Whether you've always been curious about the investment potential of real estate–or simply sick of infomercials promising little-known ways to "profit from your property!"–it's worth learning, for real, how real estate creates wealth.
In this article, we're not looking at obscure strategies for investing in real estate or offering a primer on homeownership (for the latter, see First Time Homebuyer's Guide). Instead, this article will focus on the basic ways that money is made through real estate. And, fortunately for us, these haven't changed in centuries, no matter what kind of gloss the gurus of the moment try to put on it.
Tutorial: Exploring Real Estate Investments
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 of them–if you borrowed money to buy it in the first place–is to refinance the loan at lower interest (use our mortgage calculator to calculate current refinance rates). 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 more and more valuable because of the potential for it to be purchased by developers. Then developers build houses that raise that value even further.
Appreciation in land can also come from discoveries of valuable minerals or other commodities on it, provided that the buyer holds the rights to them, of course. An extreme example of this would be striking oil but appreciation can also come from gravel deposits, trees, and so on.
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 so on, can cause the 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 and this is something a property owner can directly control. 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. Many of these techniques have been refined by property flippers who specialize in adding high-return fixes to houses in a short time.
Real estate remodeling and property flipping can be a profitable way to create rapid, short-term appreciation though it requires careful planning.
Commercial property gains value for the same reasons as raw land and residential real estate: location, development, and improvements. The best commercial properties are perpetually in demand. (For related reading, see 7 Steps to a Hot Commercial Real Estate Deal.)
The Role of Inflation
There is one major factor to include when considering appreciation: the economic impact of inflation. An annual inflation rate of 10% means that your dollar can only buy about 90% of the same good the following year, and that includes property. If a piece of land was worth $100,000 in 1970, and it sat dormant, undeveloped, and unloved 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 over $500,000 to purchase now, assuming $100,000 was fair market value at the time.
Thus, inflation alone can cause appreciation in real estate but it is a bit of a Pyrrhic victory. Even though you may get five times the money due to inflation, many other goods cost five times as much to buy now so purchasing power in the current environment is still a factor. (Learn more in 5 Tales of Out-of-Control Inflation.)
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 pump jacks, pipelines, gravel pits, access roads, cell towers, and so on. Raw land can also be rented for production, usually agricultural production.
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-and this will go up with inflation and demand–and you take out your costs from it, claiming the remaining portion as rental income. While it is true that you will get an insurance payout if your tenants burn down the place, the payout only covers the cost of replacing what is lost and is not income in a real sense.
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 far from common.
Real estate investment trusts (REITs), mortgage-backed securities (MBSs), mortgage investment corporations (MICs), and real estate investment groups (REIGs) can be known as alternatives within the real estate sector. These investments are generally considered to be 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 and MICs 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.
Other alternatives can also exist like REIGs. 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.
Smoke and Mirrors
Similar to other alternatives with real estate underlying the investment, most of the "blow your mind with super fantastic return" methods are merely a layer on top of basic streams of income.
For example, there are informal residential real estate options where you pay a fee, or premium, to have the right to buy a house for a specified period for an agreed-upon price. Then, you 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. (For a more detailed discussion, see How to Make Money wIth Real Estate Options.)
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.