12 Factors to Consider When Investing in Real Estate
When it comes to investing your hard-earned money, real estate is an excellent option. Investing in real estate can be incredibly rewarding–as long as you know what you’re doing. All too many people assume that investing in real estate will bring an automatic profit, but this is not always the case. In fact, you can lose a lot of money if you make poor real estate investment decisions. So do your research and consider these 12 important factors before making a decision to invest in any given property.
There are essentially three ways that you can make money on real estate investments: loans, appreciation, and rent.
Loans – One way to invest in real estate is to lend money to real estate developers and then charge them interest This is also known as debt investing.
Appreciation – When you buy real estate, it’s an asset. If you sell that asset, you’ll want to do so at a profit. Not all real estate will appreciate in value; however, if you’re smart about your investments (meaning that you do your research on the location of the property and nearby property value trends), you might identify real estate investments that will appreciate in value significantly over the years, allowing you to eventually flip it for a sizeable profit.
Rent – If you hold equity ownership of a property, you can earn income by renting it out. Rent can provide a regular income stream that can help pay off the loans you might have taken out to purchase the property, eventually resulting in profit.
Ways to Invest in Real Estate
Although there are three main ways to make money from real estate investments, these three fall into two categories: active investments and passive investments. Here is a breakdown of both types along with examples of each:
Active Investing – Active investors are directly responsible for the success of their investment, which means that they need to have a significant amount of real estate knowledge and know-how. Active investing not only requires you to know a lot about real estate, but it requires a lot of hands-on work and some financial expertise as well. The following are a few examples of active investment strategies:
House Flipping – House flipping is arguably the most active form of real estate investment there is. It involves buying a property and then further investing in home improvements and renovations, thereby improving its value. Usually, investors will buy real estate in need of a lot of work due to the fact that they can get it for well below its potential value. Of course, a lot of hands-on work is required to fix it up before you can flip it back onto the market for a profit. House flipping is one of the most short-term forms of real estate investing that there is as well.
Rental Properties – Buying property and renting it out also requires hands-on work. You will have to find tenants to rent the property and regularly maintain the property, paying for any maintenance and repairs that may be required. Tenants may come and go as well, which means the work never lets up. Rental properties can provide a steady flow of monthly income, but because it will take some time before you make back what you put into the property, it’s considered a long-term investment.
Airbnb Rentals – Airbnb rentals are different than the traditional method of renting out property in that the rentals are short-term. Essentially, you’re renting out a property (or simply a room in your property) as an alternative to a hotel room. Depending on where your property is located, cash flow can be regular or irregular. Generally speaking, most people who participate in Airbnb rentals will rent out a room in their personal home as a way to bring in money on the side.
Passive Investing – Little real estate knowledge is required to passively invest in real estate. You essentially provide capital for professionals to invest in real estate on your behalf. The process is similar to investing in stocks and bonds through a broker or financial advisor. Some examples of passive real estate investments include:
Private Equity Funds – A private equity fund allows you to pool your money together with a group of other investors into one single fund. This fund is usually managed by a designated manager or management group. You’ll typically be charged around 2 percent every year for the management of your fund as well as 20 percent on any profits earned. Because it’s being managed on your behalf, no active involvement is needed, although some financial and real estate knowledge is helpful to ensure that you understand the risks and potential of the real estate investments you’re making through the fund.
Real Estate Investment Trusts – A real estate investment trust is a company that offers a portfolio of real estate to investors. You can then buy shares of the company and earn income from that portfolio, which typically includes debt and equity investments. A minimum of 75 percent of its gross income must be earned from real estate and a minimum of 75 percent of its assets must be invested in real estate by law. A real estate investment trust must also distribute a minimum of 90 percent of its taxable income to its shareholders every year.
Exchange Traded Funds – Exchange traded funds are groups of stocks or bonds within a single fund. A real estate-themed exchange traded fund will allow you to invest in real estate as well as diversify your investments. There are many different exchange traded funds focusing on real estate out there, such as Vanguard’s VNQ and IYR. You’ll need to do a fair bit of research to decide what exchange traded fund you want to invest in, but once you buy into an exchange traded fund, the investment is passive.
Real Estate Mutual Funds – Real estate mutual funds are very similar to real estate investment trusts. They’re both funds into which groups of investors can combine their money. The big difference is that real estate mutual funds tend to be more long-term investments since they aren’t as liquid as real estate investment trusts, which are publicly traded and can be bought or sold at any time. Most real estate mutual funds are invested in corporate and commercial properties, although there are some funds that include apartment complexes, agricultural space, and even raw land. Many real estate mutual funds include real estate investment trusts.
