Investing in real estate is a common vehicle to create wealth. There are many strategies to approach investing, and approaching these strategies can prove tricky and complicated for the novice.
This article will offer beginner-friendly advice, terminology, and mistakes to avoid when considering your approach. Ultimately, it will come down to your preference and tolerance for risk.
You are the only person to define these parameters.
Key Takeaways
- Real estate should be a part of a diversified portfolio
- One of the common ways an investor creates wealth by investing in real estate is to become a landlord
- “Flipper” is an industry term for short-term investors who buy under-valued homes, oversee a renovation scope, and sell the house for a profit
- REITs provide an investment vehicle for those investors with no objective for physical ownership
- Direct investment in real estate is a business, and an investor needs a solid plan.
The Basics of Real Estate
Before explaining investing in real estate, you must know the definition. The basic premise of real estate investing is the purchase. The asset being purchased is land and all the improvements attached to it. The land and the improvements, like the building, landscaping, driveways, and fences, are within the definition of real estate.
The most popular asset class for beginner investors is single-family residential. Although this method of investing will seem expensive at the onset and will be for many, it is one of the proven ways to create wealth over time.
The Basics of Making Money
The three methods to make money in real estate are appreciation, equity, and recurring rental income. These methods are discussed below.
Appreciation
Property values increase over time in line with market conditions. The market will have “blips” where property values could remain stagnant or drop. However, appreciation will be most likely achieved over time. Broadly speaking, there are two kinds of appreciation. 1) Market-driven and 2) Forced.
Market-driven appreciation mostly results from increases in population and jobs, greater demand than supply, and general economic inflation. Forced appreciation could be more fascinating as it is achieved in a way that is under control of the owners intending to boost net operating income (NOI = Gross income – vacancy and credit loss – operating expenses) by increasing income, decreasing expenses, or a combination of the two. Any physical improvements to the property that bring about increased income and/or reduced expenses will lead to forced appreciation.
An investor will realize more profit when buying an under-valued house in a good neighborhood than an OK house in a not-so-good neighborhood. The term “under-value” means a motivated seller willing to accept a price below market value. The money invested into the property will increase its value, like additional living space or adding a bathroom, which will translate to appreciation. The goal is that the value of the improvements will exceed the cost.
The value gained from either market conditions or improvements can convert to cash at either the property’s sale or at the mortgage refinance.
Equity
Equity in a property is the difference between the property’s value and the amount owed on the mortgage. As payments are made, the loan amount decreases, and the equity increases. Market conditions also may affect equity up or down as the property’s current market value fluctuates.
Equity can also be converted to cash at either the property’s sale or the mortgage refinance.
Rental Income
Some investors depend solely on appreciation and equity to create wealth. These investors either live in the home as their primary residence or invest in a vacation or second home and do not rent it to third parties.
By renting a property to third parties, the investor creates wealth through recurring rental income, along with appreciation and equity. The level of the investor’s involvement in the rental is a personal preference. Some investors want a hands-on approach, while others wish for a professional manager.
In the ideal situation, the monthly rent will cover the mortgage payment, the costs of owning and maintaining the property, and any management fees. Either strategy will create passive income for the investor.
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Strategies for the Real Estate Investing for Beginners
The strategies below are for those who want to invest in real estate but do not know how or where to begin. Regardless of one’s investing experience, all real estate investors must manage the process. A true investor is responsible for the profit.
Below are eight strategies for the beginner investor to either start at a slow pace and scope or jump in with a solid plan.
Wholesaling
This strategy is prudent for an investor to begin with the least exposure. Wholesale investing is where an investor identifies a property with a motivated seller and secures it by placing it under contract. The contract will be assigned to another investor before the closing.
The wholesale investor is in effect the matchmaker between the seller and the buyer. The profits made in wholesaling are small on a per-transaction basis.
The risk to a wholesale investor is the deposit to secure the contract. The profit is made on the difference between the contract deposit and the price the end investor is willing to pay for the assignment. The profits are relatively small because the financial risk is low.
Prehabbing
Prehabbing is the next step above wholesaling. This strategy involves an investor closing on the contract and positioning the property for resale. The renovations to the house are minor and cosmetic. The property is then sold to another investor who will complete the full renovation scope and manage the sale or the refinance.
REIT Investing
Owning stock in a real estate investment trust (REIT) is an indirect way to invest in real estate. The REIT is the entity that will hold and manage the property. The investor receives dividends from the stock without the physical ownership of the asset and without influence on the profit amount.
Online Platforms
There are platforms online to connect developers with investors. Often referred to as crowdfunding, the investors finance the developer’s equity in a project and receive monthly or quarterly repayments, with interest, when the property becomes self-sustaining. The investor does not influence the profit amount.
Purchasing Rental Properties
This strategy is for the investor to become a landlord on a long-term hold. This strategy is where the investor is directly responsible for the investment’s performance and profitability.
Real Estate Syndication
Syndication is the team approach to crowdfunding. The investors’ resources (cash, skill, or a combination) are pooled to buy large-scale properties such as multifamily apartments. The syndicator takes the lead on not only sourcing and analyzing a deal but also aggregating requisite capital from a group of investors and overseeing a whole value-add project.
