So, you’re thinking of investing in real estate … congratulations! Real estate has been a vehicle of wealth-building for hundreds of years. In fact, 90% of all millionaires become millionaires because they invested in real estate.
Real estate values tend to go up over time and outpace inflation. Buying with a mortgage even provides a “hedge” against inflation, since rents could increase and the dollar could inflate, but the mortgage stays the same size.
Real estate investors also enjoy several tax advantages that make it an attractive investment choice—even if the property doesn’t perform as expected!
But real estate investing is full of pitfalls—and even a “beginner” mistake can cost thousands of dollars or wipe out life savings. Start by educating yourself. This article will cover broad basics that beginners need to know. If any of these subjects pique your interest, check out books or in-depth articles that flesh the subject out in more detail.
First things first, every real estate investment is a business. Even a single rental condo is a small business unto itself. Every business has a learning curve. The most successful real estate investors never stop learning, acquiring new tools and tricks that accelerate their wealth-building. But everyone starts somewhere, so let’s dive in!
Understanding Your Market
You’ve heard that real estate is about “location, location, location.” If every real estate investment is a business (and it is), that business is strongly influenced by local economic forces.
For example, an economic downturn in Seattle might not affect the value of a property in Houston one bit … but a law passed by the Houston City Council or a hurricane off the Gulf may have a big impact.
Houston and Seattle are both examples of markets. When we talk about a “market,” we mean the city or local environment in which the potential property investment is located. Markets also have submarkets, like the Capitol Hill neighborhood in Seattle, or the Alvin suburb of Houston.
When evaluating a market or submarket you might want to invest in, whether it’s your hometown or someplace far away, consider some basic economic factors:
- Are people moving in, or moving out? An expanding population might lead to increasing property values due to the higher need for housing. Conversely, a declining population might lead to decreasing property values.
- Are jobs moving out, or moving in? Are major employers opening up campuses in the market, or closing them down? Jobs coming into an area is a great leading indicator of rising property values.
- Is the population younger? Older? Married? Single? What is the median income within a few miles of the submarket? Different demographics might favor different strategies.
- Are there good schools nearby? Might families want to live there for the long term?
- Are many new units (new houses or apartments) being built in the area? Fast building activity usually responds to an expectation of demand, which is a good sign … but there is also a risk of a market getting over-built, with more units than needed. Check to see if the growing population of the market justifies the build activity.
As you can see, this is a lot to keep track of, but start scanning the news for items related to these indicators. Take your time—you’ll get the hang of it.
Understanding Market Cycles
Real estate markets sometimes fall victim to hype. You may have heard people say “The value or real estate always goes up!”
This is not true, or at least it’s a gross oversimplification. Over long periods of time, real estate has trended upward in value … but over cycles of about ten years, property in a market tends to increase in value, then decrease a little, then increase again, then decrease a little, like an upward-trending wave.
Basically, if you buy at the wrong time, you could end up losing money or holding onto property for much longer than expected to recoup losses in value.
Try to figure out where you are in the market cycle by assessing whether your market is in a “buyer’s market” or a “seller’s market.”
- Buyer’s Market. Supply of homes is high. Homes are sitting on the market or selling for below asking price. Landlords offer rent discounts or specials to fill their units. Usually follows overbuilding or an economic downturn. Good long-term real estate investments are easy to find.
- Seller’s Market. Supply of homes is low and homes are in demand. Units sell or lease almost as fast as they come to market. Prices get bidded up. Excitement is high. Everyone tells you this is the time to buy and real estate always goes up … but it may be a good time to wait and see. Good long-term deals are harder to find in a seller’s market.
Understanding Property Types
There are several basic types of real estate to consider:
- Condominiums. Some of the cheapest property to buy, condos are usually “apartments for sale,” attached to a larger building or at least to a condo association. Condos can be attractive because they are cheap, but HOAs and condo associations can cause many headaches for real estate investors.
- Single-Family Homes. Some of the easiest properties to understand and manage, especially if there is no HOA. Always in demand, especially in good locations.
