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How To Invest in Real Estate
How To Invest in Real Estate
Most investment portfolios and retirement plans are invested in stocks and fixed-income
investments.
But real estate is an excellent portfolio diversification because it’s a “hard asset”. As well,
the long-term investment performance of real estate is hard to argue with.
Adding some real estate to your portfolio can improve your investment returns over the long
haul.
Real estate is a scary investment for a lot of people. And it can be if you only think in terms
of owning a piece of property to rent out or to fix-and-flip.
But there’s more than just two ways to invest in real estate. And the great thing is there’s a
way to invest in real estate which can work for anybody, even if you don’t have a ton to
invest right now.
I was able to come up with 11 (and a bonus), and here they are:
Invest in Fundrise
A lot of people want to jump into real estate investing, but don’t want to worry about dealing
with tenants, handling repairs, and managing payments. Luckily, you can put your money in
real estate options without having to do all that.
Fundrise is an online investment service which allows you to put your money in Real Estate
Investment Trusts. They are managed by Fundrise professionals, while you sit back and
watch your money grow.
Why Fundrise? It’s simple, they have a history of excellent returns! In 2017, they had an
average annual return of 11.44%. I probably don’t need to tell you, but that’s A LOT better
than you’ll find with most other investments.
Sure, they can’t guarantee these kind of returns, but over the past four years, they have posted
great numbers.
One reason people love Fundrise is because it’s easy to get started. You can quickly compare
accounts and create your profile. They have several different options. They help you
determine which investments are best by requiring a short questionnaire.
Depending on your answers, they will suggest one of their three investment styles:
Long-term Growth
Balanced Investing
Supplemental Income
With as little as $500, you can invest in the Fundrise Starter Portfolio, or with a $1,000
investment in the Fundrise income eREIT or the Fundrise growth eREIT. They charge very
low fees to invest through the platform, but returns have recently been in double digits. They
have additional investments available for accredited investors.
What about the fees? Don’t worry, they aren’t too bad. Fundrise only charges a 0.85%
management fee every year. Compared to other brokerages, this is minimal.
The long and short of it is that you can get above average returns on your money by investing
in real estate. And since Fundrise offers REITs, you can earn this money without getting your
hands dirty.
Peerstreet enables you to invest in real estate loans – mainly for fix-and-flip deals with small
investors. You can also invest with as little as $1,000, but you must be an accredited investor
to do so.
You will invest in loan “notes”, which are slivers of loans, and not the loans themselves.
Loans run from six months to two years, and typically pay interest rates of between 6% and
12%.
It means you buy a home at fair market value or less. It’s also better to buy the least
expensive home in a neighborhood, rather than the most expensive.
Amortization of your mortgage. While you’re living in your home and making your
mortgage payments faithfully, the loan is gradually amortizing away. At the end of 30
years, you’ll own it mortgage-free. That will give you 100% equity in your home.
Price appreciation. A 3% annual appreciation rate means that a home will double in
value in the 30 years it takes to pay off the mortgage. The $300,000 home you buy
today will be worth $600,000 in 30 years.
Let’s say that you buy a home today for $300,000, with a 5% down payment ($15,000). Your
equity in the home will go from $15,000 to $600,000 in 30 years.
That’s a serious investment. And while the home is increasing your wealth, it’s also
providing shelter for you and your family.
No other investment combines two benefits the way owning a home does.
Warning: if you refinance your mortgage every few years, resetting the loan back to 30 years
and taking a “little” cash out each time, you’ll defeat the whole purpose. You’ll never pay off
the mortgage, and you’ll never build serious equity.
At a minimum, the rent that you receive on an investment property should cover the expenses
of owning it. If it does nothing more, your tenant will effectively be paying for your
investment. When the rent is higher than your expenses, the property will generate a positive
cash flow.
If it does produce a positive cash flow, the income can come to you tax-free. This is because
you can take depreciation expense on the property. Since it’s an investment property, you’re
allowed to “expense” the improvements over many years. But since depreciation is a paper
expense (no actual cash outlay), it can offset your net rental income.
As rents rise – while the monthly payment stays relatively flat – your net income will rise.
Once the property is paid off, the rent income will be mostly profit.
There are some things that you need to be aware of with rental properties:
They require large down payments, generally 20% or more of the purchase price.
It’s more difficult to qualify for a mortgage on investment property than on an owner-
occupied home.
There are vacancy factors – times in between tenants when there is no rent income.
Repairs and maintenance – painting, replacing carpet, etc. – will need to be done after
each tenant moves out.
Each of these factors can be overcome, but you need to be aware that owning rental property
isn’t always a smooth ride.
These platforms provide you with a way to invest in different types of real estate, and in
different ways. Your investment isn’t as liquid as it would be if you invested in mutual funds
for ETF’s, but it’s less complicated than real estate LPs.
