Real Estate Investing: How It Works and How To Get Started
Real estate investing. You’ve heard of it and likely already know some of the basics, but when you’re just starting out, making your first move can be overwhelming. But just because you’re new doesn’t mean it has to be complicated, difficult, or expensive.
In fact, while investing in real estate is one of the oldest forms of investing, a lot has changed over the years, making it more accessible to modern investors. For one, it used to be much harder to break into the world of real estate investing without fronting a substantial amount of capital. Nowadays, you’ve got options.
Whether you plan to invest $500, $10,000, $500,000, or more, adding real estate investments to supplement your portfolio can be a smart choice with unique benefits, such as portfolio diversification, tax benefits, and additional cash flow.
In this beginner’s guide, we’ll cover the basics of what you should know, how it works, and the best ways to get started. When approached correctly, investing in real estate can be a rewarding experience that helps generate a substantial income stream for you.
Before we get too ahead of ourselves, let’s start at the beginning: What does “real estate investing” actually mean?
What is Real Estate Investing?
Investing in real estate starts with purchasing a property. Then, an investor improves on the property and sells or leases it for the purpose of earning money.
Investment opportunities break down into three main categories, which we’ll dive into below, and are classified as “alternative assets.”
Main Property Types
Three main property types dominate the real estate investing market: residential, commercial, and industrial.
Residential real estate spaces are used for living, not working. This includes single-family homes, townhouses, condominiums, duplexes, and multi-family homes. Properties larger than four units are technically considered commercial property.
Commercial real estate spaces are used for working and conducting business. This can include office spaces, workspaces, retail, land, farmland, and multi-family apartment buildings (depending on the number of occupiable units). Commercial property often follows strict zoning laws and regulations.
Industrial real estate spaces serve an industrial business purpose. This can involve industrial activities like production, manufacturing, assembly, warehousing, research, distribution, and power plants.
Main Ways to Earn Money in Real Estate
Now that we’ve gone over the main types of property you can invest in, let’s get into the good stuff – how you can actually making money by investing in real estate.
While your mind may go directly to flipping residential houses for a profit (thanks, Fixer Upper), investing in real estate goes beyond home improvement reality shows.
Here’s a glimpse at the four main ways to earn money in real estate.
1. Real Estate Appreciation
When a property appreciates, it means the value increases over time. Any time an investor purchases a property (or has ownership of any equity), the appreciation potential means the investor can hope to make a profit from the property. Whether through improvements or simply a changing market over time, investors often make money when they sell or lease properties at a later date.
2. Interest from Loans
When an investor provides financing to a real estate developer, they’re essentially loaning them money for a project that will earn them consistent cash flow from interest accrued on the principal. This type of investment is known as a debt investment and is a good example of passive investing.
If you purchase a property, listing it for rent can earn more monthly income than necessary to pay the mortgage. When this happens, two big benefits emerge (among others) – the overage provides a regular income stream and your renters essentially pay the mortgage for you, leading the income to become passive over time.
4. Secondary Real Estate Investment
Secondary real estate investment can refer to investors buying into a portfolio that another investor owns, or investing in ancillary items that generate income within a property. Often, these portfolios are split among a group of investors and can be a less risky way of investing as it does not require the full investment cost of the property. Examples include things like vending machines in office buildings and laundry facilities in apartment complexes.
Why Invest in Real Estate?
With so many options in today’s market, why choose real estate investing? First, earning a steady stream of income through rental or interest payments on properties is a relatively hands-off method of earning.
Also, the inflating housing market means every property has enormous potential for price appreciation. Purchasing a property, making minor – and perhaps sometimes, major – improvements, and re-selling it at a later date can earn substantial net earnings for investors.
Another perk is that real estate investing often requires fewer hours than typical careers. Many real estate investors spend less time in an office and more time living life than people who take full-time office positions. This, of course, isn’t always the case, nor a guarantee, but many investors are drawn to real estate as a means of diversifying further into passive investments.
Ways to Invest in Real Estate
There are two primary types of real estate investment – active and passive. But how are they different, and which one is best for you?
