the value of the home will also appreciate over time and you’ll eventually be able to sell it for more than you paid.

Owning a rental property isn’t going to be for everyone. It requires much more than just collecting a rent check. You need to find quality tenants, handle any issues that might arise, and manage all of the bookkeeping. You can choose to hire a management company that will take on most of the work, making this a passive income investment, but doing so will cut into your profits.

Buying a rental property can have the potential for huge profits. If you find a house that needs a little bit of work, you have the chance to put in some sweat equity. Not only will the upgrades help you increase rent, but it will also boost the value of the home.

2. Flip Houses

Another way to invest in real estate is to purchase a property with the sole intention of flipping it quickly for a profit. The process is pretty straightforward. Start by finding a home that needs a considerable amount of work. Ideally, you want the structure of the house to be in good shape, but have it need a lot of work inside and out to make it appealing to buyers. Once you’ve purchased the house, you go in and make all the updates and then put it back on the market to sell. The goal is to sell it for a much higher price than what you paid.

The upside to flipping houses can be huge, but it comes with a lot of risk. When you purchase the home, you typically can’t see what’s inside the walls. There could be structural issues that you can’t uncover until you start opening things up. You might discover termites have lived in the home at some point. Maybe the home has out of date electrical wiring. Each of these items is a risk that can cut into your profits.

Flipping a house is also something that requires speed. Every day the house is under construction is one more day you’re paying the mortgage and losing out on potential profits. The goal is to purchase the house, renovate it and sell it again in as few days as possible. If you’re not well-versed in construction, flips will require hiring great contractors you can trust to get the job done well and quickly.

3. Buy Real Estate Investment Trusts

REITs are popular because they allow individuals to invest in real estate without actually owning physical property. A REIT is a company that owns a large group of properties. It could be apartment buildings, shopping malls, or even commercial office buildings. REITs typically pay high dividends which make them great for income investors.

REITs can be great investments, but they also come with risks. Most REITs don’t have much correlation to the broader stock market, but that’s not always the case. There are some funds that can move in unison to the markets they’re traded on. REITs are also highly affected by housing prices. When housing prices decline significantly – as they did between 2007 and 2009 – REIT values will also suffer.

Unlike investing in rental properties or flips, REITs require very few resources to get started besides cash. Most REITs are traded on an exchange just like an individual stock. This means you can use your existing brokerage account to buy and sell a REIT. However, there are other REITs that are not listed on public exchanges. These have quite a bit more risk since they tend to be less liquid.

4. Consider Real Estate Funds

A lot of people think of REITs and real estate funds as being the same thing. They are actually different investment vehicles, though they work together. Earlier we said that REITs are businesses that invest in income-generating real estate like shopping malls or office buildings. In contrast, real estate funds are mutual funds that frequently invest in REITs. Real estate funds are managed by portfolio managers, so they are a much more hands-off form of investing.

Similar to REITs, a real estate fund is going to be heavily correlated to the real estate market as a whole. When commercial and residential prices are increasing, fund prices are going to be increasing as well. Similar to a REIT, a real estate fund can be bought and sold through a broker like TD Ameritrade or directly through the mutual fund company.

5 Tips For Investing In Real Estate

1. Evaluate Your Portfolio

One of the biggest keys to your success as an investor is diversification. By investing in different sectors of the economy, you’re protecting yourself from weakness. Real estate is an excellent hedge against the overall stock market because housing prices typically lag behind the overall market. Some experts recommend investing no more than 10 percent of your portfolio in real estate, while others say you can go as high as 30 percent. The ideal number should depend on things like your risk tolerance and desire for liquidity.

2. Work With A Real Estate Agent

When you bought your primary residence, you probably worked with a real estate agent. The same should be true for an investment property. There are a lot of benefits to having a knowledgeable professional on your side throughout the process. It doesn’t matter if you’re looking to purchase your first investment property or your 10th, agents know exactly what you need to look for when purchasing a home. You probably know how many bedrooms or bathrooms you want or whether you prefer carpet or hardwood floors. But an agent understands deeper issues like potential problems with an HVAC system or an aging roof.

3. Buy With Location In Mind

You’ve probably heard the saying, “Location, Location, Location.” If you’re purchasing a rental property or a flip, the location should be a major factor in where you purchase. Buyers want to live in desirable locations that have a lot of upsides. They want to see amenities like grocery stores, restaurants and shopping malls nearby. They like being able to walk to parks or public transportation. When you’re buying a property, make sure you’re considering what your ideal buyer or tenant would want.

4. Consider The 1% Rule

If you’re planning to purchase a rental property, consider the 1% rule. This states that potential rent should be at least 1% of the purchase price. That means if you’re buying a house for $100,000, you should be able to charge $1,000 or more per month in rent.

5. Start Small

Getting started as a real estate investor is exciting, but it’s important to take things slow instead of jumping in too fast. This is especially true if you’re planning to purchase a rental property. A lot of younger investors are choosing to start with a duplex. They rent out one side and live in the other. This has become known as house hacking. When done right, the rent you collect can cover a majority of the mortgage payment each month. This can help you save money and grow your real estate business.

The Tax Considerations Of Real Estate Investment

Beyond generating income, real estate investing offers many benefits. One is the tax incentives given by the federal government. Because real estate is considered a business, you’re allowed to deduct all reasonable expenses. That includes things like interest paid on the mortgage, the cost of hiring a management company and any maintenance that’s required.

You might also assume that upgrades you make to the home would also be a deductible expense, but the IRS looks at these differently. Any update you make would be considered an improvement, which isn’t deductible. Instead, they’re depreciated using IRS Form 4562.

The most significant tax benefit you’ll receive as an investor is depreciation. Typically, you’re allowed to depreciate residential property over 27.5 years and commercial property over 39 years. Depreciation gives investors the ability to deduct a certain amount each year, reducing your tax liability. There are two ways this can be done. The first way would give an equal deduction each year. Or you could use an accelerated method which allows you to deduct a greater amount in the beginning and then decreased amount over time.

Finally, when you sell a real estate investment, you’ll have either capital gains or losses. If you own a REIT or a real estate fund, capital gains are taxed the same way as a stock or mutual fund transaction. You’ll pay short-term capital gains, based on your tax bracket, if you held the investment less than 1 year. But if you held it for more than 1 year, you’d pay long-term capital gains of 0, 10, or 20 percent depending on your income.

When you sell a primary residence, you’re given an exclusion on paying capital gains taxes on the profits. Currently, you can exclude the first $250,000 when filing single or $500,000 when filing married. Unfortunately, real estate investment properties are not taxed the same way. Instead, when you sell a rental property, you’ll be taxed on any amount over the original purchase price plus the costs to bring it to its current rentable state.

Is Real Estate The Right Investment For You?

It’s no secret that real estate is a great way to build wealth. It can lead to a continuous stream of passive income. However, certain types of real estate investments are not going to be for everyone. If the thought of fielding calls at 2 a.m. when the water heater breaks or having a difficult conversation with a tenant who’s late on rent doesn’t excite you, then becoming a landlord probably isn’t a great fit.

Luckily, with the growing popularity of REITs, real estate funds and even crowdfunding platforms like Fundrise, the ability to diversify your investment portfolio with real estate is more accessible than ever.

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    Hanna Kielar

    Hanna Kielar is an Associate Section Editor for Rocket Companies focused on personal finance, recruiting and personal loans. She has a B.A. in Professional Writing from Michigan State University.