- Small Multifamily. Duplexes, triplexes, fourplexes. While these properties have more units, the rules of single-family house investing still apply.
- Multifamily/Apartment. For buildings of five apartments or more, rules for commercial property start to apply.
- Commercial Property. Office and retail property. More rules, more advanced.
- Industrial Property. Storage and manufacturing space. Possibility of environmental hazard liability. Even more advanced.
Understanding Property Classes
In addition to property types, properties tend to be sorted into classes, like giving the property a letter grade:
- Class A. Brand-new build. Commands high prices, but little room for improvement. Units also tend to be bigger and more expensive to turn (more carpet to clean, etc.) Considered “less risky,” but with less opportunity for big profits.
- Class B. Somewhat dated but in good condition. Class B properties in bad shape can often make excellent “fix-and-flip” properties, while Class B properties in Class A areas may appreciate quickly.
- Class C. Dated and possibly functionally obsolete, but still inhabitable. Class C properties in Class B or A areas can appreciate quickly or command higher rents, especially in an infill area with lots of Class A construction happening. Considered “risky,” but the potential gains are big.
- Class D. Dilapidated or abandoned properties in bad neighborhoods with endemic poverty and crime. Not good for beginners.
Buying a property “all cash” without a loan is one of the least risky ways to buy real estate. It’s easy to have positive cash flow, but the benefits of appreciation are small. That’s also a lot of capital to tie up in one investment … and most beginners don’t have that kind of cash to begin with.
So, just like homeowners, most real estate investors buy property with a loan. Buying property with a loan is sometimes described as “leveraging” the asset—giving yourself more exposure to gains by financing the deal with someone else’s money. Of course, the repayment obligation on the loan means that there is more risk—if a pipe bursts and you use the mortgage money to fix it, you’re in trouble.
Like the mortgage on your home, all real estate loans use a deed of trust and a promissory note, whether the lender is a bank or a private individual. Here are a few loan categories to be aware of:
- Traditional Mortgage. If you can get approved for a traditional mortgage, a bank will probably give you a loan on an investment property … but you will have to put at least 20% down on the appraised value. Interest rates are typically low, terms favorable.
- Commercial Loan. With a few exceptions on available terms, commercial real estate loans resemble home mortgages in most respects.
- Private Loan. Private individuals with money to loan may be interested in your deal and may lend you more than 80% of the purchase price. They may even loan repair costs. Interest rates tend to be higher. A private lender might be willing to close on the transaction more quickly than a bank.
- Hard-Money Loan. These short-term, high-interest loans are targeted at fix-and-flips. Don’t be too scared of the high interest rate—flips tend to go quickly, so you won’t pay that rate for long. If the fundamentals of the deal are strong, the lender may loan you the whole purchase price, along with repair costs. Hard money loans also close quickly.
- Bridge Loan. Bridge loans are usually for commercial properties that need a complete rehab or a repositioning to become viable. Interest rates tend to be higher, but the loan may cover repair costs.
Understanding Real Estate Investing Strategies
“Real estate investing” is a blanket term that means different things to different people. There are actually many possible strategies you can use to make money off a property investment. Most of the strategies can be applied to any type or class of real estate—A, B, or C; single-family, multifamily, or commercial; and so on.
Here’s a quick hit on some of the best-known, best-loved investing strategies. If one or more of them resonates with you, consider a deep dive to learn more about that strategy.
This is the classic “real estate investment,” where you become a landlord who rents out property. Most people understand this process at least a little, having rented a home, bought a home, or both at some point in their lives. But let’s unpack a few of the nuances you can apply to this basic strategy …
A common choice for beginners, “house hacking” involves living on part of a property while renting part of it out. You could buy a duplex, live in one unit, and rent out the other unit; or you could buy a 3-bedroom house and rent out two of the bedrooms.
Since the home is your personal residence, you can put less than 20% down, lowering the barrier to entry. By renting space, you can wipe out or at least substantially reduce your own house payment. Since you live on the property, some of the logistics of managing it are much easier.
