ELI5

Real estate investing – you might watch HGTV in your spare time and see shows like Flip or Flop or Property Brothers that make real estate investing seem exciting and very hands-on. All of this can be true, but it’s important to note that there are many ways to participate in real estate investing (REI). The two primary types are passive and active REI.

However, it is important to note that your primary residence should not be considered a real estate investment. Why? Your home’s primary purpose is not a store of money that appreciates – it is to provide you a shelter for you and your family. Unlike rental properties, you won’t capture monthly rental income, and you can’t assume appreciation on the property (i.e. 2008-2009 Great Recession).

In a normal “market” the price of real estate increases at the price of inflation. The floors on real estate prices are set by interest rates, housing shortages, income levels (affordability), desirability and rent control policies.

Passive REI includes investing in real estate investment trusts or owning a rental property and hiring a property manager to assist with the operational and maintenance aspects. REIT’s or real estate investment trusts enable individuals to invest money into real estate developments or other real estate assets. Investors typically receive a steady dividend as a form of payment. REIT’s are safer than stocks to some extent, but are equally exposed to recession cycles.

Active REI includes purchasing a rental property and gaining a steady cash flow through rental income and, ideally, equity appreciation. People can build large rental portfolios through the concept of leverage – where investors tend to put a small down payment down on several properties. The tenants for the rental properties ends up covering the mortgage assuming rent is priced appropriately. Over time and many (or a few) tenants later, the property is paid off and you end up owning these rental properties outright!

At the same time, you are the landlord of these properties and are responsible for maintaining the property, dealing with finding responsible tenants, and covering the mortgage payments and property taxes when the unit is vacant. This can be a time consuming endeavor and can turn into a full-time job depending on the size of your rental portfolio. Real Estate Investing may come with tax benefits for the landlord which should be factored into valuing rental real estate.

Flipping properties is another common form of active real estate investing. In this case, you end up purchasing a property for a short period of time – typically a run down apartment or home. You’ll realize that properties around the area are selling for significantly higher and that all this one needs is some renovation. With a crew of contractors you end up sprucing up the place for a reasonable cost and listing it back on the market at a premium as quickly as possible. The key is holding the property for as short a time as possible since that will eat into your profits.

Detailed Definition

Real estate investing is the go-to option for many investors all over the world for good reason. A more detailed examination of some of the principles behind it reveals why.

Investing in Rental Property

Rental properties, when managed right, can produce a nice, healthy income stream. Properly investing in rental properties is a matter of balancing three main factors: leverage, cash flow, and property management.

Leverage involves using other people’s money to purchase properties to rent. Typically, this involves acquiring a loan from a bank or a private investor to buy a property. You effectively “leverage” a small amount of money by investing it in the down payment. The rest of the cost of the property is thereby covered by whomever you borrowed the money from.

For example, if you only have $35,000 to invest, you likely aren’t going to find a property to purchase and rent out at such a low price. But you can leverage that money by using it for a down payment. You purchase a property for $350,000 using your $35,000 as the down payment. You are then able to rent the property out for a total of $2,100 a month. This ends up giving you a monthly profit of around $400 a month. While this isn’t necessarily a large amount of money, this is what leveraging your $35,000 has gotten you: $400 a month in profit and a property worth at least $350,000. As a result, you now have a higher income stream, and if property values increase, more material assets. These also can be leveraged in order to help you buy another rental property. You simply repeat the process. After a few years, you can leverage your initial $35,000 into a portfolio of properties with a gross value well over a million dollars and a significantly higher income stream.

Cash flow is whether the money is coming in and out of your account. Rental income serves as the primary source of income while renting and to increase cash flow you can increase rent in a healthy rental market. There are other ways of improving cash flow — such as building niche rentals. This could either be by allowing pets, providing free laundry, renting out an extra room, etc. Due to the use of leverage, be aware of all operating expenses while renting including apartment maintenance – it’s important to build a budget to understand cash flow. Examples of operating expenses include property damage, occupancy rates, property taxes, and insurance costs. It is important to have a firm grasp of your own non-real estate assets which can be used to service property related expenses in an economic downturn when the rental market is weak and vacancies are high. The last thing you want to do is sell rental properties in a weak real estate market.

Property management is one of the most overlooked aspects of investing in rental properties. Properly managing your property (or properties) should be seen as part of the job. Furthermore, the money involved in property management should be viewed as part of deal. It is important to consider how much time you’re going to have to put into the upkeep of your property as well as making sure your tenants are happy. Because this can be so time-consuming and intricate, many investors hire property managers to give their renters quick access to solutions and to give themselves peace of mind. The cash flow would have to justify such a move, however, so you are going to want to assess the property management needs well before making an offer.

When done right, property management can itself become an indirect source of greater income. Each time a renter leaves, you face the possibility of losing income due to the apartment or house being empty while you locate another tenant. When a property is well-managed, renters tend to stay longer. Having consistent renters equals consistent income, so many investors use good property management to their advantage.

