Real estate can be a great way to invest. Property investments have excellent return potential and diversify your portfolio to insulate you from recessions and other adverse economic conditions. But what's the best way to invest in real estate?
There's no single right answer. You have to look at the best options and decide which will work for you. There are several ways to invest in real estate, each with different capital requirements, risk levels, and investment dynamics.
Here’s a rundown of nine of the best ways to invest in real estate.
1. Buy a rental property
The most obvious way to become a real estate investor is to buy an investment property (or several). When I use the term "investment property," I’m referring to a residential or commercial property that you plan to rent out to tenants -- not a fix-and-flip, which we’ll cover later.
Owning rental properties is an excellent way to invest in real estate while building wealth and generating income. The return potential is strong thanks to a combination of income, equity appreciation, and the easy use of leverage when buying real estate.
However, owning rental properties isn’t right for everyone, so consider these drawbacks before you start looking:
- Cost barriers: It can be very expensive to buy your first rental property. Most lenders want at least 25% down for an investment property loan and it’s smart to keep several months’ worth of expenses in reserves.
- Uncertainty: When it comes to rental properties, vacancies happen and things break. While the overall return potential can be great, rental properties have considerable short-term risk.
- Time commitment: Even if you hire a property management company, owning a rental can be a time-consuming form of real estate investing.
2. Invest in a REIT or other real estate stock
Real estate investment trusts, or REITs, can be an excellent way to invest in real estate.
If you’re not familiar, check out our introductory guide to REITs. But here’s the quick version: REITs are specialized companies that own, operate, manage, or otherwise derive their income from real estate assets. Many REITs trade on stock exchanges, so you can buy them with the click of a mouse and very little capital.
I’d also put real estate mutual funds and real estate ETFs in this category. If you don’t want to choose just one REIT, you can invest in a ready-made portfolio of them. The Vanguard Real Estate ETF (NYSEMKT: VNQ) is one excellent example of a real estate ETF that can help you get real estate exposure.
It’s also important to mention that some real estate stocks aren’t classified as REITs. Land developers and homebuilders are two other ways to invest in real estate through the stock market.
3. Participate in a real estate crowdfunding opportunity
Crowdfunding is a relatively new way to invest in real estate, and it's growing rapidly.
Here’s the basic idea. An experienced real estate developer identifies an investment opportunity. Typically, these involve one commercial real estate asset and a value-adding modification. This could be as simple as restructuring the property’s debt or as complex as a complete renovation. There's usually a target end date when the developer plans to sell or refinance the property. Instead of funding the entire project with their own money and bank financing, the developer raises some of the necessary capital from investors like you in exchange for an equity interest in the project.
You can find crowdfunded real estate investment opportunities on CrowdStreet, Realty Mogul, and other platforms. These platforms act as intermediaries between investors and real estate developers (known as the deal "sponsors"). The platform makes sure the investments it lists are legitimate and meet a quality standard. They also collect money from investors on behalf of the sponsors.
There are some major advantages to crowdfunded real estate investing. First and foremost, the return potential can be huge. It’s not uncommon for a crowdfunded real estate project to target an internal rate of return (IRR) of 15% or more -- and early results indicate that these results are achievable. These projects often produce income as well as a lump-sum return when the property is sold. They can also diversify your investment strategy and let you piggyback on the experience of the developer (as opposed to attempting such a project on your own).
On the other hand, there are some major drawbacks to consider. With increased reward potential comes increased risk. Unlike buy-and-hold real estate strategies, the value-add nature of crowdfunding adds an element of execution risk. Liquidity is another major concern. Unlike most other types of real estate investing, it’s difficult or impossible to get out of a crowdfunded real estate investment before it’s complete (meaning the property has sold). If you invest in a crowdfunded real estate deal with a target hold of five years, you should anticipate that your money will be tied up for at least that length of time.
In a nutshell, crowdfunded real estate can be a great fit for many investors, but there’s a lot to know before you get started.
4. Buy a vacation rental
A vacation rental is different than a long-term rental property in a few key ways.
On the positive side, you may be able to use the home when it isn’t occupied. It can also be significantly easier to finance a vacation rental, especially if it meets your lender’s definition of a second home and you don’t use the rental income to qualify. Finally, a vacation rental tends to bring in more income per rented day than a comparable long-term rental property.
However, there are some potential drawbacks to owning a vacation rental. Marketing and managing a vacation rental is more involved than a long-term rental. As such, property management is far more expensive -- expect to pay a property manager about 25% of rent on a vacation rental. That's more than double the 10% industry standard for properties with long-term tenants.
Furthermore, you might not be allowed to rent out properties in your preferred locations -- or you might need a special license, which can be very expensive. And it can be easier to get second home financing, but you’ll need to qualify for it based on your existing income, not your anticipated rental revenue.
5. House hack your way to a real estate portfolio
House hacking is essentially a hybrid of buying a home to use as a primary residence and buying a rental property. In general, the term refers to buying a residential property with two to four units and living in one of the units while renting the others out. But it can apply to buying a single-family home and renting one or more of the rooms.
Let’s say you find a quadruplex (four units) for $200,000. Including taxes and insurance, we'll say your mortgage payment is $1,500 per month. After you buy the property, you rent out three of the units for $600 each and live in the fourth. Not only do you live for free (the rent covers your entire mortgage payment), but you’re generating positive cash flow of $300 per month and are building equity in a more valuable property than if you had bought one unit to live in.