One of the downsides of a buy-and-hold strategy is that the down payment money is tied up. If you spend all the money you have to invest on your first property, are you stuck waiting until you sell the property to buy your second? You learn by doing, but this strategy feels like a lot of waiting rather than doing.
BRRRR is a beloved way to acquire multiple rental properties fast with little money down. Here’s the breakdown:
- Buy a fixer-upper at a reduced price with a private or hard money loan.
- Renovate the property so it rents for top-dollar.
- Rent the property out.
- Refinance the property with a traditional mortgage based on its higher “fixed-up” value. If you got a deep enough discount for the “as-is” property, you can probably pay off the entire private or hard money loan and get your down payment back.
- Repeat the process with the down-payment money you recouped in the refinance.
Properties in amazing locations may be in demand as a short-term or “vacation” rental. You will usually have to invest in making the property very nice, as well as furnishing and outfitting it … but a good vacation rental in a great location can more than justify this cost. Specialized property managers run vacation rentals for you, while sites like AirBnB make them easy to manage yourself if you choose to.
Property close to a popular college or university may be a prime candidate for student housing. Student housing often rents by the room or the bed, so a 3-bedroom house could effectively be run as a 3-bedroom apartment for outsized gains. Students usually have fewer requirements for apartment amenities, and parents often foot the rent bill … but watch out for damage due to parties.
Along with “buy-and-hold,” “fix-and-flip” is another major strategy of real estate investing. It involves buying a “fixer-upper,” renovating it as fast as possible, and selling it for a profit.
Note that the profit has to cover both the acquisition cost and the cost of repairs and renovations, before you can take a profit. Renovations are also notorious for being more expensive than expected, so it pays to be conservative when considering a fix-and-flip.
Both buy-and-hold and fix-and-flip investments are labor-intensive, with a steep learning curve for the business. Many investors just want “passive income” or “mailbox money” from their investments. There are ways to do this, although the risk-vs-reward profiles vary widely, as does the barrier to entry.
Instead of owing a mortgage payment, why not collect a mortgage payment? Individuals can invest in real estate debt by investing in mortgage notes. They could do this by:
- Selling their own home with seller financing.
- Becoming a private lender on real estate deals.
- Buying a note from a bank, paying either the balance due on the note or a discount on that face value. Now you have the right to collect mortgage payments on that note.
- Buying a note from a note broker (easy to find on Google).
Note-servicing companies can take care of collecting the payments. A note you buy may be either performing (the borrower is making payments) or non-performing (the borrower is in default—more labor-intensive to get your profit, but you can probably buy the note at a discount).
You can also buy part of a note with less cash down. Note investments tend to be lower-return and have fewer tax advantages, unless you buy your notes using a tax-exempt vehicle like an IRA or 529 Plan.
Tax Lien Investing
Some counties sell their delinquent tax liens to private investors for the amount of the unpaid taxes or less. These investments require very little money down, while the penalty interest is quite high. You could even foreclose and get the house for a song if the delinquency lasts long enough. The downside is that if the delinquent property owner pays off the debt, you have to find a new investment for that money—i.e. there’s a lot of potential turnover.
Crowdfunding sites like EquityMultiple or Fundrise allow you to invest as little as $500 in large real estate funds—one of the most passive, easiest-to-enter ways to invest in real estate.
REITs are like mutual funds, but for real estate instead of stocks. Traded on the open market like stocks, you can buy a share of a REIT and sell it any time, making it unusually liquid (easy to exchange for cash) compared to other real estate investments. Most REITs buy Class A property. The returns are low, but so is the risk.
Syndications are like private REITs that pool investor money to buy big commercial properties, like apartment complexes or retail centers. Access to these investments may be limited to wealthy or experienced investors, because the potential gains are huge but the risks high.
