If you're branching into the world of investing, you may be considering real estate as an alternative investment to a traditional stock, mutual fund, or bond. When done correctly, real estate investing can be a worthwhile way to grow your money or earn additional income while diversifying your investments. However, navigating the ins and outs of a real estate investment can be intimidating when just getting started. This guide will break down the fundamentals of how real estate investing works and help you get a thorough understanding of the basics of real estate investing.
Types of real estate to invest in
Real estate comes in many forms and fashions. You're likely familiar with residential real estate, which includes single-family homes, as well as smaller multi-unit homes like a duplex (two units), triplex (three units), or fourplex (four units).
Residential real estate is one of the most popular ways to invest in real estate. The abundance of properties in the marketplace, as well as the lower purchase prices, make it an easier, more affordable way to get started.
However, there is also commercial real estate (CRE), which includes real estate used for business purposes, such as office buildings, retail space, hotels, or malls; industrial real estate buildings like warehouses or storage facilities; or large apartment buildings (five units or more). Commercial real estate is usually more expensive than residential property, making it a popular investment opportunity for larger investment firms or those with a lot of money to invest in real estate.
Land is another investment option and can include raw undeveloped land, farmland, or vacant lots.
Who can invest in real estate?
Since real estate investing doesn't require any licenses, those with the right knowledge can invest in real estate. However, how much knowledge, time, and money you have available to invest will determine how and what you invest in. Individuals can own and invest in real estate, as can companies such as a limited liability company (LLC), corporation, trust, or larger real estate investment group.
Why invest in real estate?
Investing in real estate offers a lot of benefits to those who participate, diversification being one. Diversification reduces risk for an investment portfolio. If all your money is invested in one place, such as the stock market, bonds, or a single real estate investment, the investment could be jeopardized if the market turns or the investment goes south. By owning multiple investments in different asset classes, you reduce your risk and exposure.
Owning income property also opens the door to certain tax advantages that can reduce your tax burden each year through a number of deductions. Additionally, investors have the benefit of owning real estate that may increase in value, or appreciate, over time. Natural supply and demand and inflation cause real estate values to increase.
Some markets with higher demand appreciate faster than others, which means real estate can increase dramatically over a two-, five-, or 10-year period or even longer. Even if a property is purchased with debt, as the debt is paid down, the property owner gains equity, or the difference between the property value and the amount owed.
These benefits, in addition to the opportunity to earn income from the property, make it an appealing investment strategy.
How to invest in real estate
There are a lot of ways to invest in real estate, which means how you earn money from real estate will change depending on the method of investing you pursue. The biggest choice investors have to make when getting started is whether they want to invest passively or actively.
An active real estate investment means you, as the buyer, own and likely manage the investment property. You are responsible for things relating to the upkeep of the property, which can include property taxes, insurance, debt payments on any loans used to purchase the investment, and the management of any tenants, contractors, or other related parties.
Passive real estate means you, as the investor, place your money with an investment company, such as a real estate investment trust (REIT), real estate fund, or another experienced real estate investor, who then takes on the role of active investing, owning and managing the investment or group of investments and paying you as the passive investor an agreed-upon return, which could be a dividend or interest payment. The income earned this way is considered passive income because the investor isn't actively participating to receive the return.
Regardless of whether you or another person or company invests as the active investor, money is typically earned in real estate through one of three ways:
- Rental income.
- Property appreciation or the real estate's value.
- Mortgage interest.
Rental property is by far the most common way to invest in real estate and is used in both commercial and residential real estate. With rental property, using a short- or long-term contract called a lease, the owner rents the land or property to a tenant. The tenant occupies the property for the specified time period, paying the landlord, also known as the property owner, an agreed-upon rental rate.
Ideally, the rental rate will be greater than the monthly or annual expenses for the property, resulting in positive cash flow. For example, if a property is rented for $1,500 a month but has a total monthly expense of $1,200 (including the mortgage payment, property taxes, insurance, and setting some money aside for future repairs), the monthly cash flow is $300.
Land, commercial real estate, and residential property can all be rented to a tenant. Each party's roles and responsibilities will vary, depending on the type of property being leased and the type of lease.