The Positive Factors
The potential benefits of investing in real estate are many, and include:
Great Income Potential
If you do your research, you can earn a lot of money investing in real estate. While some investments might be riskier than others, certain types of real estate investments could net you a significant profit. For example, a study published by USA Today last year revealed that single-family rental homes in large cities throughout the U.S. generate an average annual return of around 9 percent. The study focused on a 20-year span as well. This indicates that real estate investments can be more lucrative than the stock market.
Regular Cash Flow
Investing in real estate–specifically, rental properties–can be an excellent way to earn regular cash flow. Being able to depend on regular additional income can go a long way towards improving your financial situation.
You can deduct the depreciation of the building as well as structures that you own and use for rental activity, such as your rental office or storage shed. Even property within the rental property, such as stoves and refrigerators, can be depreciated. However, you won’t be able to deduct the cost of the land your property is on since that does not depreciate.
Depreciation works by determining how much the property is worth and then depreciating it for the recovery period (the amount of time the IRS says it must be depreciated for). You can then deduct a certain percentage of its basis every year during the property’s recovery period. Keep in mind that the recovery period for rental buildings is 27.5 years, while the recovery period for personal property (such as office furniture and computers) is usually between five and seven years.
Leverage is a term describing the use of borrowed capital (or other financial instruments) in order to increase the potential financial return of your real estate investment. For example, if you put down 20 percent on a house and the house appreciates in value at a rate of 5 percent a year, it means that you’re using leverage to increase your potential net worth.
Besides writing off depreciation, there are numerous other tax benefits you can take advantage of when investing in real estate. For example, you can write off the mortgage interest on any loans you’ve taken out to purchase real estate. You can also deduct the cost of repairs to a rental property. Starting last year, landlords can also deduct upwards of 20 percent of their net rental income or 2.5 percent of the rental property’s initial cost in addition to 25 percent of what they pay their employees. This new pass-through tax deduction was created by the Tax Cuts and Jobs Act.
While the potential benefits of investing in real estate can be quite attractive, the potential drawbacks are also very real. Consider these main drawbacks of real estate investments before you invest:
Large Initial Investment
Real estate is one of the most expensive things that you can invest in. The only way you can dabble in real estate investing without putting up a large initial investment is through a passive investment, such as in a real estate investment trust. If you want to make an active real estate investment, you’ll have to make a large initial investment. You’re taking a significant financial risk, since not all real estate investments are good investments, after all.
It’s Not a Liquid Investment
Most real estate investments are not liquid, meaning that you can’t sell at an instant to make a profit. It means that your money will be locked up in your investment, which could be risky if you suddenly find yourself in a situation where you need money. Even with short-term real estate investments, such as house flipping, it can take some time to find a buyer.
The Real Estate Market is Erratic
There’s no foolproof way to judge the real estate market. Just because home values are going up in one particular area doesn’t mean that they will continue doing so forever. For example, maybe the construction of a large factory is being planned near a community that’s driving up home values, but then the construction is canceled and the values begin dropping. You could find yourself invested in a property that’s depreciating in value over the years as a result.
It Takes a Considerable Amount of Time
If you’re buying property as a long-term investment, realize how rare it is for the value to increase significantly within a short period of time (unless you invest in home improvements, in the case of house flipping). This is because real estate appreciates in value slowly — it can take decades before you can put the property back onto the market and make a profit.
Expenses and Tenants
Although buying rental properties is one of the most effective ways to invest in real estate by earning regular monthly rental income, being a landlord is not without its drawbacks. As the property owner, you’ll still be responsible for the property and for the tenant’s safety, and managing the property will require both skill and know-how.
As the landlord, you will be responsible for maintaining the property and paying for any repairs that might be required. You will also be required to keep the property safe since you’ll be held liable for any injuries that occur on your property.
Skill and Know-How
A lot goes into managing just a single rental property. Not only do you have to find tenants and to maintain the property, but you’ll also need to be familiar with all the legalities involved with being a landlord (such as what rights you have as the landlord and what rights your tenant has). There’s quite a bit of paperwork involved too. Managing a rental property is no easy task.
When is it a Good Time to Invest?
One of the reasons why the idea of investing in real estate is attractive to so many people is because real estate will always hold value and it can result in significant profits. However, you need to be careful when you consider real estate investments, whether active or passive. One of the dangers of real estate investing is the misconception that real estate investments result in an automatic profit. It is possible to lose money on real estate–and considering how much money is on the line, it can be financially devastating if you’ve put all your money into a single real estate investment that fails.
Because of the risk involved, consider your own financial situation before you decide it’s time to invest. If you’re thinking about an active real estate investment, odds are you will need to take out a loan, which means you’ll be taking on more debt. Not only is your financial situation important, but you should also do your due diligence. Educate yourself on the pros and cons of real estate investing so that you know exactly what you’re getting into and so that you can make smart investment decisions. Be aware that active real estate investing requires time and hands-on work. You need to put both into your investment in order to see a positive return, whether it’s short-term or long-term.
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