Whether you're curious about the investment potential of real estate or you're simply sick of infomercials promising little-known ways to "profit from your property," it's worth learning, for real, how real estate creates wealth.
Rather than providing obscure strategies for investing in real estate or a primer on homeownership for first-time buyers, this article will focus on how to make money through real estate. It will cover both the basic methods that haven't changed in centuries, no matter what kind of gloss the gurus of the moment try to put on them, as well as specific opportunities that have arisen relatively recently.
- The most common way to make money in real estate is through appreciation—an increase in the property's value that is realized when you sell.
- Location, development, and improvements are the primary ways that residential and commercial real estate can appreciate in value.
- Inflation can also play a role in increasing a property's value over time.
- You can also make money in the form of income from rents for both residential and commercial properties, and companies may pay you royalties on raw land, for example, for any discoveries, such as minerals or oil.
- Real estate investment trusts (REITs), mortgage-backed securities (MBSs), mortgage investment corporations (MICs), and real estate investment groups (REIGs) are investment alternatives within the real estate sector.
Real Estate Profits From Increasing Property Value
The most common way real estate offers a profit: It appreciates—that is, it increases in value. This is achieved in different ways for different types of property, but it is only realized in one way: through selling. However, you can increase your return on investment on a property in several ways. One way—if you borrowed money to buy the property—is to refinance the loan at lower interest. This will lower your cost basis for the property, thus increasing the amount you clear from it.
The most obvious source of appreciation for undeveloped land is, of course, developing it. As cities expand, land outside the limits becomes increasingly valuable because of the potential for it to be purchased by developers. Once developers build houses or commercial buildings, it raises that value even further.
Appreciation in land can also come from discoveries of valuable minerals or other commodities—provided the buyer holds the rights to them. An extreme example of this would be striking oil, but appreciation can also come from gravel deposits, trees, and other natural resources.
When looking at residential properties, location is often the biggest factor in appreciation. As the neighborhood around a home evolves, adding transit routes, schools, shopping centers, playgrounds, and more, these changes cause the home's value to climb. Of course, this trend can also work in reverse, with home values falling as a neighborhood decays.
Home improvements can also spur appreciation. Putting in an extra bathroom, heating a garage, and remodeling a kitchen with state-of-the-art appliances are just some of the ways a property owner may try to increase the value of a home.
The Role of Inflation in Property Values
When considering appreciation, you have to factor in the economic impact of inflation. An annual inflation rate of 10% means that your dollar can only buy about 90% of the same goods the following year, and that includes property. If a piece of land was worth $100,000 in 1970 and it sat dormant and undeveloped for decades, it would still be worth many times more today. Because of runaway inflation throughout the 1970s and a steady pace since, it would likely take more than $500,000 to purchase that land now, assuming $100,000 was fair market value at the time.
Thus, inflation alone can lead to appreciation in real estate, but it is a bit of a Pyrrhic victory. While you may get five times your money due to inflation when you sell, many other goods cost five times as much to buy too, so purchasing power in your current environment is still a factor.
Real Estate Profits From Income
The second big way real estate generates wealth is by providing regular payments of income. Generally referred to as rent, income from real estate can come in many forms.
Raw land income
Depending on your rights to the land, companies may pay you royalties for any discoveries or regular payments for any structures they add. These include, for example, pump jacks, pipelines, gravel pits, access roads, and cell towers. Raw land can also be rented for production, usually agricultural production, and land tracts with trees may be valuable for the timber that can be periodically harvested.
Residential property income
The vast majority of residential property income comes in the form of basic rent. Your tenants pay a fixed amount per month—which will go up with inflation and demand—and you take out your costs from it, claiming the remaining portion as rental income. A desirable location is critically important to ensure that you can secure tenants easily.
