Many investors have real estate positions in their portfolios. But adding other real estate investments can help you diversify your portfolio and protect you from stock market volatility. Let’s take a look at your options for investing in real estate, the pros and cons, and how you can get started.
What are my investment options?
Here are the most popular real estate investment methods:
- Rental properties
- Real estate investment groups
- Flipping houses
- Real Estate Limited Partnership
- Real Estate Mutual Funds
Let’s go deeper into how this works.
Rental properties are the most affordable option in this list. You buy a piece of residential real estate and rent it out to tenants. Many rental properties are rented for 12-month periods, but short-term rentals are also becoming more popular through companies like Airbnb ( NASDAQ:ABNB ) .
As a property owner, you are the landlord. You are responsible for maintenance, cleaning between tenants, major repairs and paying property taxes. Depending on the terms of the lease, you may be on the hook for replacing appliances and paying for utilities.
You make money from rental properties from the rental income you receive from tenants and if you sell the property for more than you paid for it.
You can also avail tax write-off. Under the passive activity loss rules, you can deduct up to $25,000 of losses from your rental properties from your ordinary income if your modified adjusted gross income is $100,000 or less. Depreciation (non-cash expenses) and interest (which you pay anyway), can show the property as an accounting loss even when you’re still making money.
When you buy a rental property, you may need a down payment of up to 25%. But if you charge enough rent to cover your mortgage payment, you’ll have the rest covered by your tenant, plus any price appreciation.
If you don’t want to put up with the headache of managing a rental property or can’t come up with a 25% down payment, real estate investment trusts (REITs) are an easy way to start investing in real estate. REITs are publicly traded trusts that own and manage rental properties. They can consist of anything: medical office space, malls, industrial real estate and office or apartment buildings, to name a few.
REITs have high dividend payouts because they are required to pay out at least 90% of their net income to investors. If a REIT meets this requirement, it will not have to pay corporate tax.
Additionally, while selling a rental property can take months and mountains of paperwork, REITs have the advantage of liquidity because they trade on .
Real estate investment groups
Investing in a real estate investment group (REIG) is a way to retain the profit potential of private rental properties while potentially gaining more upside than a REIT trading at a premium.
REIGs buy and manage properties and then sell portions of the properties to investors. REIG will buy something like an apartment building, and investors can buy units inside.
The operating company retains a portion of the rent and manages the property. This means that the company finds new tenants and takes care of all maintenance. Often times, investors will also collect some rent to continue paying off debt and meet other obligations if certain units are vacant.
Flipping houses is the most difficult and risky of these options, but it can be the most profitable. The two most common ways to flip houses are buy, fix and sell, or buy, wait and sell. In either case, the key is to limit your initial investment with a low down payment and keep renovation costs low.
Let’s say you manage to buy a home for $250,000 with 20% down or $50,000. You make another $50,000 in renovations and then list the house for $400,000. You use $400,000 to pay off a $200,000 loan and then make a $100,000 profit on a $100,000 investment. It’s a great return if you can get it.
The problem is that you usually can’t. Housing markets aren’t known for being volatile, but when leveraged — as you should be — it kills you in the flipping house game. Keeping renovation costs to a minimum may seem easy, but it can be nearly impossible if you don’t have direct construction experience.
By 2021, material prices are through the roof, workers are in short supply everywhere, and almost no homes are for sale on the cheap. This is the worst possible part of the cycle for house-flippers: everything is expensive, and the market can turn at any minute.
If you like to flip houses, be smart and find a way to sit it out when the market gets too hot. It may seem counterintuitive, but it will save you in the long run.
Real Estate Limited Partnership
Real estate limited partnerships (RELPs) are a form of REIG. A RELP is structured similarly to a hedge fund, where there are limited partners (investors) and a general partner (manager). The general partner is usually the real estate business that takes on all the responsibilities.
RELPs are more passive investments in real estate. Generally, a general partner establishes a partnership and appoints investors as limited partners. Investors then receive a K-1 to report the income on their taxes, but they don’t have much influence over performance.
RELPs can be very profitable if you find a good general partner. But you are completely dependent on the general partner who must manage the property without much supervision and reliably report the finances to you.
Real Estate Mutual Funds
Real estate funds invest in REITs and real estate operating companies (REOCs). REOCs are like REITs, but they don’t have to pay dividends, so they grow much faster.
Real estate mutual funds or exchange-traded funds (ETFs) are among the easiest ways to invest in real estate. When you collect dividends you allow the manager or even the index to pick the best real estate investments.
Even if you’re a stocks-only investor, consider using a real estate fund to get diversification while maintaining the liquidity profile you’re used to.
How to Get Started in Real Estate
If you choose to invest in real estate, follow these five steps to get started:
- Save money: Real estate has one of the most expensive barriers to entry of any asset class. Before you get started, you’ll want to pay off your high-interest debt and build up significant savings.
- Choose a strategy: Each of the strategies listed above can be successful. If you choose to buy REITs or funds, you can research your options online to help you get started. If you want to buy physical assets, you will need to determine the market.
- Assemble a team: You may want to work with an agent when you start out. Great agents will send you off-book opportunities that haven’t been listed yet. Eventually, you may need someone to manage your properties and an accountant to handle the finances. If you succeed, you may eventually need investors too.
- Do a Deal Analysis: Whether you’re investing in residential or commercial real estate, you should do plenty of research on any investment. For example, with rental properties, you’ll need to analyze what future rental payments might be, what expenses you might be responsible for, and predict what you might sell the property for.
- Close the deal: The final step is pulling the trigger. Close your property or make purchases in your brokerage account.