If done right, you could see significant returns on your money but, as with any type of investment, “never invest in anything you don't understand (or can't explain to a 5th grader.”)
Even Mark Twain knew that real estate investing was valuable as he said, “Buy land. They're not making it anymore.”
One of the main reasons that hold most people back from real estate investing is the lack of knowledge. One misconception is that it takes lots of time and money, but you'd be surprised at the multiple different ways you can get started in real estate.
If you're not sure where to begin, let's start by addressing the different types of real estate investing.
Types Of Real Estate Investing
Wikipedia defines real estate investing as the purchase, ownership, management, rental and/or sale of real estate for profit.
The four main categories of real estate generally break down as follows:
1) Residential real estate
Most are familiar with residential real estate, which includes:
- single-family homes
2) Commercial real estate
Commercial real estate is a property that is used for business to make a profit.
- office buildings
- retail (strip centers)
- storage units
- multifamily (five units and larger)
3) Industrial real estate
These properties serve an industrial business purpose.
- shipping warehouses
- power plants
Land is a property without structures residing on it.
Owners can earn money from land via:
- development/sale of the land
- usage such as in farming/agriculture
4 Ways To Make Money In Real Estate
#1 Cash flow
Cash flow is what's left over after all the property expenses and mortgage get paid each month.
One of the first places I learned about cash flow was from the book Rich Dad Poor Dad.
Cash flow is what attracts most investors to real estate as it helps to eliminate the fear of outliving your money during retirement.
Most of us learn that we have to work for 40+ years and do our best to build the biggest nest egg possible in hopes of it not depleting when the drawn down occurs plus taxation.
But if you invest in assets with continuous streams of cash flow, you'll be able to rest easier knowing your expenses get paid.
If you've ever bought and sold a home for a profit, then you've experienced appreciation.
Appreciation happens when the value of a property increases (appreciates) over time. Just like the stock market, there are ups and downs in the housing market (2008 crash). But historically, the value of real estate has typically increased in the U.S.
There are two main types of appreciation:
Passive appreciation happens as a result of time. Typically the overall value of homes seems to increase at a rate in line with inflation (around 3-4%).
Forced appreciation is the concept of increasing the value of the property while physically updating/improving it. You will see this type of appreciation in the value-add deals.
Some ways you can achieve are by updating countertops, appliances, and lighting. By doing this, rents can be raised, thereby increasing the overall net operating income.
This, in turn, increases the building's value.
#3 Loan amortization
Amortization is the process of paying off debt (in this case, a mortgage) over time through regular payments.
A portion of each payment is for interest, while the remaining amount is applied towards the principal balance.
An amortization schedule is determined by the percentage of interest versus principal in each payment.
Initially, a large portion of each payment is devoted to interest. As the loan matures, larger portions go towards paying down the principal.
What's great about this is that the tenants are paying down the mortgage each month. That means you don't have to take out a huge loan to cover the property.
Here's an example:
Let's say you purchased an apartment complex for $500,000 with a mortgage of $400,000. During the time that you held it, it broke even (had $0 in cash flow) and never appreciated – which is very unlikely. Stay with me here while I try to make a point.
So after the 30-year mortgage is paid off, guess what? You now own an apartment complex free and clear worth $500,000 that you never had to save for. Why? Your tenants bought it for you via the loan pay down. Good stuff!
#4 Tax advantages
One of the most overlooked advantages of building wealth with real estate is the tax benefits that are associated with it.
The IRS loves for people to buy real estate, and for this reason, they offer many excellent tax breaks.
Some common deductible expenses are:
- property management expenses
- insurance premiums
- property tax
Over time, wear and tear lower the value of a rental property and its contents. This process, known as depreciation, is tax-deductible.
The deduction can be taken for the expected life of the property, but it must be spread out over multiple years.
You can obtain a cost segregation study to help, which identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.
You can also take advantage of a 1031 exchange, which may allow you to defer taxes from any sale indefinitely.
Active vs. Passive Investor?
One of the biggest decisions that you're going to have to decide is on which route you want to take: Active vs. Passive Real Estate Investing
For me, I thought I wanted to be an active investor as it was the only thing I knew about once I started the self-education process.
I have several friends that manage properly locally in my town. I spent several months picking their brains about the pros and cons of being a landlord and even went to look at a few single-family homes with them.
But then I realized while going through the process that I didn't want a second job. My goal was to create other income streams so I can start to free myself from work and spend more time with my kids (while they're still under our roof.)
Again, what's best for me may not be for you so. My advice is to think long and hard to help direct you down the right path.
Active investor (Do-it-yourself)
Most active investors (landlords) that I know that also have a “day job” typically have been involved in real estate in some form or fashion in the past. Unlike them, I didn't have any type of real estate except for the home I grew up in.
If you want to pursue the active real estate route, you need to have two things at your disposal:
Here's a few questions to answer:
- Do your full-time job and family obligations leave you enough spare time to be an active investor?
- Have you been exposed to real estate investing? If not, how do you plan on educating yourself?
- Have you had a mentor show you what it takes to be successful in this business?
If you've answered “no” to these questions, then perhaps you're better off passively investing.
Passive investor (Hands-off)
Here's the good news. There are multiple different ways to invest passively in real estate, especially for the busy professional.
Again, this is the route I chose as I wanted the benefit of an extra stream of income and more free time minus the headaches of managing the property myself.
For me, this was a win-win situation.
Putting It All Together
Studies show that 90+% of U.S. millionaires have real estate in their portfolio. They know that real estate investing has a proven track record and offers the potential to earn significant returns and diversification to portfolios
After you determine whether you want to become an active or passive investor, make sure you understand and weigh the risks and potential rewards before beginning.
Spend time educating yourself so you'll be able to make the best decision you'll need moving forward.