They’re probably closest to REITs, but you have more control over what it is you invest in.
With a P2P platform, you can select the deals that you invest in.
This also gives you an opportunity to diversify a relatively small amount of money across
many different deals.
Real estate centered P2P crowdfunding platforms have only been around for a few years. But
there’s already a wide variety of platforms that give you the opportunity to choose how and
where you want to invest.
With as little as $5,000, you can invest in either real estate loans or equity (there are a few
investments you can participate in for $1,000). The platform enables you to invest in real
estate across the US, and in a wide variety of different projects.
One reason RealtyShares is popular is because of how much work they do for you. When an
investment opportunity pops up, they are going to look at the executives of the real estate
company and the title reports and inspections. They are going to get as much information as
possible about the real estate.
Now onto the fees. RealtyShares is going to charge you a 1% annual fee. This is on par with a
lot of other P2P companies out there.
Lending Club is another excellent source for P2P lending. At this point, you’ve probably
heard of Lending Club. They are one of the most popular P2P sites out there, but a lot of
people don’t think of them for real estate lending.
Lending Club has average annual returns between 5.06% and 8.74%. What’s important to
note, is these numbers account for defaults as well, which makes the returns even more
impressive.
The Lending Club restrictions for investors is a little more lenient than other P2P sites out
there. They make it easy to create an account and start investing.
After you’ve been approved to start investing with Lending Club, you will be able to browse
the hundreds and hundreds of investment options. Looking for a quick way to diversify your
portfolio? Look no further.
Peerstreet enables you to invest in real estate loans – mainly for fix-and-flip deals with small
investors. You can also invest with as little as $1,000, but you must be an accredited investor
to do so.
You will invest in loan “notes”, which are slivers of loans, and not the loans themselves.
Loans run from six months to two years, and typically pay interest rates of between 6% and
12%.
It’s generally more complicated than residential rental property since you’re dealing with
business tenants. But it’s also potentially more lucrative.
On the plus side, commercial real estate usually involves long-term leases. Since the property
is being rented to a business, they’ll want a multiyear lease. This will ensure the continuity of
their business.
A lease can easily be for 10 years or more. The cash flow will be more steady since you
won’t be changing tenants every year or two.
Appreciation on the property can also be more generous than it is for residential. This is
especially true if the property is producing large annual profits. That’s more likely to happen
with commercial property, since the tenant often pays for the upkeep of the building, in
addition to the monthly rent.
Leases can be structured to give the landlord a percentage of the profits of the business as
well.
The tenant may even go out of business, leaving you with an empty building. Since
commercial tenants come in all shapes and sizes, it may take months or years to find a new
tenant for your property.
Investing in commercial property is for more experienced investors who have a higher risk
tolerance. It’s a true high risk/high reward investment.
Is it?
Yes and no. It’s easy if you know what you’re doing, and a potential disaster if you don’t.
The basic idea is to buy a property that’s in serious need of an update. For that reason, you
should be able to buy for a lot less than the current market value of updated homes in the
neighborhood.
For example: You buy a house for $100,000, that’s located in a $200,000 neighborhood.
$40,000 in renovations later, you sell the property for a $60,000 profit.
On TV it always works. In real life, you have to know property values in the neighborhood,
and you must be able to buy a house for well below it’s completed market value.
You also have to be able to reliably estimate renovation costs. It helps (a lot) if you can do a
lot of the work yourself.
What could go wrong? The two biggest issues are paying too much for the property upfront,
or discovering that what you thought to be a minor repair is something much bigger.
For example, that the “little bit” of wood rot on the doorframe is hiding the fact that the entire
frame of the house is termite-ridden and needs to be torn down.
That’s extreme, and it can usually be determined by a thorough home inspection – which a
veteran flipper will always get.
Three rules:
If you’re missing any one of the three, the whole project can go horribly wrong.
This is a cautionary tale from yours truly. Remember how I wrote above “on TV it always
works”? That was my mistake – thinking it would work just like it does on TV.
Real Estate Investing Rule #1 – nothing works the way it does on TV – ever!
I fell for the myth that investing in real estate was going to be easy. That’s the way they make
it look. But I was stepping way outside of my area of expertise. Financial planning is what
I’m good at. Turns out that real estate isn’t.
I don’t want to sour you on investing in real estate. A lot of people are making a lot of money
by investing in it. I know a few, and I’m sure you do too.
But real estate investing is more challenging than investing in paper assets, like stocks
and mutual funds.
If you’re actually investing in properties directly, it’s a very hands-on affair. Even if you’re
not getting your hands dirty flipping houses, you still have to get involved in the not-always-
pleasant business of buying and selling.
If, on serious self-assessment, you recognize you’re not, you’re better off to leave real estate
investing for those who are well suited for it. Read my article to learn how NOT to invest in
real estate.