“Creative” investing strategies tend to involve a lot of marketing, but they can produce outsized returns with very little money down. Here are a few creative investing strategies that might interest you:
A real estate wholesaler finds property available at a deep discount, gets it under contract, and then sells the contract to another investor for a markup. This method is popular because it requires no money down and no risk of the wholesaler, and can be done even with bad credit.
However, it’s hard to find a property at such a deep discount that it would make an appropriate wholesaler. You usually have to find a very motivated seller—someone facing foreclosure, bankruptcy, or worse.
Lease-options involve renting out a property with a down payment, which secures the lessor an “option” to buy the property at a later date if (s)he qualifies for a loan. If the lessor doesn’t qualify for the loan in the option period, the down payment is forfeit and the landlord can evict the lessor and offer a new lease-option. Since this practice is often predatory, many states have adopted strict laws for the regulation of lease-options.
If a person owes more on a property than it is worth, that person can’t sell and pay off the loan. It’s quite a pickle. Banks and lenders usually have a “short-sale” percentage, a magic number that represents the portion of the loan that they will accept to release the borrower from the loan after they become delinquent.
Real estate investors can get the property under contract at a discounted rate, and then negotiate with the lender to find that magic number, then close on the property. This can be a long process, but if you learn a particular lender’s “magic number” it can be quite quick. A popular strategy in recessions.
Motivated sellers facing foreclosure may agree to a “subject-to” sale—that is, “subject to the original financing.” This is a kind of transaction that leaves the original mortgage in place, which is very appealing to investors with bad credit.
Of course, the lender has the right to call the mortgage due when ownership changes, but if the investor uses his/her “down payment” money to bring the loan current, the bank is likely to chalk that up as a “win” and allow the loan to stay in place, even as the title changes hands.
A combination of “subject-to” and “seller-finance” note investing. The investor buys the property subject-to or leaves his/her own mortgage in place, then sells the property to collect a down payment and create a new note, usually with a mortgage payment bigger than the original mortgage payment. The investor gets to pocket the down payment and the difference on the mortgage payments.
How to Find Deals
Any property can become a real estate investment, but in order to make the best profit, you need the proverbial “good deal”—an overlooked gem that you can buy at a discount.
It can’t be too easy. Beautiful new-construction houses or fixed-up houses listed for top dollar aren’t usually the way to go. The margins are small, and a lot can still go wrong.
On the other hand, a derelict building in a warzone neighborhood that no one wants is probably way too challenging for a first-time investor. Look for a “sweet spot” in between.
Here are some possible sources of deals:
- REALTORs. This is a “go-to” source for finding property, but most REALTORs are used to working with family homes and simple transactions like new-build developments. You should look for a REALTOR who is investor-friendly, especially if you want to do a “creative” deal. Make sure your REALTOR looks for “motivated sellers” or “fixer-uppers.” These are some of the best deals.
- Online Listings. Sites like Zillow, Redfin, or Craigslist are good places to look. Again, check for fixer-uppers and “motivated sellers,” as well as FSBO (“for-sale-by-owner”).
- Wholesalers. Real estate wholesalers’ only role is to bring attractive deals to investors. Find them online or at networking events and get on their buyers’ list.
- Finding Motivated Sellers. “Motivated sellers” need to sell fast, usually as-is for a discount. Examples include people facing foreclosure, bankruptcy, divorce, code violations, or probate. These proceedings are a matter of public record. You can look them up at the courthouse, either in person or online, or pay a data service to get you a list to call.
If you see a derelict or abandoned house while driving around, this might also be evidence of a motivated seller. Do some research and see if you can find the owner. This requires legwork, but can be a source of amazing deals.
- Marketing for Motivated Sellers. Get the word out that you buy the proverbial “ugly house.” This could take the form of door hangers, lawn signs, car wraps or magnets, fliers, mailers, billboards, online ads … whatever you can afford. This is an advanced technique for people who want to make an entire career out of real estate investing.
How to Analyze Deals
If every real estate deal is a business, every business has income and expenses. Your job as a real estate investor is to try to predict the income and expenses before you buy, and then move forward on deals that you expect to have a good profit margin.
