Buying real estate can be more than just finding a place to call home. Most people have to do a real estate transaction at some point in their lives, and some find it an intriguing opportunity for capturing and creating value. Real estate has become a common investment vehicle, and it continues to be popular despite a very rocky market correction in 2007-09.
Although the real estate market has plenty of opportunities for making a profit, buying and owning real estate can be a lot more complicated than investing in stocks and bonds. In this article we’ll go beyond buying a home and introduce you to some of the basic real estate investments.
The Power of Leverage in Real Estate
Before we dive into types of real estate investments, it is worth looking at one of the main attractions it holds for investors. Investing in real estate gives you one tool that is not as easily available to stock market investors: leverage. If you want to buy a stock, you have to pay the full value of the stock at the time you place the buy order. Even if you are an individual investor buying on margin, the amount you can borrow is still less in total than what you can easily access for a real estate purchase.
A traditional mortgage generally requires a 20% to 25% down payment. However, depending on where you live, there are many types of mortgages that require as little as 5% down. This means that you can control the whole property and the equity it holds by only paying a fraction of the total value up front. Of course, your mortgage will eventually pay the total value of the house at the time you purchased it (plus a not insignificant amount of interest), but you control the whole asset the minute the papers are signed.
This is what emboldens both real estate flippers and landlords. They can take out a second mortgage on their homes and put down payments on two or three other properties. Whether they rent these out so that income from tenants pays the mortgage or wait for an opportunity to sell for a profit, they control these assets, despite having only staked a small part of the total value.
1. So You Want to Be a Landlord
Ideal For: People with DIY and renovation skills and an aptitude for dealing with tenants
What It Takes to Get Started: A healthy amount of capital to ensure access to financing and cover up-front maintenance costs and vacant months
Pros: Rental properties can become new sources of regular income if the investment is successful. They also maximize your available capital through leverage. Moreover, many of your expenses are tax deductible, and any losses can offset gains in other investments.
Cons: Rental properties tend to be hands-on investments unless you use a property management company. Rental property owners often must choose between being ready to field a tenant call at any hour and forgoing income (or taking a loss) to have someone else do it for them.
Rental real estate is an investment as old as land ownership. Basically, you buy a property and rent it out to a tenant. The owner is now a landlord, responsible for paying the mortgage, taxes and costs of maintaining the property. Ideally, the landlord charges enough rent to cover all of the aforementioned costs with enough left over to produce a monthly profit right from the start. However, depending on the rental market, a landlord may have to be patient and only charge enough rent to cover expenses or even take a loss to keep a property occupied. Although this can be uncomfortable and requires a capital cushion to absorb periods of loss, landlords tend to invest for the long term. After all, once the mortgage has been paid on a rental property, the majority of the rent becomes profit.
Of course, the monthly income from a property is not the only focus of a landlord. As with all real estate, the property can appreciate over the course of the mortgage, leaving the landlord with a more valuable asset. According to U.S. Census Bureau data, sales prices of new homes – which can be used as a rough indicator for real estate values – consistently increased in value from 1940 to 2006 before dipping during the financial crisis. Sales prices have since resumed their climb, surpassing pre-crisis levels.
Source: Survey of Construction, U.S. Census Bureau
There are, of course, blemishes on the face of what seems like an ideal investment. You can end up with a bad tenant who damages the property or, worse still, end up having no tenant at all. This leaves you with a negative monthly cash flow, meaning that you might have to scramble to cover your mortgage payments. There is also the matter of finding the right property. You will want to pick an area where vacancy rates are low and choose a place that people will want to rent.
Perhaps the biggest difference between a rental property and other investments is the amount of time and work you have to devote to maintaining your investment. When you buy a stock, it simply sits in your brokerage account and, one hopes, increases in value. If you invest in a rental property, you also acquire the mountain of responsibilities that come with being a landlord. When the furnace stops working in the middle of the night, it’s you who gets the phone call. If you don’t mind handyman work, this may not bother you. Otherwise, a professional property manager would be glad to take the problem off your hands – for a price, of course.
2. Real Estate Investment Groups
Ideal For: People who want to hold rental real estate without the headache 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 also a vacancy risk with real estate investment groups, whether it is spread across the group or owner specific. In addition, management overhead can eat into returns.
Real estate investment groups are similar to a small mutual fund for rental properties. If you want to own a rental property, but don’t want the hassle of being a landlord, a real estate investment group may be the solution for you.
In a typical real estate investment group, a company will buy or build a set of apartment blocks or condos, then allow investors to buy them through the company, thus 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 the units, taking care of maintenance, advertising vacant units and interviewing tenants. In exchange for this management, the company takes a percentage of the monthly rent.