With that in mind, let’s look at some ways to invest in real estate which are better suited to
the real estate challenged among us…
Rent Out Space in Your Home or on Your
Property
This is probably the easiest way to make money in real estate through direct participation. If
you already own a home, you can pick up some extra income by renting out space.
I’m saying “space” for a reason. Most people think in terms of renting out a room to a border.
That’s one way to do it. But you can also rent out part or all of any of the following:
Your basement
Garage
Attic
An outbuilding on your property
Driveway
A corner of your land
Any of these rental arrangements can provide an extra income source, in the same way as
renting a room to a border. People and businesses have all kinds of space needs. In a lot of
cases, they just need extra space to store their stuff or vehicles.
If your home is located in a rural area, an older downtown area, or in a community that has
lax property use restrictions, this can be a real alternative.
But if you live in a suburban area, with tight property use restrictions, you’ll run into legal
obstacles. And if you live in a neighborhood with a homeowner’s association (HOA), don’t
even think about it.
But if your house is located in the right area, and you have extra space, this is a pretty easy
way to make extra money in real estate.
In fact, they’re something like mutual funds for real estate. Larger ones are publicly traded
and can be held in a brokerage account or even a retirement account.
That might be large apartment buildings, office buildings, retail space, industrial property,
hotels or warehouses.
This gives you an opportunity to invest in either commercial real estate or large residential
projects as a shareholder, rather than as an investor with direct responsibility.
The REIT itself pays no federal income tax on the earnings. They distribute 90% or more of
those profits to their shareholders as dividends.
The dividends become taxable at the shareholders’ personal tax rate. (They’re not however
considered qualified dividends, which get more favorable tax treatment.)
If you hold a REIT in a retirement account, like a Roth IRA, you won’t have to worry about
tax consequences anyway. It’s also an excellent way to add some real estate to diversify your
retirement portfolio.
That means that while you participate in the profits, your losses are limited to your actual
investment. This is referred to as “limited liability”.
Much like REITs, limited partnerships give you an opportunity to invest in larger, more
complicated real estate deals with just a few thousand dollars.
Real estate limited partnerships are a lot like owning stocks. If the partnership has good
management, and invest in successful deals, they can be very profitable. You can earn a
steady stream of dividends that are higher than what you can get on stocks.
But at the opposite end, a poorly managed LP can cost you your entire investment. Many are
set up primarily as tax shelters.
Since real estate generates large amounts of depreciation, the tax loss that LPs generate may
be more important than producing any actual profits.
Real estate LPs are not particularly liquid. If you decide that you’re not happy with your
investment, you may not be able to get out of it.
The downside of real estate ETF’s and mutual funds – which is true of nearly all real estate
related investments – is that they run with real estate cycles. When the real estate market is
doing very well, they can be incredibly profitable. But when real estate is in one of its bust
cycles, they can be one of the worst investments possible.
Both can be highly profitable, but the payback can take several years. You have to invest with
money you don’t need right away, and also be prepared to go through the foreclosure process
in order to get paid.
You’re buying bad loans. You buy the notes from banks at deep discounts.
For example, if a homeowner owes $100,000 on a mortgage, and hasn’t paid in six months,
you may be able to purchase the loan for much less than face value. The bank is just trying to
get something on the loans to get them off their books.
The profit – or loss – is the difference between what you pay for the loan, and how much you
collect when it pays out.
If you purchase a $100,000 note for $70,000, you can make a $30,000 profit once the loan is
settled. Settlement often takes place through foreclosure. As the new lender on the property,
you can foreclose and sell the house. If it’s worth at least $100,000, you collect your profit.
Profit on real estate notes is tremendous, but the loss potential is equally dramatic. That’s
why these loans are only for sophisticated investors.
Tax-lien Certificates
These are a play on non-performing real estate but from a different direction.
Municipalities have the same problem that mortgage lenders do – owners stop making tax
payments. When the owner stops paying their property taxes, the municipality places a lien
on the property. The liens are then sold to investors as certificates. This enables the
municipalities to collect at least most of the taxes owed.
The owner of a certificate can collect the unpaid taxes, plus prevailing rates of interest. Those
interest rates can be as high as 30% per year.
If the property owner is unable to pay the tax lien, the lienholder can foreclose on the
property.
A tax lien has priority over a mortgage, so the owner of the tax lien is virtually guaranteed to
collect the full amount of taxes owed, plus accrued interest.
Reader Comments
1. Jake says
Hey Jeff – great post! Love that you included using the space in your current home – I bought
a house after college and started ‘house hacking’ by renting the rooms out. Looking back, it
was one of the better things I did to help get me on the financial independence track. But I
never thought of renting out other ‘space’, like letting someone use the driveway – intriguing
idea! Thanks!