Fix-and-Flip
This is a popular strategy for the beginner investor who wants a hands-on approach to creating value by renovation without wishing to become a landlord. The fix-and-flip method follows that of a long-term hold but stops at the point of securing a tenant and stabilizing the cash flow.
The property is sold for a quick profit at the end of the renovation scope. The buyers of a fix-and-flip property can be either the homeowner wanting the property for a primary residence or an investor with a long-term hold.
Real Estate Investment Groups
Investment groups focus their business primarily on real estate. The capital collected from investors is pooled to purchase multi-unit or commercial properties. The group can be the equity investor partnering with the owner or developer.
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Mistakes to Avoid in Real Estate Investing for Beginners
Unfortunately, there is no set path or list of rules for an investor to follow. Every deal will be different. However, the path forward will become evident when an investor knows the mistakes to avoid.
The common mistakes every investor should avoid are listed and discussed below.
Following the Herd
An investor needs to remain true to their plan and tolerance for risk. If you follow the herd, you will subject yourself to the objectives of others that may not align with yours.
Do not rely on speculation and the hope for profit.
Buying at Market Value
There is no potential for profit when a property is purchased at market value. The most gain will be realized when a property is bought from a motivated seller and value is created through renovation.
Getting Attached to a Deal
It is human nature to become emotionally attached to the first few deals. Maintaining a business approach and a level head will result in a successful investment. Never be afraid to walk from a deal if the numbers do not pencil out.
Not Performing Due Diligence
A complete scope of due diligence will determine the potential for a successful deal. Due diligence must include determining the timetable, renovation costs, buyer demand, and cash flow forecasts. Always remain mindful of the results of your due diligence.
Investing Too Many Personal Funds
The purchase price is the most significant influence on an investor’s equity. The higher the price, the higher the required equity. Maintaining separate accounts for personal and business funds is a good practice. A reserve account should be maintained and funded from the rent to cover unplanned maintenance expenses.
Not Having Multiple Plans for the Exit
An investment may perform differently than planned. Experienced investors know how important it is to have backup plans when the renovation costs increase, or the timing of a fix-and-flip takes longer than projected. There needs to be contingency plans for the contingencies.
Going Alone
Unfortunately, there are some investors who “go it alone.” These investors are under the false impression that money will be saved when acting as the contractor, sole investor, and real estate professional to secure a tenant or a buyer. Investing in real estate is a “people” business, and successful investors know to rely upon the expertise of others. A strong network of professionals is needed.
Terminology for the Beginner Investor
The real estate industry comes with acronyms and jargon an investor will hear from lenders, realtors, and colleagues in the investment world. A basic understanding of these terms and the proper context for use will help in conversations.
Below are the common terms you will encounter regardless of your level of investment or chosen platform.
Net Operating Income (NOI)
The calculation of NOI is the step before the analysis of cash flow. The NOI is the difference between the collected rent and the expenses to operate the property. The mortgage payment and the funding of any reserve accounts are not considered operating costs. The formula is:
Net operating income = Rental income – operating expenses
Capitalization Rate
Also known as the “cap rate” in industry terms, it is the expected rate of return on a real estate investment property and used to calculate the value of a deal. The rate is expressed as a percentage. The formula is:
Cap Rate = Net operating income ÷ current market value
This rate measures the yield generated by a property over one year.
Cash Flow
Cash flow is a concept used by investors in both business and personal finance. After calculating the remaining rent after the operating expenses, the mortgage payments and the funding of reserve accounts are netted out to calculate the cash flow. The cash flow is the net cash for distribution to the investors. The formula is:
Net cash flow = Net operating income – (mortgage payments + reserves)
Real Estate Investment Trust (REIT)
REITs own and operate income-producing properties in special niches like retail, multifamily, or self-storage warehouses. The investors in REITs are shareholders in the owning firm. This investment vehicle is for those investors wanting a passive ownership role.
Real Estate Owned (REO)
REOs are properties that have been through foreclosure and are now owned by the lender. A lender’s list of REO properties is an excellent source for locating under-valued properties, but be aware of the extensive renovation scope needed for REOs.
Return on Investment (ROI)
The ROI is the measurement of the success of an investment. From the investor’s view, the measurement is the cash-on-cash return. This means the cash distributed to the investor is compared to the investor’s equity investment. The formula is:
Cash-on-cash return = Cash distribution ÷ Cash invested
The ROI is expressed as a percentage.
Summary
Real estate investing is a business, and an investor needs to understand the business. A plan needs to be in place regarding the hold period, asset class, and type of investment sought. An investor beginning in this industry is well advised to start on a small scale with partners to learn the process and get a feel for risk tolerance.
Investment in real estate will create wealth and financial independence. However, getting to this position will take patience, foresight, and allegiance to the plan. The creation of wealth comes with risk—the more risk, the greater the potential to generate wealth. But, the more risk, the greater the chance for loss.
This is where an investor in real estate needs to find balance and their tolerance for risk.