There are several versions of investment groups, but in the standard version the lease is in the investor’s name and all of the units pool a portion of the rent to guard against occasional vacancies, meaning that you will 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. In extreme cases investors may be asked to pay back in if costs exceed income for a longer period of time.
Of course, the quality of an investment group depends entirely on the company offering it. In theory it is a safe way to get into real estate investment, but real estate investment groups are vulnerable to the same fees that haunt the mutual fund industry. More important, they are sometimes private investments where unscrupulous management teams take investors for a ride and leave them with nothing but legal proceedings to look forward to. To avoid unpleasant surprises, it is critical to do your research on the company and conduct a thorough review of the details in the investment offering.
3. Real Estate Trading (Better Known as 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. Depending on market conditions, there can be significant returns even on this shorter time frame.
Cons: Real estate trading requires a deeper market knowledge and a bit of luck. Hot markets can cool unexpectedly, leaving short-term traders with a loss or a long-term headache.
Real estate trading is the wild side of real estate investment. Like day traders, who are distinct from buy-and-hold investors, real estate traders are an entirely different breed from buy-and-rent landlords. Real estate traders buy properties with the intention of holding them for a short period of time, often no more than three to four months, after which they hope to sell them for a profit. This technique is also called flipping properties and is based on buying properties that are either significantly undervalued or in a very hot market.
Pure property flippers will often forgo putting any money into a house for improvements; the investment has to have the intrinsic value to turn a profit without alteration or they won’t consider it. Flipping in this manner is a short-term cash investment. To take advantage of potentially large returns, flippers have to have cash on hand or access to other people’s money, as traditional financing doesn’t generally work for this type of transaction.
If a property flipper gets caught in a situation where he or she can’t unload a property, it can be devastating because these investors generally don’t keep enough uncommitted cash to pay the mortgage on a property for the long term. This can lead to continued losses for a real estate trader who is unable to off-load the property in a bad market.
A second class of property flipper also exists. These investors make their money by buying reasonably priced properties and adding value by renovating them. This can be a longer-term investment depending on the extent of the improvements. The limiting feature of this investment is that it is time intensive and often only allows investors 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 having to go through a traditional real estate transaction
What It Takes to Get Started: Investment capital
Pros: REITs are essentially dividend-paying stocks whose core business is commercial real estate – an area where long-term, cash flowing leases are the norm.
Cons: REITs are essentially stocks, so the leverage available to traditional rental real estate investors is absent.
Real estate has been around since our cave-dwelling ancestors started chasing strangers out of their space, so it’s not surprising that Wall Street has found a way to turn real estate into a publicly traded instrument.
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, just like any other stock. A corporation must pay out 90% of its taxable profits in the form of dividends to keep its status as a REIT. 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.
Much like regular dividend-paying stocks, REITs are a solid investment for stock market investors who want regular income. In comparison to the aforementioned types of real estate investment, REITs allow investors into nonresidential investments, such as malls or office buildings, that are generally not feasible for individual investors to purchase directly. More important, 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.
REITs are, in practice, a more formalized version of a real estate investment group. The number of REITs has grown from 34 in 1971 to 222 in 2017. The market capitalization of these REITs, which is mostly a reflection of the value of the underlying real estate, has similarly grown from $1.5 billion in 1971 to $1.1 trillion in 2017.
When looking at REITs, it is important for an investor to 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.
Of course, Wall Street has gone far beyond REITs when it comes to financial innovation in real estate. In comparison with some of the other innovations, a REIT is a plain vanilla gambit, whether equity or mortgage. And unlike MBS, REITs have never starred as a key player in a real estate bubble and subsequent burst. In fact, the financial crisis did bring to light some differences in REIT capital structure and how too much leverage can cause REIT share prices to swing much more wildly than expected. So REIT investing isn’t entirely painless, but the research and analysis required is in line with that of any income stock.
The Bottom Line
We have looked at several types of real estate investment but have only scratched the surface. There are countless variations within these examples and many more types that don’t really fit the definition of simple. As with any investment, there is profit and potential within real estate whether the overall market is up or down.
Of course, this does not mean that investing in real estate is an assured gain. Hopeful real estate investors need to put in the work of becoming conversant with major market indicators and investment-level metrics before diving in. We all tend to put a lot of thought and planning into a home purchase. A real estate investment requires that same diligence without promising the same emotional payoff of living in your dream home. Not that getting a nice financial payoff from being smart about real estate isn't also an emotional high.