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How Real Estate Investing Works: The Basics

This guide will give you a solid foundation on how real estate investing works.

May 02, 2021 by Liz Brumer
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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, but 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, affordable way to get started.

However, there is also commercial real estate (CRE), which includes real estate used for business purposes, including office buildings, retail space, hotels, malls, industrial real estate buildings like a warehouse or storage facility, 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, which 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 of 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. Investors also 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 2-, 5-, or 10-year period, or even more. 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, makes 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 if 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 other experienced real estate investor who 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 in order to receive the return.

Regardless as to whether you or another person or company invests as the active investor, money is typically earned in real estate through one of three ways:

  1. Rental income
  2. Property appreciation or the real estate's value
  3. Mortgage interest

Rental income

Rental property is by far the most common way of investing in real estate and is used in both commercial real estate and residential real estate. With rental property, the owner rents the land or property to a tenant using a short-term or long-term contract called a lease. 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, which results 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.

Property appreciation or value

Many investors rely on a property's value as their method of investing in real estate. Buying property that needs improvements at a discount, adding value through renovations, and selling the property at a higher value is one way to achieve this. This method of fix and flipping property is an active investment strategy but can be quite lucrative if done well.

As an example, let's say a property is purchased for $150,000 and $40,000 is spent on renovations and costs like utilities and financing the property. After three months of work, the property is listed for sale and sells for $240,000. The investor is able to net the difference between their cost of $190,000 ($150,000 + $40,000) and the sales price of $240,000 (not accounting for closing costs), or $50,000.

Wholesaling is another way to use a property's value to create income or earn a profit. When you wholesale a property, you get a property under contract at a set price and assign the contract to a third-party buyer at a higher price. Essentially, you're buying low, selling high.

For example, you get a distressed property that needs to be improved under contract for $125,000. You then find a third-party buyer who has the funds and skills necessary to renovate the property and is willing to pay $135,000. You assign the contract to the end buyer at $135,000, making the $10,000 difference as a fee.

Relying on property value or appreciation is a higher-risk investment strategy. In a strong market, this method can work well. However, valuations are vulnerable to market conditions, which can positively or negatively impact real estate values at any given time.

Mortgage interest

Just as banks and other lending institutions loan money to buy real estate, individuals can loan money to purchase real estate too. Mortgages in the private sector can include owner financing, a hard money loan, or a private loan secured by real estate and providing a return to the lender through interest.

The interest rate, which is often much higher than that offered by a traditional lender, provides the investor with a return over time, which could be a year or less, or up to 30 years, depending on the type of loans. The private real estate market often uses mortgage interest as a way to invest in real estate. There are even mortgage real estate investment trusts (mREITs) that specifically invest in real estate debt.

How much money is needed to invest in real estate?

While there are ways to invest in real estate with little to no money upfront, it's a good idea to have money set aside specifically for buying real estate investments outside of your main savings account. While you can invest with just a few hundred dollars, having several thousand to tens of thousands will certainly help jump-start your investment career. Some investments from a crowdfunding site, investment group, or private equity group may only be available to accredited investors, or high-earning, high-net worth individuals.

The Millionacres bottom line

While real estate investing holds a world of opportunity, it also comes with risk and important tax and liability considerations. What you invest in and how you invest can impact how you're taxed, and investing in real estate should only be done after conducting thorough research, due diligence, and with careful consideration.

11% of the mega-wealthy swear by this investment…

The richest in the world have made their fortunes in many ways, but there is one common thread for many of them: They made real estate a core part of their investment strategy. Of all the ways the ultra-rich made their fortunes, real estate outpaced every other method 3 to 1.

If you, too, want to invest like the wealthiest in the world, we have a complete guide on what you need to take your first steps. Take the first step toward building real wealth by getting your free copy today. Simply click here to receive your free guide.

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