Every new investor needs to have a firm understanding of investing basics. Just like a home cannot be built without a solid foundation -- in order to make money, develop a retirement plan, or achieve financial security through real estate, you need a strong foundation in real estate investing.
While there are some commonalities between real estate investing and more traditional investing methods like the stock market, mutual funds, or municipal bonds, there are also a lot of differences. Even those familiar with terms such as return on investment (ROI), yield, or dividends, can feel intimidated when they hear new terms like net operating income, cap rate, or pro forma.
To shorten the learning curve and help you build a strong foundation in real estate, let's dive into some real estate investing basics.
Why invest in the first place?
Investing can help create or supplement income which can be used to grow your nest egg, boost your savings account, and create financial security well into retirement.
Unfortunately for most people, Social Security isn't enough to live off of through retirement and may not be around in its current form forever. That means you may need to have a backup plan, an additional source of income that can help support or supplement your retirement. By investing a portion of your income now, your savings can grow for you by earning a return. The higher the rate of the return, the faster your money grows.
For many, investing includes having a diversified portfolio, holding traditional investments and real estate investments. While the great debate of which is the better investment can be argued for both sides, there is no denying real estate can be a tremendous addition to an investment portfolio. After all, real estate:
- can produce passive income,
- has the potential to appreciate or increase in value over time,
- allows you to use debt to increase your purchasing power and rate of return,
- and produces competitive returns as high as 8%-15% or more.
While all types of investing involve risk, much of the risk in real estate investing can be mitigated by conducting thorough due diligence prior to investing. Now, let's explore the different ways to invest in real estate.
Ways to invest in real estate
You can invest in real estate passively, meaning you are a passive participant and are not responsible for managing the property or investment yourself; or actively, in which you are an active participant and responsible for the acquisition, management, and disposition of the property.
While all forms of real estate investing require your time, passive investments require far less ongoing time commitment than active real estate investments. However, active investments often bring higher rates of return. Before you start investing in real estate, review the amount of time you have available to dedicate to your real estate investments. Determine which style of investing aligns best with your available time and desire for participation.
Passive real estate investments
Passive investments provide income called cash flow, typically paid in the form of rental income or dividends. Passive income is taxed differently than ordinary income and for many, is the ideal income source because it requires little ongoing participation.
It's not uncommon for those who start investing to want to branch outside of the stock market and diversify their portfolio to hold real estate investments. But there are still ways to invest in real estate with individual stocks through real estate investment trusts (REITs) and exchange-traded funds (ETFs).
A real estate investment trust is a company with a specific designation that buys commercial real estate by pooling investors' money, paying at least 75% or more of all income to their investors in the form of a dividend. REITs can be publicly traded or privately traded and historically have a strong performance.
You can purchase shares of a REIT through a brokerage account for just a few hundred dollars. While there are two primary categories for REITs -- equity REITs or mortgage REITs -- there are companies that specialize in every type of commercial real estate (CRE) possible. Investing in REITs is relatively easy and a great way for those who have a limited amount of funds to begin investing in real estate.
Real estate ETFs
A real estate exchange-traded fund is similar to a mutual fund but focuses on buying real-estate-related commodities, like REITs. The fund manager chooses specific REITs to invest in, which allows the investors buying shares in the real estate ETF to diversify their holdings across a number of different CRE sectors and with a variety of different REITs.
You can purchase a real estate ETF through a brokerage account typically for a few hundred dollars, making this a great entry investment option.
Real estate crowdfunding is a relatively new investment opportunity that allows accredited investors to pool money to fund a real estate venture. Investors can join a crowdfunding platform that connects a sponsor, the active partner in the real estate venture, with funding from multiple investors. The investment opportunity is professionally managed by the sponsor and the sponsor's team, paying the investor a specified return over a set period of time. Funds invested in a crowdfunding opportunity are often illiquid for a set period of time, meaning the investor cannot pull the funds without paying a penalty. Crowdfunding can be a lucrative passive investment option for qualifying investors, but does come with risk.
Rental real estate
In rental real estate, income is earned by collecting monthly rent. Unlike in a job where you trade your hours for money, a landlord earns cash flow each month without having to work an equal amount of hours for it. Rental income is ongoing. As long as the property is rented and the tenant is paying, you earn cash flow for the long term, potentially making it a reliable income source in retirement.
You can rent a residential property, like a single-family home, condo, or triplex -- or you can rent a commercial property like an office, industrial building, retail center, or apartment complex.
While the IRS considers rental income to be passive, there is still active participation by the investor. The investor is responsible for finding the investment opportunity, managing it, and is on title holding liability and responsibility for the property including paying for taxes and insurance, as well as maintaining and improving the property over time.
How passive or active a rental property is greatly depends on how it's managed. You can hire a third-party management company that handles the ongoing management for you for a fee, or you can manage it yourself. While some rentals require more work than others, typically if you manage a property yourself your income is no longer passive, as you are trading your time for income.
Residential real estate is a common starting point for new investors because of the lower upfront cost making it an easier entry point. In many cases, getting a mortgage for a $100,000 single-family home is easier than getting a commercial loan for a $1,000,000 property. Additionally, commercial rentals are analyzed differently than residential rentals, so it's important to distinguish the varied types of rental real estate to determine which investment strategy appeals to you most.
Private equity fund
A private equity fund pools money from multiple investors to purchase real estate securities. The fund manager and their team manage the investments, paying investors a preferred return or dividend monthly or quarterly. There are private equity funds for investing in commercial real estate, residential real estate, and even real estate debt like performing or non-performing mortgage notes.
Investment funds placed in a private equity fund are illiquid for a specified period of time, meaning the investor is unable to pull their investment out of the fund without penalty. Private equity funds must pool their money according to the Security Exchange Commission (SEC) rules and are not publicly available.
Performing mortgage notes
Investing in or creating mortgage notes is often seen as a higher-level real estate investment strategy but is accessible to even those just starting out. You don't own real estate when you invest in a mortgage note, instead, you are investing in the debt behind the property.
Just as a bank lends money to buy a home, an individual can lend money to buy a home. The property buyer signs a note and mortgage promising to repay the debt and makes a monthly payment in the form of a principal and interest payment to the lender each month.
A performing mortgage note does require work, especially in reviewing the borrower's qualifications to buy the property and repay the debt. Once the note is purchased, though, it is a form of passive income.
Unlike with a rental, the lender does not own the home, meaning they are not responsible for taxes, property insurance, or maintaining the property. As long as the borrower pays, the investor receives passive income in the form of cash flow.