Active Investing vs. Passive Investing
Active investing means when you invest, you’re likely signing up to be heavily involved, hence “active.” This can include using a property as a rental property and managing it yourself, or flipping a home and putting it back up on the market for sale. Active investing can also involve hiring a management company to oversee your rental and manage the upkeep of the property.
Passive investment, on the other hand, means when you invest, you’re likely doing so under the assumption of being involved as little as possible, hence “passive.” Usually, this means another entity or “sponsor” manages the property you own, giving you the freedom to check in as often or as little as you’d like. Passive investment is common with apartment complexes or other properties with multiple units.
There are three main differences between active and passive real estate investing:
Passive investing gives investors the least amount of control over a property. The sponsor typically oversees most of the project, including purchasing and managing it. If this approach sounds good to you, it’s important to make sure your sponsor is appropriately qualified to help avoid any major control issues.
In contrast, active investing allows you to control the business plan from start to finish. You can control what tenants to approve, how much to charge in rent, and what renovations to perform on the property. Generally speaking, the more control you’d like to have over your properties, the more time you’ll likely need to commit.
2. Time Commitment
Passive investors typically commit very little time to assisting in a project, opting instead to contribute financially only. Occasional consultations and/or vetting may take place, but as a passive investor, you can assume that once the financing is set, no further action will likely be required.
As the name implies, active investing is a more hands-on approach, and therefore likely requires a significant time commitment. Being a property owner and full-time property manager can mean full-time hours on-site. It also means that the decision making falls on your shoulders, whether it’s in the middle of the night or the middle of the workday.
Investing passively typically requires less risk-taking than investing actively. As a passive investor, there’s usually already a system in place for the investment and you’ll have a comprehensive understanding of how the project will go and the expected projections.
You may have already guessed, but active investing involves significantly higher risk. Owning an entire investment, and therefore its potential profits, can be rewarding, but it also means you carry all the risk. While this doesn’t mean it should be avoided, as some investors thrive on these types of investments, it’s certainly something to stay aware of. Risk factors include changes in the local market, macroeconomics, and any significant issues that might come up regarding the structure of the property.
Which is Right for You: Active or Passive?
To determine which method is better for you personally, a good first rule of thumb is to consider how much responsibility you want to have when it comes to your investment property.
If you plan to get involved in multiple investment opportunities, a passive investment may allow you the freedom to choose more projects and financially benefit from them.
If a more hands-on approach strikes your fancy, active investing is probably a better fit for you. This is especially true if taking the reins on a real estate investment project and owning the entire process from start to end interest you.
When you’re just getting started, it’s important to figure out which suits you and your situation best. Keep in mind, you don’t necessarily need to side with one over another or just choose one, but having a comprehensive overview of how each investment is classified is a good idea so you don’t get in over your head.
In case you’re still unsure, let’s dig deeper into each type of real estate investing and go through some examples of how each one works.
Active Real Estate Investing
To recap, being an active real estate investor means when you invest in a property, you’re ready to commit the time, money, and resources needed to help your investment yield a higher return. You’ll not only control the day-to-day operations and the decision-making process on behalf of the property, you’ll also have the majority stake in the profits.
Here are a few examples of active investing and how it could work for you.
Investing in rental properties is one of the most common ways to actively invest in real estate. It essentially involves purchasing a property, finding tenants, and renting it out for an amount that ideally covers the mortgage payments and then some.
How it works: Your responsibilities as an investor include managing the property yourself or hiring a management company or other qualified individual to oversee it. Depending on which route you choose, you may also have to make repair valuations and decisions, find and interview prospective tenants, handle the renter application process, collect rent, address any complaints that may arise, and more.
When considering a rental property investment, the next best step would likely be to consult and crunch some numbers through a good investment property calculator.
Going out on a limb here, but chances are good that your initial interest in flipping homes for profit coincided with the craze of related reality shows on TV. And you’re not alone. In fact, the number of house flips is at an 11-year high, with over 207,000 U.S. single-family homes and condos were flipped in 2017, up one perfect from the 204,167 homes flipped in 2016, according to Attom Data Solutions, a research firm that collects and analyzes nationwide real estate data.
