How to invest in real estate

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Real estate investing is popular, and perhaps now more so than ever, as low mortgage rates make real estate more affordable. In fact, Americans love real estate, and a 2019 Bankrate survey showed that it was their favorite long-term investment, even beating out stocks.

Consumers have a variety of ways that they can invest in real estate, including many options beyond just becoming a landlord, although that’s a time-tested option for those who want to manage a property themselves. Plus, new business platforms also make it easier than ever to invest in real estate without having to come up with tens of thousands or more in cash.

Below are five tested methods for investing in real estate and what to watch out for.

5 best ways to invest in real estate

While many people get involved in real estate to generate a return on investment, it can also be about just simply finding a place to live. So for many, a real estate investment is their home.

1. Buy your own home

You might not normally think of your first residence as an investment, but many people do. It’s one of the best ways for you to invest in real estate, offering numerous benefits.

The first benefit is building equity in your home from your monthly payments, rather than paying rent that always seems to rise year after year. Some portion of your monthly mortgage goes into your own pocket, so to speak. However, experts remain divided on the pros and cons of owning your own home, and a home is not a buy at any price, as homebuyers of the 2000s learned.

If you’re planning to stay in an area long term, it can make sense to purchase a home because you’ll be able to lock in a monthly payment that may be as affordable as rent. Plus, banks treat owner-occupied properties more favorably, giving borrowers a lower mortgage rate and requiring a lower down payment. You may also be able to deduct interest expenses on your taxes.

Mortgage rates are now at historical lows, helping to make homes more affordable than they have been in the recent past. Unsurprisingly, then, demand has been surging.

“For owners and occupiers now is the best time to invest because they are never going to get mortgage payments this low and can get more square footage for their price point,” says Chris Franciosa, principal agent at Compass Real Estate in Delray Beach, Florida.

How you make money: Capital appreciation, building equity, potential tax break on appreciated value

2. Purchase a rental property and become a landlord

If you’re ready to step up to the next level, you might try your hand with a residential rental property such as a single-family home or a duplex. One of the bigger advantages of this kind of property is that you know the standards of the marketplace and the market may be easier to gauge, as opposed to commercial properties, such as a shopping center.

Another advantage is that it may take a lower investment to get started, for example, with a single-family house. You may be able to get into a property with $20,000 or $30,000 instead of the potentially hundreds of thousands required for a commercial property. You may be able to buy in even cheaper if you’re able to find an attractive distressed property via a foreclosure.

You’ll generally have to put up a sizable down payment to start, often as much as 30 percent of the purchase price. So that may be prohibitive if you’re just starting out and don’t have a huge bankroll yet. One way around this may be to buy a rental property in which you also live.

Another downside is that you’ll need to manage the property and make decisions as to what needs upgrading, for example. While owning property is considered a passive activity for tax purposes, it may end up being anything but passive as a landlord. And if a tenant ducks out on rent, you still have to come up with the monthly payments, lest you go into default on the loan.

Also note that real estate is relatively illiquid and usually requires a substantial brokerage fee, often 6 percent of the sale price, so you usually can’t sell immediately and without a big bite being taken out. Those are some of the bigger downsides, but landlords have other ways to mess up, too.

Historically low mortgage rates may make this avenue more affordable than in the recent past. A 1031 exchange can also help you roll your investment into a new one tax-free.

How you make money: Capital appreciation, growing rents and equity over time, 1031 tax-free exchanges

3. Consider flipping houses

House-flipping has become more of a popular avenue to investing in real estate, and it requires a keen eye for value and more operational expertise than becoming a long-term landlord. However, this path may help you realize a quicker profit than being a landlord, if you do it right.

The biggest advantage of this approach is that you can turn a profit faster than by managing your own property, but the expertise required is also higher. Typically house-flippers find undervalued properties that need to be cleaned up or even completely renovated. They make the required changes, and then charge market value for the houses, profiting on the difference between their all-in price (purchase price, rehab costs, etc.) and the sales price.

