Buying and owning real estate is an exciting investment strategy, that can be both satisfying and lucrative. Unlike stock and bond investors, prospective real estate owners can use leverage to buy a property by paying a portion of the total cost up front, then paying off the balance, plus interest, over time. While a traditional mortgage generally requires a 20% to 25% down payment, in some cases, a 5% down payment is all it takes to purchase an entire property. This ability to control the asset the moment papers are signed emboldens both real estate flippers and landlords, who can in turn take out second mortgages on their homes in order to make down payments on additional properties.
- Unlike stock and bond investors, prospective real estate owners can use leverage to buy a property, by paying a portion of its total cost up front, then paying off the balance, plus interest, over time.
- The four chief ways in which investors can make money through real estate are: 1) becoming landlords of rental properties, 2) Real Estate Trading (aka Flipping), 3) Real Estate Investment Groups, and 4) Real Estate Investment Trusts (REITs).
Here are four ways in which investors can put properties to good use:
1. So You Want to Be a Landlord
Ideal For: People with DIY and renovation skills, who have the patience to manage tenants.
What It Takes to Get Started: Substantial capital needed to finance up-front maintenance costs and cover vacant months.
Pros: Rental properties can provide regular income, while maximizing available capital through leverage. Moreover, many associated expenses are tax deductible, and any losses can offset gains in other investments.
Cons: Unless you hire a property management company, rental properties tend to be riddled with constant headaches. In worst case scenarios, rowdy tenants can damage property. Furthermore, in certain rental market climates, a landlord must either endure vacancies, or charge less rent in order to cover expenses, until things turn around. On the flip-side, once the mortgage has been paid off completely, the majority of the rent becomes all profit.
Of course, rental income isn't a landlord's sole focus. In an ideal situation, a property appreciates over the course of the mortgage, leaving the landlord with a more valuable asset than he started with.
According to U.S. Census Bureau data, sales prices of new homes (a rough indicator for real estate values) consistently increased in value from 1940 to 2006, before dipping during the financial crisis. Thankfully, sales prices have since resumed their ascent, even surpassing pre-crisis levels.
Source: Survey of Construction, U.S. Census Bureau
2. Real Estate Investment Groups
Ideal For: People who want to own rental real estate without the hassles of running it.
What It Takes to Get Started: A capital cushion and access to financing.
Pros: This is a much more hands-off approach to real estate that still provides income and appreciation.
Cons: There is a vacancy risk with real estate investment groups, whether it's spread across the group, or whether it's owner specific. Furthermore, management overhead can eat into returns.
Real estate investment groups are like small mutual funds that invest in rental properties. In a typical real estate investment group, a company buys or builds a set of apartment blocks or condos, then allow investors to purchase them through the company, thereby joining the group. A single investor can own one or multiple units of self-contained living space, but the company operating the investment group collectively manages all of the units, handling maintenance, advertising vacancies and interviewing tenants. In exchange for conducting these management tasks, the company takes a percentage of the monthly rent.
A standard real estate investment group lease is in the investor’s name, and all of the units pool a portion of the rent to guard against occasional vacancies. To this end, you'll receive some income even if your unit is empty. As long as the vacancy rate for the pooled units doesn’t spike too high, there should be enough to cover costs.
While these groups are theoretically safe ways to invest into real estate, they are vulnerable to the same fees that haunt the mutual fund industry. Furthermore, these groups are sometimes private investments where unscrupulous management teams bilk investors out of their money. Fastidious due diligence is therefore critical to sourcing the best opportunities.
3. Real Estate Trading (aka Flipping)
Ideal For: People with significant experience in real estate valuation and marketing.
What It Takes to Get Started: Capital and the ability to do or oversee repairs as needed.
Pros: Real estate trading has a shorter time period during which capital and effort are tied up in a property. But depending on market conditions, there can be significant returns, even in shorter time frames.
Cons: Real estate trading requires a deeper market knowledge paired with luck. Hot markets can cool unexpectedly, leaving short-term traders with losses or long-term headaches.
Real estate trading is the wild side of real estate investment. Just as day traders are a different animal from buy-and-hold investors, real estate traders are distinct from buy-and-rent landlords. Case in point: real estate traders often look to profitably sell the undervalued properties they buy, in just three to four months.
Pure property flippers often don't invest in improving properties. Therefore investment must already have the intrinsic value needed to turn a profit without any alterations, or they'll eliminate the property from contention.
Flippers who are unable to swiftly unload a property, may find themselves in trouble, because they typically don’t keep enough uncommitted cash on hand to pay the mortgage on a property, over the long term. This can lead to continued snowballing losses.
There is a whole other kind of flipper who makes money by buying reasonably-priced properties and adding value by renovating them. This can be a longer-term investment, where investors can only afford to take on one or two properties at a time.
4. Real Estate Investment Trusts (REITs)
Ideal For: Investors who want portfolio exposure to real estate without a traditional real estate transaction.
What It Takes to Get Started: Investment capital.
Pros: REITs are essentially dividend-paying stocks whose core holdings comprise commercial real estate properties with long-term, cash producing leases.
Cons: REITs are essentially stocks, so the leverage associated with traditional rental real estate does not apply.
A REIT is created when a corporation (or trust) uses investors’ money to purchase and operate income properties. REITs are bought and sold on the major exchanges, like any other stock. A corporation must pay out 90% of its taxable profits in the form of dividends in order to maintain its REIT status. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed on its profits and then have to decide whether or not to distribute its after-tax profits as dividends.
Like regular dividend-paying stocks, REITs are a solid investment for stock market investors who desire regular income. In comparison to the aforementioned types of real estate investment, REITs afford investors entrée into nonresidential investments, such as malls or office buildings, that are generally not feasible for individual investors to purchase directly. More importantly, REITs are highly liquid because they are exchange traded. In other words, you won’t need a realtor and a title transfer to help you cash out your investment. In practice, REITs are a more formalized version of a real estate investment group.
Finally, when looking at REITs, investors should distinguish between equity REITs that own buildings, and mortgage REITs that provide financing for real estate and dabble in mortgage-backed securities (MBS). Both offer exposure to real estate, but the nature of the exposure is different. An equity REIT is more traditional, in that it represents ownership in real estate, whereas the mortgage REITs focus on the income from mortgage financing of real estate.
The Bottom Line
Whether real estate investors use their properties to generate rental income, or to bide their time until the perfect selling opportunity arises, it's feasible to build out out a robust investment program by paying a relatively small part of a property's total value up front. But as with any investment, there is profit and potential within real estate, whether the overall market is up or down.