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Real Estate Investing for Beginners

Staying consistent with the theme of investing long-term for wealth creation, aim to invest in real estate. Investing in real estate is one of the best ways to make money and should be a key part of your investment strategy. At the very least, owning your own home is an investment on its own. Paying down on the mortgage(s) means paying an expense in the form of interest. But as many already know, each mortgage payment also consists of two parts: interest and principal. The principal portion of those payments works to your benefit! Any principal paid down also builds equity that contributes to your net worth and your goals toward wealth creation.

Current State of Real Estate Market

At this point, the real estate market is in flux. With the Federal Reserve hiking interest rates to stave off inflation, those increases flow into mortgage rates. So, acquiring mortgages to fund real estate costs a little more right now. A 30-year fixed mortgage rate is about 7% as of Dec 2022. If you're already invested in real estate, the impact of inflation will also aid in the appreciation of your property(ies), as prices of all types are rising. It's costing more to buy real estate right now, both in terms of the mortgage rates and property prices. Today's rates are still historically low though. And as always, with the goal wealth creation in mind, it's best to focus on the long-term.

Why Invest in Real Estate

In contrast to investing in stocks or bonds, real estate is considered an illiquid investment. This means that it may take a while to cash out on real estate as an investment. Reselling real estate or refinancing is typically a timely process that may take days, weeks, or months. Stocks and bonds are considered more liquid because they can be cashed out the same day that a decision to sell is made. However, your money investment is generally much more stable with real estate, since it's not prone to the short-term volatility of the securities markets. Whether you buy a home or a commercial building, you obtain a physical, useable asset that can generate rental income. And holding that property for the long-term will eventually result in appreciation in its value.

Benefits of Real Estate Investing

Let's look at some general real estate investment analysis. The first reason to invest in real estate is appreciation. Over the long-term, and in the near term in some cases, the value of real estate generally goes up due to inflation, supply & demand factors, and/or improvements made to the property.

The second reason to invest in real estate is leverage. You can purchase a real estate investment of high value with relatively little out-of-pocket cash. For example, many real estate investment properties will require a 20% down payment relative to the value of the property. You mortgage the rest. This means a $500K property can be bought with only $100K out-of-pocket upfront. As a result, investment returns are magnified using leverage.

Thirdly, most real estate investments will serve as rental properties to provide positive cash flow; the more, the better.

Another solid reason for investing in real estate is the beneficial impact on taxes. The highest such benefits are available to real estate investors in rental apartment buildings. This is because the U.S. Government allows a tax break, in the form of depreciation allowances in effort to encourage investors to provide much needed housing for the average citizen.

The National Council of Real Estate Investment Fiduciaries (NCREIF) details that real estate held for investment purposes over time have averaged returns of just over 10% taking into account both appreciation and cash flow from rents. This applies to commercial as well as residential and diversified real estate investments. According to Forbes magazine, in the 5 years leading up to 2017, both commercial and residential real estate have rewarded investors with annual returns greater than 7%.[1] And according to the S&P 500 Index, the overall average annual return on investment for residential real estate in the United States is 10.6%. As a whole, investing in real estate remains a sound investment strategy and one of the best ways to invest money.

Eight Most Common Types of Real Estate Investments

Perhaps the most common way to invest in real estate is simply by buying a house (single-family house) that you don't intend to live in, and then renting it out to another family. You then become a landlord. It'll generate rental income, and if you are able to charge more than the monthly mortgage on the property, it should also provide positive cash flow. One can also aim to become a flipper, buying houses in need of improvement, making the renovations, and hopefully making a substantial profit upon the sale of the property. This investment strategy is entirely contingent on having a solid and reliable contractor to handle the renovations, as well as the amount of time it takes for the contractor to finalize the renovations. The monthly mortgage payment must still be made while renovations are being made!

Below are eight other common types of real estate investments to consider.

1. Apartment Complexes: popular and easy-to-understand, apartment buildings and complexes offer unique depreciation benefits. If you live in one of the units, you should still consider the value of that apartment as part of the annual income because you would be paying rent somewhere else if you were not living in your own building. You should also account for any operating expenses if you're managing it yourself.
2. Hotels and Motels: these are generally considered the most difficult to manage but are potentially profitable investments. You'll have to account for seasonal aspects and vacancies that lead to fluctuating income, among other things. These factors can make it challenging to obtain financing as well.
3. Office Buildings: most are not individually metered, so owners pay the cost of electricity. But tenants usually pay all or part of the cost of interior finishes. This also leads to longer leases and renewal options, since tenants are making a sizeable investment in their suites. Office buildings offer a sound, relatively easy-to-manage investment option, but the new work-from-home and flexible work options driven by COVID may be challenging for demand.
4. Shopping Centers: retail as a whole has taken a major hit as a result of the increase in e-commerce and the COVID pandemic. As investments, shopping centers can be pretty complicated and expensive anyway, but smaller neighborhood centers can be had with a moderate cash investment and not much required in terms of expertise.
5. Warehouses and Industrial Buildings: tenant stability tends to be poor. But as an owner, you can protect yourself with advance rents and security deposits. Larger spaces are generally leased on longer terms to more stable tenants like manufacturing plants or major corporations.
6. Mobile Home Parks: caters to increased demand for more reasonably priced homes.
7. Vacant Land: a speculative investment.
8. Condo Conversions: condos have become a much needed form of housing. Converting existing apartment buildings to condos is a solid option for investment with a great exit strategy.

Real Estate Investment Trusts (REITs)

An additional, and oftentimes preferred, type of real estate investment is a real estate investment trust (REIT). REITs are one of the best real estate investments and is a great way to invest in real estate passively. There are hundreds of REITs, and they exist as a security similar to a mutual fund that's traded and managed in the same manner. After selling shares to the public, a REIT invests the money in mortgages and various types of real estate. Investing in an REIT provides you with partial ownership of the real estate portfolio held by the real estate investment trust.

The primary appeal of REITs is the passive nature of this investment. They allow the investor to receive both capital appreciation and current income from real estate ownership without all the headaches of property management. They are also liquid, better diversified, more cost-efficient, and tend to provide very attractive dividend yields!

REITs can basically be broken down into 3 categories:

1. Property REITs (aka Equity REITs): these invest funds in properties such as apartment buildings, office buildings, hotels, etc.
2. Mortgage REITs: these invest in mortgages. More income-oriented and essentially invest in debt.
3. Hybrid REITs: invest in both properties and mortgages.

REITs have generated competitive total returns based on dividend income and long-term capital appreciation. According to the NAREIT, during the 20-year period from 1998 to 2018, REITs have compounded an average annual return of about 11.50%. They also afford the investor increased diversification of their portfolio, having a low correlation with other assets. This aids in reducing risk and increasing returns. As such, they are certainly one of the best ways to invest money in real estate.

Conclusion

Interest rates are rising, but historically, they remain very low. Average monthly rents are also rising. This will potentially drive increases in positive cash flow for property owners, as well as increases in property values. As a part of any investment strategy, real estate as a whole has very low correlation compared with investments in other asset classes. Real estate investing does have risks, but it also has rewards in the form of competitive returns. It is, therefore, a meaningful way to diversify and enhance your investment portfolio.

Disclosure/Disclaimer

The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.

[1] Prosser, M. (2017, July 19). Data Proves REITs Are Better Than Buying Real Estate. Retrieved December 12, 2022, from https://www.forbes.com/sites/marcprosser/2017/07/19/data-proves-reits-are-better-than-buying-real-estate/?sh=32b92560d6b7