Some considerations for deal analysis:
The most important number in a fix-and-flip is the ARV, or “after-repair value.” This is what you expect the house will sell for once it is renovated (assuming the market doesn’t take a nose-dive). The ARV is the income of a fix-and-flip.
You can do this by looking at what nearby houses have sold for recently. Note that it behooves you to price the house competitively—it sits on the market because you shot the moon on the asking price, you have to carry costs for every day, week, and month it sits on the market, which eats into your profit margin.
Once you have an estimate of the ARV, you need to calculate:
- Acquisition Cost. The sale price plus closing costs. A good flip should be bought at a discount—the deeper the better.
- Repair Costs. Consult a contractor if need be. Over time you will learn what different repairs cost. You also need to know how long the repairs are likely to take, because of the next calculation …
- Carrying Costs for the renovation period, as well as time spent on the market. This includes your loan payments, utility costs, and insurance. Note that since the house will probably be vacant during the renovation, insurance costs will be higher.
These three items make up the expenses of the project. Subtract them from the ARV and see if you like the profit margin you come up with. Many flippers want to see a profit margin of 15% or even 30%, understanding that they need a cushion in case repair costs inflate or the house fails to sell quickly.
The income of a buy-and-hold property are the rental payments and tenant fees. You might also reap appreciation at resale, but this can be hard to predict. It’s more important to make sure you buy a rental with positive cash flow, because positive cash flow is a good indicator of future appreciation, especially if you are able to increase rents over time.
The expenses are the operating expenses, as well as non-operating expenses. Make sure you account for:
- Mortgage Payment
- Reserves for Replacements and Capital Expenditures (new roof, new HVAC, etc.)
- Property Taxes
- Property Insurance
- Utilities (unless the tenant pays them)
- Repairs and Maintenance
- Property Management and Admin Expenses
- Marketing Expenses
Understanding Due Diligence
You hear a lot about “due diligence” in investing with little explanation of what that means. Due diligence is really just the process of verifying all the information you have about the property, in search of problems that could upend your analysis of the deal. Due diligence comes in three stages:
- Financial. Check your assumptions about your financial analysis by analyzing utility bills, tax records, etc. Get quotes from insurance brokers, and check nearby rentals to make sure you can get the rent you think you can get.
- Physical. Perform inspections of the property itself. Hire contractors like plumbers, electricians, and home inspectors as needed.
- Legal. This is the title work, to make sure the seller is legally in a position to sell the property to you, clear of liens and without any competing claims of ownership. The title or escrow office should be able to handle this. If you want to do a “creative” deal like subject-to or a mortgage wrap, find a title officer or lawyer experienced with this kind of deal.
How to Manage your Property
Congratulations! You found your first deal. Now the real fun starts … managing the deal. Here are some considerations for managing your investments.
You can either …
- Perform the Renovations Yourself. If you are a contractor or renovation expert, you can always save some money and do the renovations yourself … but that is time you could be spending finding the next deal, so use your time wisely. Remember, a less-than-professional renovation won’t get you your ARV.
- Hire a Contractor. Do your due diligence to find a reputable contractor. You will probably still need to spend a lot of time on the site to make sure the renovation is on track.
Managing a buy and hold has two similar tracks you can take …
- Manage the Property Yourself. A few rentals should be easy enough for you to self-manage, especially if you live close by. Once you have five or more rentals, it could start to get cumbersome.
Some relationships that might help you in the long run include an eviction attorney, in case your tenant defaults on the rent and you need to execute a by-the-book eviction; and an emergency maintenance contractor, so your tenant has a number to call other than your cell phone if and when the toilet breaks at 3am.
- Hire a Property Manager. This is the “passive income” approach. A property manager will take a percentage of the collected rent as payment … but it may be worth it if it frees you up to find the next deal or take a vacation. Property managers can also help you avoid rookie mistakes.
Shop around, get references, and remember that big management companies might prioritize their big clients.
