Real Estate: You Need to Read This Before Investing

In a previous blog, we talked about how the main components of your investment portfolio will typically be cash, stocks, and bonds. But what about other asset classes, like real estate? Should you strive to add real estate to your investment portfolio? Before understanding how to invest in real estate, it’s important to first understand the 3 basic ways real estate investors make money.

Personal property real estate

Some of you may be real estate investors and not know it. That is, if you bought a personal property, you are technically a real estate investor! There are some investors that argue a personal property doesn’t count as an investment. But for the sake of simplicity, let’s just assume that it is. Simply because you are saving money each month and putting it towards the equity of your house. Eventually, you will be able to sell the house and make money from the sale. Buying your own home is the most common way to invest in real estate. So should you buy a personal property rather than renting because buying a property is an investment? No, there are a few caveats you should be aware of.

One rule of thumb states that if you don’t own the property for at least seven years, you will likely lose money on your investment upon selling the home. This is because maintenance costs, taxes, and interest fees add up. The home value would likely not exceed this sum in seven years. For this reason, it’s important to only buy a home if you can see yourself there for a long time.

 If you’re a first time home buyer, you likely are borrowing a lot of money to purchase a home. Be aware of interest rates before qualifying for a mortgage and purchasing a home. Even a difference of a few percentages in interest rate can double your monthly mortgage payments!

Owning a personal property could be a great investment vehicle which can store your cash in increasing equity in a way that diversifies from stocks and bonds. But before purchasing, know your investment timeline.

How to invest in real estate: rental income

Another popular form of real estate investing is buying rental properties. When you buy a rental property, you buy an apartment or house that you don’t plan on living in. Instead, you rent it out and collect monthly rent from your tenant. There are two basic ways of investing in rental properties:

1. Leveraged purchase – You purchased the property with a mortgage and will have monthly mortgage payments to your bank

2. Cash purchase – You purchased the property with your own cash, and will not have monthly mortgage payments to your bank

Both ways of buying rental properties can be very profitable, and they both have their pros and cons. 

Leveraged Purchase vs. Cash Purchase

With a leveraged purchase, you don’t need as much cash to invest in real estate. This lowers the barrier of entry for real estate investing. It also assures that you have less to lose if the investment doesn’t go well (tenant doesn’t pay rent, no tenant, etc.). With a leverage purchase the sky’s the limit with profit, and you have a pretty low amount of cash you can lose (though the house can be foreclosed on if you don’t make monthly mortgage payments).

However, you are a slave to the tenant in this case. That’s because you have to worry about rent every month in order to make your mortgage payments. Any missed payments can have you paying excruciating fees in interest, and maybe foreclosure. This isn’t the case with a cash purchase.

When you buy a rental property all cash, you don’t have to worry about rental income keeping your bills paid. Of course, you invest because you expect rental income. Either way, you can still appreciate the fact that the property will increase in value over time. Also, you often get a discount for buying the home outright and not taking out a mortgage.

The main caution real estate investors warn about is that it is not unlikely for renters to avoid paying rent. You should be aware of this so you aren’t surprised if it happens to you!

How to invest in real estate: house flipping

Some real estate investors don’t want to chase their tenants for rent, and so they do something called house flipping. House flipping starts when you buy a property at a bargain. You can buy a house for a bargain from a foreclosure auction like this site.  The reason the property is bought at a bargain is because it usually has a lot of issues, either aesthetically or internal maintenance. The goal is to buy the property at a low price point, fix it up, and then resell at a higher price. 

When it comes to how invest in real estate, house flipping is one of the hardet ways. That’s because it’s not easy to buy a house, fix it, and then resell for profit. This is usually the form of investing done by individuals who are handy around the house: they understand plumbing, construction, gardening, and more. Investing in a house flip requires a lot of work, and the fixes better be good if you want to make money! Before trying to flip a house you should ask yourself: Is this property a bargain for an unfixable reason (bad neighborhood, bad climate conditions, etc.)? Do you have the skills/time to fix the fixable problems? 

If you don’t like the answer to these questions, then the property is probably not for you. There are some house flippers that get contractors to fix up the house for them, but this will be more expensive than doing it yourself and it can cut into your profits from reselling the property.

Summary

In general, real estate can be a great investment vehicle, even if it’s a personal property. That being said, it’s not recommended to buy a personal home unless you are sure you will be living there for at least seven years. Also, rental properties can be a great source for monthly income, but there are some downsides when it comes to leveraged investments. This is because you are counting on someone else to pay your mortgage for you. A lot of rental property owners warn about tenants who often don’t pay rent. House flipping can be a quick way to to make money if you are willing to get your hands dirty and fix up the house. But house flipping can be riskier than other real estate investments since it requires precise timing of the market and value added to the property that exceed the work you put in.

In a future blog, we’ll discuss in more detail how to invest in real estate. For the average investor wanting to be exposed to the real estate market in order to diversify their investment portfolio, I’d recommend buying a REIT. REITs (Real Estate Investment Trusts) are basically mutual funds that manage income-producing real estate. You can buy REITs just like you would any index fund or mutual fund, and we’ll discuss the pros and cons of investing in REITs in another blog.