How it works: investors purchase a property in need of several repairs. Because it’s usually in poor condition, the property can be purchased for cheap compared to market values. Once the keys are handed over, the investor puts cash into the home to fix it up, thus “flipping” it, and sells the property for more than their investment, pocketing the difference as profit.
While this is an ideal scenario, even the most industrious investor may have difficulty running a renovation project that comes in under budget. For that reason, many investors hire professionals to help, which can incur more costs and lower the potential profit margin.
When considering home flipping as an investment strategy, it’s crucial to keep an eye on the housing market throughout the process. Fluctuating values and mortgage interest rates can impact an investor’s ability to effectively flip and sell a property.
Vacation rentals, also known as short-term rentals, are another massively popular way to invest in real estate. People travel all over the world, opting to stay in privately owned homes and spaces rather than large chain-hotels these days, giving investors a unique opportunity to run a boutique rental property at a profitable rate.
How it works: Investors interested in renting out a property on a short-term basis purchase a property (either turnkey or one in need of updating), and prepare it for guests. Then, they connect with local rental agencies or websites like Airbnb and VRBO to list the property for rent. Payments and correspondence are typically handled through the booking agency and investors have their share of profit sent to their account.
Vacation rentals can potentially earn significantly higher income than typical rental properties, especially in areas or seasons where vacation rentals are in high demand. But there are some things to watch out for, since owning a short-term rental isn’t always a walk in the park. You’ll have to be prepared for frequent tenant changes, money handling, repairs, cleaning, and more.
Passive Real Estate Investing
Jumping back to the basics of passive real estate investing, this hands-off approach means when you invest in a property, you’re typically investing financially and not much more in terms of time, day-to-day operations, etc. The investors that fall into this category typically have minimal experience on running a rental property, or have significant funds available and choose to diversify their income with multiple passive projects simultaneously.
Here are a few examples of passive investing and how it could work for you.
REITs, Real Estate Investment Trusts, are companies that own or finance commercial properties with debt or equity investments. Typically, REITs offer a portfolio of real estate to investors, not just a single property.
How it works: These companies do all the frontend work and sell shares of the REIT to investors who then earn income in the form of dividends. Similar to the way mutual funds work, REITs give investors the ability to earn income from a variety of properties with minimized risks.
The three types of REITs offered to investors are private REITs, publicly-traded REITs, and public non-traded REITs.
We won’t go into full detail on what each one entails, but just to give you a quick idea:
- Private REITs are not publicly traded on the stock market and are usually limited to accredited investors with high net worth.
- Publicly-traded REITs are publicly traded on the stock market and considered the most volatile and liquid investments.
- Public non-traded REITs are a hybrid of the two; registered with the SEC, but not traded on the stock exchange.
Real Estate Investment Groups
Like management groups, real estate investment groups handle tenant and maintenance responsibilities. Investors, on the other hand, receive the proceeds from property rent, minus the real estate investment group’s fees.
How it works: The investment organization buys or builds the properties, then presents the portfolio to investors as an investment opportunity. While real estate investment groups do take a cut of the profits, choosing this route allows investors a simpler way to earn rental income without sourcing and rehabbing properties themselves.
Online Platforms for Real Estate Investing
Similar to the rise in crowdfunding platforms we’ve seen take hold online over the last few years, real estate investing platforms are following suit. These online platforms help investors easily find and connect with portfolios that meet their needs and serve their interests.
Historically, accessing single investments or a diversified portfolio involved going through several middlemen in the process and relying on financial institutions. Now, investors can directly choose and obtain shares of investments online, making it more accessible to people than ever before. Platforms like Fundrise can help you get started for as little as $500.
How it works: Once you're accepted as an investor to a platform that meets your needs, you'll be able to invest directly in a real estate portfolio organized by the platform's team of professionals. This team is in charge of identifying, acquiring, and managing properties on your behalf.
RELPs, or Real Estate Limited Partnerships, are groups of people that invest in real estate together. Typically experienced in one way or another with real estate, it’s not uncommon for these partnerships to include a property manager or real estate development firm serving as a general partner.