Even the safest real estate investment involves some risk. Some considerations to manage the risk include:
- Insurance. Your mortgage lender will require that you carry property insurance so there is money to pay off the loan if the house burns down. Landlords with tenants should also consider “umbrella” liability policies, in case the tenant slips on the porch and decides to sue.
- Holding Entity. You can hold your investment in your own name, but holding it in the name of a separate entity, like a land trust or LLC, can be a key step to limiting your risk. If the house is owned by an LLC that you control, and a tenant wins a lawsuit against you after slipping on the porch of the house, the court cannot attach your wages or retirement savings in the judgment because technically you don’t even own the offending house—the LLC does.
Know Your Tax Strategy
One of the best reasons to invest in real estate are the tax advantages. Early on you will want to partner with an accountant, CPA, or tax preparation expert who is familiar with real estate tax law. Here are some pressure points to be aware of in the tax code:
Ordinary Business Income
Profit made from fix-and-flips are usually taxed as “ordinary business income,” since you hold the property for less than two years. Ordinary business income faces a higher tax liability than other types of income.
Rental income is taxed at lower rates than ordinary business income.
If you own a buy-and-hold property for two years or more and sell it at a profit, the profit is taxed as a “capital gain,” at a lower rate than ordinary business income.
One of the best advantages of real estate is the ability to claim “depreciation” of the asset as an expense. This is a loss of value due to wear-and-tear recognized by the tax code. Of course, we know that real estate often gains value over time rather than losing it, so the depreciation expense is a deduction you get to claim without any money out of your pocket.
Depreciation has to be “recouped” at sale, but it can lower your tax liability significantly in a long buy-and-hold play.
A 1031 exchange is another great tax benefit of real estate. If you sell a property at a profit, you can defer the capital gains taxes indefinitely by buying another, larger property of the same type (a bigger house, a complex with more apartments, etc.)
By rolling the profits into bigger and bigger properties, you can avoid paying capital gains while benefiting from bigger and bigger rental cash flows across your investing career.
Using a Tax-Exempt Vehicle
Real estate can be bought and held in a tax-free vehicle like an IRA, 401(k), or 529 Plan. You won’t hear about this from most IRA custodians, because they are attached to money managers and only authorized to buy managed funds for your IRA, like mutual funds or REITs.
If you find a specialty “self-directed IRA” company, however, you can buy property in an IRA and owe no taxes, just like a typical IRA. Of course, the same statutory penalties apply if you try to make withdrawals early.
Using a tax-exempt vehicle is an especially good choice for note investments, which enjoy fewer tax advantages than rental property or flips.
If you live in a state with a “homestead exemption” in the tax code, a little-used, undervalued strategy is available to you. You can buy a “fixer-upper,” fix it up, live in the house for two years, then sell the house at a profit. Because you lived in the house for two years, up to $500,000 in profit is exempt from the hefty capital gains tax. You can then buy another fixer-upper and do it all again.
This is a low-risk way to build a huge sum of cash investing in real estate. It entails some sacrifices that some people aren’t willing to make, though—you have to live wherever you find the fixer-upper, fix it up, and move every two years. But those tax exemptions add up to huge money if you can make it work.
Know Your Exit Strategy
Nothing lasts forever—not even the best real estate investments. You might think it makes sense to keep a good buy-and-hold property forever, but this entails opportunity cost—that is, loss of money you could be making with a more strategic exit.
Eventually your loan will be paid off, so there’s no more leverage. You will take all the depreciation expenses you are legally allowed to take. Major repairs could eat into your profit. The market could take a downturn, requiring another ten years to recoup the loss of value, when you could have sold at the top of the market and flipped the cash into notes, tax liens, or other vehicles.
Remember, the “exit” might not mean getting rid of the property … it just means getting your initial cash investment out of the deal so you can use that capital on the next deal. Examples include:
- Selling at a profit when the market heats up.
- Refinancing your loan when the principal is paid down or the value increases, getting your down payment out of the deal.
- Transitioning to a note investment with seller financing and/or a mortgage wrap.
- Selling a note you own, or part of the note.