House-flippers need a sharp eye for what can be fixed at a reasonable price and the unfixable. They also need to estimate what a house can later be sold for. Miscalculate, and their profit might quickly evaporate, or worse, turn into an outright loss. Or a home might not sell quickly, and then the house-flipper is stuck paying any interest on a loan until a buyer can be found.

House-flippers may turn to non-traditional sources of funding, since they often prefer to hold houses for months, rather than years. Plus, the closing costs of a traditional mortgage are high.

House-flipping actually makes being a landlord feel like a passive activity. You’ll have to manage a crew of people doing many if not all of the repairs, and you’ll need to be the driving force in every transaction ensuring that it gets done and comes in at the budget or below. And you’ll always be searching for another deal, since you get paid only when you turn around a property.

House-flippers can also take advantage of 1031 tax-free exchanges if they roll the proceeds from one investment into another within a certain period and according to certain rules.

How you make money: Buying undervalued property and rehabbing, selling for more and repeating, 1031 tax-free exchanges

4. Buy a REIT

Unlike prior options, the next two ways to invest in real estate really are passive. Buying a REIT, or real estate investment trust, is a great option for those who want the returns of real estate with the liquidity and relative simplicity of owning a stock. And you get to collect a dividend, too.

REITs have numerous advantages over traditional real estate investing, and may make the process much easier:

  • Less money needed to start, potentially only $20 or $30, depending on the stock
  • No hassles managing a property (e.g., no 3 a.m. phone calls)
  • Very liquid, and REIT stocks can be sold on any day the market is open
  • Transaction costs are $0, as brokers have slashed commissions
  • Attractive long-term returns, averaging about 12 percent from 1998 to 2018
  • Regular quarterly dividends, with the best REITs growing their payout over time
  • Diversification, across many properties or even across real estate sectors

However, investing in REITs is not without its own downsides. Like any stock, the price on a REIT can fluctuate as the market gyrates. So if the market declines, REIT prices may go with it. That’s less a problem for long-term investors who can ride out a dip, but if you need to sell your stock, you may not get what it’s worth at any single point in time.

If you’re buying individual REIT stocks, you’ll need to analyze them carefully, using the tools of a professional analyst. One way to avoid this downside, however, is to buy a REIT fund, which owns many REITs and thus diversifies your exposure to any one company or sector.

Investing in a REIT is a great way to start for a beginner with a little cash, but you’ll need to work at it, too, since there are still some ways to mess up a REIT investment.

How you make money: Capital appreciation, growing stream of dividends

5. Use an online real estate platform

An online real estate platform such as Fundrise or Crowdstreet can help you get into real estate on bigger commercial deals without having to plunk down hundreds of thousands or even millions on a deal. These platforms help connect developers with investors looking to fund real estate and take advantage of what can be quite attractive potential returns.

The big advantage for investors here is the potential to get a cut of a lucrative deal that they may not have been otherwise able to access. Investors may be able to take part in debt investments or equity investments, depending on the specific deal terms. These investments may pay cash distributions, and may offer the potential for returns that are uncorrelated to the economy, giving investors a way to diversify their portfolio’s exposure to market-based assets.

These platforms do have some disadvantages, though. Some may accept only accredited investors (such as individuals with a net worth of $1 million or more), so it may not be possible to even use them if you don’t already have money. Still, while some platforms may require a $25,000 minimum investment, others may let you in the door with $500.

The platforms also charge a management fee annually, often 1 percent, and they may add other fees on top of that. That may appear pricey in a world where ETFs and mutual funds may charge as little as zero percent for constructing a diversified portfolio of stocks or bonds.

While platforms may vet their investments, you’ll have to do the same, and that means you’ll need the skills to analyze the opportunity. The investments are often relatively illiquid, with only limited chances for redemption until a given project is completed. And unlike investments in a REIT or even your own rent property, once a deal is completed and your investment is returned, you may have to find another deal to keep your portfolio growing.