How it works: Once formed, RELPs seek additional financing from outside investors for their real estate project in exchange for shares of ownership and coming onboard as a limited partner. While there can be trade-offs entering a limited partnership, such as having limited influence on decisions, investors also have limited liability, so if your RELP faces a hardship, you’re only liable for the amount of your capital contributions.
How Real Estate Investing Gives You Leverage
As you can imagine, having leverage in real estate can be a power move for your portfolio. And in the world real estate investing, the amount of leverage you have refers to your real estate net worth. This covers financial means and capital that increase the potential return on an investment. Thus, the more real estate you own, the higher your leverage.
Bobby Arora, a self-made millionaire investor, shares an example of how having leverage can enhance returns.
“Let us assume a hypothetical scenario – a house costs $50,000 and pays a rent of $1,000 per month. A rich person who has $500,000 to invest in real estate can buy 10 houses and earn an income of $10,000 per month, or $120,000 per year.
Now if the rich borrows money to buy houses – he puts down $500,000 and borrows an additional $2,000,000 from the bank. Now the rich has a total of $2,500,000 and he can buy 2,500,000/ $50,000 = 25 properties.
These 25 properties will pay him $25,000 per month in rent, equaling $300,000 per year. The rich person has to be interest rate to the bank, say 5%. 5% on $2,000,000 is $100,000. After paying interest the rich has $300,000 – $100,000 = $200,000 remaining as compared to the $120,000 he had without the loan (leverage).”
Potential Drawbacks of Investing in Real Estate
Here are a few potential drawbacks to be on the lookout for as a newcomer.
Cash flow. An obvious one, but to get into real estate investing, you’re going to need a decent chunk of cash to invest in properties.
Market fluctuations. Rising housing costs and dropping family budgets can be a fine line to walk, so it’s important to keep a pulse on what’s happening in the area of your investment property and beyond.
Underestimating repairs. When renovating a home, there’s always a chance you might run into snags that blow your budget, and potentially slims your profit margins. A good way to combat this is to assume you’ll need to build in a buffer around your budget when the project starts.
Inflated projections. If you’re focusing on residential real estate and rental properties, there’s a chance your projected rental income may not match up to the realities of the market. To mitigate this risk, be sure to do your homework before snapping up a property that seems too good to be true.
Real Estate Investing or Investing in Stocks – Which is Better?
Choosing between real estate investing and investing in stocks ultimately comes down to a personal decision on which is right for you, although according to U.S. News, investing in real estate could be a better investment than choosing stock options.
This, of course, varies by investor and various schools of thought, but many agree and acknowledge that while the overall investment and time commitment in real estate may be higher than managing a stock portfolio, the potential income is higher as well – especially when using the right strategies.
The biggest piece of advice for minimizing risky investments? Do your research.
Further, the risks of investing in real estate are often reasonable in comparison with return expectations, according to experts. The biggest piece of advice for minimizing risky investments? Do your research. Check the market thoroughly before you commit, research the going rates for rent (past, present and future projections), and look at comparable home prices to help determine whether a property is a secure investment.
Do You Need a Lot of Money to Get Started in Real Estate Investing?
It depends. Historically speaking, yes, you needed a lot of money to get started, but now, there are several options and levels of commitment for real estate investors to choose from. Depending on what type of property you want to invest in, and whether or not you plan to partner with someone, you may only need as little as $500 to get started.
That said, it’s helpful to continually build up your reserves if you plan on buying property to flip or rent on an ongoing basis.
Many investors purchase a home through a conventional home loan, then renovate and flip the home, pocketing the cash from the sale. If this sounds similar to what you’d like to do, the only cash you’ll need upfront is enough for the down payment (typically 20 percent) plus funds for renovating the property.
The Bottom Line
We’ve covered a lot on the basics on real estate investing, but this is only the beginning of your journey. As you gain more experience and exposure to investing in real estate, you’ll see it can be a rewarding experience with lucrative returns and high-growth potential. What is really boils down to is weighing the pros and cons of each type of investment and comparing it to the goals you have for your portfolio.