House hacking can be an excellent low-cost way to start building a portfolio of rental properties. Because you live in the property, even a multi-unit residential property can qualify for primary residence financing, which comes with lower interest rates and lower down payment requirements than investment property loans. You’re typically required to live in the property for a certain amount of time after you buy it, but once that period expires (usually a year or two), you’re free to repeat the process with another multi-unit property.
The obvious downside is privacy. There’s value in having your own yard, and it can create some awkward situations when you live in the same building as your tenants. Even so, if you’re a new real estate investor and don’t really need your own house, you may want to consider house hacking. My first real estate investment was a house hack where my wife and I bought a duplex and rented out one of the units.
6. Rent out all or part of your own home
This isn’t as much of an investment strategy as it is a side hustle, but it’s still worth mentioning here. With the emergence of platforms like Airbnb, it’s easier than ever to rent out your home when you aren’t around or to rent out a spare room in your home for a few days here and there.
One interesting aspect of this strategy is that if you rent out your home for fewer than 14 days in a year, you don’t pay tax on the money you collect. If you go out of town for the holidays or take a summer vacation, using your home as an occasional short-term rental can offset your travel expenses with tax-free income.
7. Fix and flip a house
The terms "flipping houses" and "fix-and-flip" refer to buying a home for the sole purpose of making repairs and quickly selling it for a profit.
Thanks to several TV shows on the subject, house flipping has become popular in the past few years. And to be fair, there's a ton of money to be made if a flip is done properly and goes according to plan.
However, flipping houses is a job, so if you’re a passive investor it’s probably not right for you. And there’s quite a bit of risk involved with flipping houses, even for the most experienced professionals.
If you give flipping houses a try, here are a couple things to keep in mind:
- You make your money when you buy, not when you sell: Use the 70% rule when shopping for a property -- your acquisition costs, repair expenses, and holding costs shouldn’t exceed 70% of what you expect to sell the property for. This gives you a nice cushion to deal with the uncertainty of flipping houses without major risk of losing money. If you can’t get the property while sticking to the 70% rule, don’t hesitate to walk away.
- Time is money when it comes to flipping houses: You can destroy your profit margins by taking your time on repairs and dragging your feet when it comes time to sell. Aim to have renovations scheduled before you close on the home and set a realistic sale price for the finished product.
There’s quite a bit that can go wrong when flipping a house, so do your homework and have a plan before jumping into your first flip.
8. Build a new home on spec
This is like fixing and flipping houses in terms of investment dynamics, but with the obvious additional step of building a house from scratch. Building a spec home can be an especially lucrative investment strategy in markets with a limited supply of new homes to choose from.
In several ways, building a spec home can actually be less risky than fixing and flipping an existing house. You generally know what a new construction is going to cost -- you don’t have as much potential to run into unexpected repairs as you would with fixing and flipping.
On the downside, spec houses are more time-consuming. It generally takes a couple of months to fix up an existing home, but it can take a year or more to build a house from scratch. Be sure your returns justify the increased time commitment, as you can potentially complete several fix-and-flip projects in the time it takes to build one house from the ground up. The longer timeframe also creates the additional risk factor of market fluctuations. Your real estate market might be hot right now, things can change quite a bit in the year it takes you to build a house.
9. Be a lender
One type of real estate investment that doesn’t get too much attention is debt. You don't need to start a mortgage company or directly lend money to anyone -- there are other ways to add real estate debt investments to your portfolio.
Many of the same crowdfunding platforms I discussed earlier also list debt investments. In other words, instead of being a stakeholder in the project, you’re one of its financiers. There are also some platforms, such as Groundfloor, that let you choose individual real estate loans to invest in (think of this as a Lending-Club-type platform for real estate).
There are several reasons that a debt investment might be smart for you. For one thing, you can typically get more income from a debt investment than you can from an equity investment. Instead of an investor making interest payments to a bank, they make payments to you and other debt investors. It’s not uncommon for crowdfunded debt investments to generate cash-on-cash yields in the 8% ballpark for investors.
Debt investors also have a senior claim to the assets of an investment project. If a crowdfunded investment goes sour, debt investors get their money back before equity investors do. While there’s a broad spectrum of risk here, debt investments are typically lower-risk in nature than equity investments.
On the downside, debt investments as a whole have less total return potential than equity. When you invest in real estate debt, your return is the income payments you receive -- that’s it. If the project makes a ton of money, debt investors won’t see an extra dime. When you invest in real estate debt, you give up some potential upside in exchange for steady income and lower risk.
A combination of these strategies could be ideal
There’s no rule that says you need to pick just one of these. In fact, the best way to invest in real estate for most people can be a combination of a few options. For example, I own a few rental properties, invest in several REITs, and plan to buy a vacation rental within the next year or so. Longer-term, I’m planning to add a crowdfunded investment or two after I form a nice "base" out of investment properties with steady cash flow and rock-solid REITs.
There’s no perfect real estate investment -- by diversifying your capital amongst a few of these, you can get the best aspects of each one. My REITs give me lots of liquidity if I need it and my rental properties give me excellent long-term return potential while providing a nice income stream. The best course of action is to figure out what’s most important to you and decide the best way to invest accordingly.