How you make money: Capital appreciation, dividend or interest payments

How to decide if you should invest in real estate

Does investing in real estate make sense for you? You’ll need to ask yourself what kind of investor you’re willing to be. You can make a lot of money in each kind of real estate investment, so it’s more a question of your financial position and your willingness to do what’s necessary. The type of investment should match your temperament and skills, if at all possible.

In particular, potential investors should ask themselves questions across three broad areas:

  • Financial resources: Do you have the resources to invest in a given real estate investment? There are opportunities at every investment level. Do you have the resources to pay a mortgage if a tenant can’t? How much do you depend on your day job to keep the investment going?
  • Willingness: Do you have the desire to act as a landlord? Are you willing to work with tenants and understand the rental laws in your area? Or would you prefer to analyze deals or investments such as REITs or those on an online platform? Do you want to meet the demands of running a house-flipping business?
  • Knowledge and skills: While many investors can learn on the job, do you have special skills that make you better-suited to one type of investment than another? Can you analyze stocks and construct an attractive portfolio? Can you repair your rental property and save a bundle on paying professionals?

“If your retirement is on the line, it’s best to leave the ‘speculation’ to the experts and focus on industries that you have a deeper understanding of, so that you can easily follow the progress of your investments,” says James Richman, CEO at JJ Richman, an asset manager.

You’ll want to understand your own skills, abilities and willingness in order to assess what kind of investment fits best. And you don’t need to add real estate to your asset portfolio to do well. Many investors stick exclusively to stocks, with the goal of equaling the market’s long-term return of about 10 percent annually, and enjoy the benefits of passive investing.

Taxes on real estate investing

The taxes on real estate vary widely, depending on how you invest, but investing in real estate can offer some sizable tax advantages. Let’s run through them based on the investment type:

  • Your own residence: You’ll owe annual property taxes on any owned real estate, but you may be able to deduct any interest expenses from your mortgage, depending on your specific financial situation. When you sell your residence, you can also receive $250,000 in capital gains (or $500,000 for married filing jointly) tax-free, if you’ve lived in the house for two years and two of the last five years.
  • Your rental property: You’ll also owe annual property taxes here, but it’s also a cost of business as a landlord, so you can deduct that from any rental revenue, reducing any taxable gains. You can also deduct your interest expense and depreciation, reducing your taxable income still further, even as you still collect the cash flow. When you sell the investment property later, the taxes are assessed on its lower depreciated value. However, if you move the proceeds of a sale into a new house and follow the 1031 rules, you can defer the taxes on the gain.
  • House-flipping: The 1031 tax-free exchange can be an important factor here in keeping taxes low, because house-flippers don’t really benefit from depreciation typically. By rolling their proceeds into their next deal and following the rules, they can keep deferring any taxes on gains — as long as they can keep finding good property deals. Otherwise they’ll owe taxes on their gains, less any costs of doing business.
  • REITs: REITs offer an attractive tax profile — you won’t incur any capital gains taxes until you sell shares, and you can hold shares literally for decades and avoid the tax man. In fact, you can pass the shares on to your heirs and they won’t owe any taxes on your gains. However, any dividends that you receive are taxable that year, and much of the return from REITs over time is due to their sizable dividends, which typically do not enjoy the lower qualified dividend rates but instead are taxed at ordinary rates.
  • Online real estate deals: The taxes incurred by these investments can vary depending on exactly the kind of investment you make. Some investments are technically REITs and so will be treated according to that tax setup, while others may be debt or equity investments. In general, any income such as a cash distribution from these will be taxable in the year it’s received, while any tax on capital gains will be deferred until it’s realized.

By knowing how each of these types of real estate is taxed, you can make smarter choices about how to manage any given investment and minimize the cut that goes to Uncle Sam.

Bottom line

Investors looking to get into the real estate game have a variety of options for many kinds of budget. Real estate can be an attractive investment, but investors want to be sure to match their type of investment with their willingness and ability to manage it, including time commitments.

Featured image by Busa Photography of Getty Images.

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