Interested in Real Estate Investment? Here’s how to do it
Investing in real estate can seem complex. There is a lot to know about cash flows, tax strategies, investment costs, etc. But if you are thinking about testing the waters with real estate as way to diversify your investment portfolio, you aren’t alone. As property values and rents increase, real estate is the one asset that almost always goes up (with some obvious exceptions, of course – there are always hiccups in the market, but they usually don’t last forever).
To better understand your options when it comes to investing in real estate, here is a quick summary of the most common types of investment. There are more complex options, such as private placements and limited partnerships that you can explore as you become more comfortable in the real estate space, so we’ll focus on the ones that are the most accessible to new investors.
1. Rental Property
Before you start investing in rental property, you’ll want to own your own home. Owning your own home allows you some financing options that you won’t have without the collateral of your home to provide the capital to purchase other properties (unless you have significant assets and can pay cash for investment properties).
Basically, with this strategy, you purchase property, make repairs/updates as necessary, then rent it to qualified renters. Before you undertake this strategy, make sure you understand your rights and obligations as a landlord, and the legal recourse you have. Each state has different rules for the eviction process, so you’ll want to become very familiar with the tenant’s rights, as well as your own. You’ll probably want to have a real estate attorney draw up the rental contract that you can use as a template for each of your tenants/properties.
There are some legal risks with being a landlord, as you will have to deal with tenants who don’t pay or who destroy your property. The best defense is to do a complete screening on prospective renters before you sign a contract, which includes credit checks, checking references, and calling previous landlords. Ask for deposits up front to cover damages, and include in your contract the penalties for excess damage, failure to pay, etc.
Here is how you make money with rental property:
- If you finance the property, the mortgage payment subtracts from your cash flow (money comes in from rent, and goes out to the mortgage company). However, as you make payments, your mortgage decreases, which increases your equity in the property (just like with your own home).
- Over time, the value of the property appreciates (again, just like your residence), so your wealth increases as value of the property increases.
- Depending on your situation, you may be able to take advantage of tax deductions for investment costs. You’ll want to have a solid tax advisor to help you navigate this part.
Once you gain some experience with rental property, you can graduate to commercial property. Small apartment complexes (anything more than four units), and other small projects can generate healthy cash flow. However, commercial real estate is not for beginners. Commercial lenders will not lend to you until you have established yourself with a solid, successful track record of real estate investment.
Wholesaling is also commonly known as “flipping” but not to be confused with “rehabbing”. The latter two terms are often used interchangeably. If you immediately think of Property Brothers or Selling Las Vegas when you think of “flipping”, those shows are actually “rehabbing”, which you’ll find below. With true “flipping”, the flipper never takes possession of the property and therefore never requires financing. There are no credit checks, no mortgage applications, and no cash required, other than the earnest money to secure the contract with the seller. Here’s how it works:
The flipper contracts with a seller and pays the earnest money (usually $1,000 or more). Then, within the space of a couple weeks, the flipper markets the property aggressively, and contracts with a buyer. The goal is to “double close” on the property, meaning that the sale and the purchase close on the same day, which requires no additional cash from the flipper. The money you make is the difference between the price you contracted with the seller, and the purchase price you contracted with the buyer. The difference is your commission.
If you are familiar with late night real estate infomercials, this is the strategy they are marketing. It’s not rocket science, but it does take a little practice. The key is to identify properties that will sell quickly without the need for rehabbing and repairs. You need to then secure a contract with the seller that is less than what you think you can flip it for. It sounds complicated at first, but it is possible to make a decent income with flipping.
Rehabs, as opposed to flipping, actually require you to take possession of the property. This will require you to have the ability to get financing or to pay cash. The most common ways to acquire homes for rehabbing is through real estate auctions. These could be foreclosures, tax sales, estates of deceased owners. Occasionally, you may find a good deal with short sale, which is basically a distressed property where the owner owes more than the home is worth, and the mortgage company agrees to take a reduced amount to release the homeowner from the mortgage obligation.
Rehabs are risky. They are usually sold as-is, and you often don’t have access to the home to do an inspection. You have no idea what you are getting into in terms of repairs. Best case scenario, you only have to make some cosmetic updates, and then you can sell it for considerably more than you have invested in it. Worst case scenario, the home is a complete teardown, due to unforeseen structural problems, mold, or other issues. In the latter case, you stand to lose considerable money. In between is the scenario where you have to spend a considerable amount of money to make repairs and updates, and you are unable to sell it for enough profit to make it worth the time and effort you put into it.
The amount of time needed to complete the rehab is also a factor. If you can’t turn it around in a few weeks or a couple months, you start losing money because you paying substantial interest on the financing. The longer it takes, the more you stand to lose. Most people are not successful with this type of real estate investing, because there are just too many variables and unknowns. Even a home that looks sound when you walk around the perimeter and and peek through the windows can have a lot of hidden problems.
4. New Construction
Most people don’t realize that they can invest in new construction. This type of investment only works in a sellers market, so you have to be careful. And timing is everything – you need to be one of the first buyers in a new development in order to maximize this strategy. You get your pick of lots, and usually have more design control over elevations, floorplans, and colors, than a development that is nearing completion.
You will need to have excellent credit, and enough cash and income to get the ball rolling with the builders. Builders typically self-finance the construction, and you only start paying after closing when your mortgage kicks in (theoretically). Earnest money required is usually higher than buying an existing home, and you may have to pay additional earnest money for upgrades or changes you request to the home. However, your goal is to sell the home before you start actually making mortgage payments.
Ideally, you will have 1-2 homes under construction at all times. Builders don’t like investors using this strategy, so they will usually limit the number of homes you can have in process at any given time. In a sellers market, you will likely be able to sell the home before construction is even finished the mortgage payments start, and turn a healthy profit. Builders offer the best prices when the development is brand new, because they are trying to attract enough interest to get construction moving. You want to hit the sweet spot of getting a great price, and then selling for a profit as the home nears completion. There are a lot of buyers out there who want new construction but don’t want to go through the 6-9 months of waiting for the home to be completed.
5. Mutual Funds and REITs
If you invest in the stock and bond markets through your retirement accounts or brokerage accounts, then you are likely familiar with mutual funds. They are basically pools of cash that fund managers invest for the the people who have purchased share of the mutual fund. Every mutual fund has a particular investment strategy and type of investment vehicles that the manager will invest in. There are mutual funds that invest in real estate or in mortgage obligations that will allow you to participate in a real estate investing more passively. People who don’t have the time invest directly in real estate, or who want to start with a small portion of their portfolio might find mutual funds attractive.
Real estate investment trusts (REITs) are a less conventional. They are a little similar to mutual funds, except that they are typically closed-ended (meaning once all the shares are sold, then the REIT is closed to new investors). Some do trade on the open market like stocks, but not all of them. REITs are typically billed as income-generating investment vehicles. The are packaged by companies that own and operate portfolios of income-producing commercial real estate (like malls, hotels, etc.), and the income is passed through to the investors in the form of dividends. If the REIT does not trade on the market, there may be liquidity issues if you need to get out of the investment quickly, and there often is not a lot of transparency in the value of the shares. However, they are a possibility for people who are interested in regular income for cash flow purposes.
Let my team at Keystone Realtors® meet all your real estate needs. Paul Phangureh has over 16 years of experience in buying and selling in the Santa Clara and San Mateo County areas, specializing in the high-end, luxury market, as well as commercial and multi-use real estate. We can help you navigate the process of getting started with real estate investment. Visit our website at Keystonesv.com for listings and information. You can contact Paul at 650-924-2544, or email at [email protected].