Commercial property income
Commercial properties can produce income from the aforementioned sources, with basic rent again being the most common, but can also add one more in the form of option income. Many commercial tenants will pay fees for contractual options like the right of first refusal on the office next door. Tenants pay a premium to hold these options whether they exercise them or not. Options income sometimes exists for raw land and even residential property, but they are not common.
Residential Real Estate: Paths to Profits
Here is a closer look at some of the many ways that you can earn income from residential properties.
Buy and hold
This is one of the more traditional ways of earning income from real estate. There are a number of ways to accomplish this: You can buy a single-family home and rent it out; buy a multi-family home and live in one of the units while renting the others—ideally to cover the mortgage and your own housing expenses; or purchase a multi-family home and rent all of the units—either managing the property yourself or hiring a management company to handle renting units, collecting rent, addressing needed repairs, and so on.
Property flippers specialize in adding high-return fixes to houses in a short time and then selling them. Flipping can be lucrative if you know how to find properties to fix up, you have the necessary skills to do the renovations yourself or oversee a crew to carry them out, and you have a sense of a property's underlying costs and potential value.
Airbnb and vacation rentals
The demand for home-away-from-home rentals had taken off in recent years as many travelers preferred this option to staying in a hotel. Homeowners could earn income by renting out a house or even just a room on a short-term basis, especially if the property is in area that's a well-known tourist destination. It's unclear when that market will return. But should it reappear, keep in mind that short-term rentals are regulated and sometimes even banned in certain cities. Check your city's bylaws before listing a property on a website such as Airbnb, VRBO, or HomeAway. And also figure in what additional deep cleaning and sanitizing between guests will add to the costs.
Alternative Real Estate Income Sources
Real estate investment trusts (REITs)s, mortgage-backed securitie(MBSs), mortgage investment corporations (MICs), and real estate investment groups (REIGs) are investment alternatives within the real estate sector. They are generally considered vehicles for deriving real estate income but they have varying processes for doing so and varying processes for entry.
With a REIT, the owner of multiple commercial properties sells shares (often publicly-traded) to investors (usually to fund the purchase of more properties) and then passes on the rental income in the form of a distribution. The REIT is the landlord for the tenants (who pay rent) but the owners of the REIT record income once the expenses of operating the buildings and the REIT are taken out. There's a special method to assessing a REIT.
MBSs, MICs, and REIGs
These are even a further step removed, as they invest in private mortgages rather than the underlying properties. MICs are different from MBSs in that they hold entire mortgages and pass on the interest from payments to investors, rather than securitizing portions of principal and/or interest. Still, both are not so much real estate investments as they are debt investments. REIGs are usually private investments with their own unique structuring, offering investors equity investments or partnership servicing.
Several credible real estate alternatives are available for making money in the sector but they come with varying caveats and entry points.
Other Ways to Invest in Real Estate
One option is an informal residential real estate option, which requires that you pay a fee, or premium, to have the right to buy a house for a specified period for an agreed-upon price. You then find investors who will pay more than your option price for the property. In this case, the premium you get is essentially a finder's fee for matching a person looking for an investment with a person looking to sell—no different than a real estate agent's commission, really. Although this is income, it doesn't come from owning (i.e. holding the deed to) a piece of real estate.
Other options include:
- Short sales—this involves purchasing a home from a lender when the mortgagee is behind on payments. Short sales can be a time-consuming and complicated proposition.
- Lease options—these are what the name implies. When you lease with an option to buy in a bull real estate market, where prices are rising, you may be able to complete the purchase later at a lower, pre-set price, or make a profit by selling your purchase rights.
- Contract flipping—instead of flipping houses, this type of flipping involves the transfer of the rights of a purchase contract to another buyer. If you can locate distressed sellers and motivated buyers and bring them together, you may be able to make a profit this way.
The Bottom Line
There are several proven strategies for making money in real estate. Appreciation, inflation, and income rank high on the list but several alternative real estate investments also exist. Understanding your investments, risks, and whether the overall process is worth it or not is up to you.