Flipping Houses

As mentioned earlier, flipping houses has gained popularity in the media and entertainment world as of late. This is because when well-executed, the flipping of a house can provide very nice profits. On top of that, the time spent in the investment is minimal when compared to many other investment strategies. We’re going to examine two key concepts of house flipping: how profits are made and how losses are incurred.

Distressed properties are properties that need work in order to be either sellable or have significantly more appeal, resulting in a higher sales price. A distressed properties blessings are also its “curses.” A house may have undergone a tragedy, natural or otherwise, making it a relative steal on the market. If you can repair the house without investing too much capital, you may be able to flip it for a solid profit. Also, a house may be deteriorating due to age. It may look unappealing on the outside and even upon first glance when inspecting the inside, but the basic structure, or the “bones” may be good. Most aesthetic aspects of a home such as drywall, paint, or landscaping can be vastly improved without spending a lot of money.

Sweat equity is the work you personally put into a house you want to flip. The value of sweat equity is realized most dramatically when a line item you had earmarked funds for becomes something you do yourself. For example, if you had decided to hire professionals to do the drywall and painting of the bedrooms, you may be able to save all of the labor costs by devoting a couple of weekends to doing the work yourself. In effect, you have added equity to the house.

Curb appeal refers to how a property is viewed when a prospective buyer passes by. While it sounds superficial, the value of curb appeal cannot be overstated. Regardless of where you are in the world, you see the place you live as a representation of who you are as a person. Even though a well-kept lawn doesn’t necessarily make a house more livable, we often see it as a reflection of who we are. By the same token, chipped paint, missing roof shingles, or unruly landscaping can make a prospective buyer shy away from an otherwise nice home. They don’t want to be associated with those traits of the house. Enhancing curb appeal is often the best way to maximize the bang you get for your buck. This works both ways. Not only can you raise the value of your property by upping its curb appeal. You should look for properties with poor curb appeal because they may be selling at a discount. And if you add some curb appeal, you add value.

ROI as it Applies to Flipping Houses

ROI, or return on investment, has to be calculated carefully when flipping houses. It’s not as simple as the selling price minus what you paid. The cost of holding the house until it sells as well as any maintenance required factors in as well. Some of the expenses are less predictable than others. Here is a brief list of a few of the major line items affecting your ROI:

  • Mortgage paid until the house is flipped
  • Real estate agent fees
  • Cost of upkeep
  • Variable interest payments
  • Appreciation or depreciation after changes are made to the home

How Losses Are Incurred: An Example of How You Could Lose Money Flipping a House

You buy a distressed home right now for $300,000. To make it sellable, you need to make $70,000 of repairs. This brings your total cost for the house to $370,000. You hope to make a $10,000 profit by selling it for $380,000.

After a 10% down payment, the mortgage payment and property taxes are factored in, your monthly payment is $1,890. Further, after adding in the cost of maintaining the home, you have to spend around $2,010 each month.

Most of the $2,010 goes to paying interest and not to reducing the principle, or how much you still owe on the house. This means for the first year, each month, on average, you only decrease the amount you owe on the home by $890. At the same time, you’re giving the bank $1,120. That is money you never see again and that doesn’t help give you more equity in the house.

Before you know it, selling the home for $10,000 more simply isn’t enough to make the overall deal profitable. And if the buyer offers less than the sales price, you would make even less money. You also have to pay the real estate agent 5% of the sales price. And your relative loss is further exacerbated if the market cools.

All-in-all, in this situation, if it takes you 5 months to sell the house, you could easily lose $15,000 or more even if you sell the house for $10,000 more than you paid for it. This begs the question: How can you make money using short term real estate investing?

How to Profit from Flipping Houses

The key is to focus on your profit margin. Factor in the cost of the real estate agent, the repairs, and the cost of paying the mortgage for a conservatively estimated amount of time. Then take that number and add 15% to it. So if all that equals $25,000, add 15% to it or $3,750, to get $28,750, and that gives you the cost of holding the house. Now decide how much profit you want to make and add that to the cost of holding the house.

For instance, if you want to make $20,000, your total number will be $20,000 + $28,750 = $48,750. That’s how much more you have to sell the house for in order to make a decent profit. Because you have factored in the extra 15%, you have some leeway. If the sale prices in the area aren’t high enough to get you a profit margin that big, this isn’t the deal for you. If the length of time it takes to sell a property looks close to or even a little more than what you calculated, you’re better off looking elsewhere to invest.

Because real estate investing is relatively high risk, you need to be as conservative as possible when it comes to calculating your possible returns. Conservative estimates can help offset the riskier elements of real estate deals. But if you are able to find some great deals with strong profit margins, you can make a handsome profit from flipping houses.

Real Estate Investment Trusts

A popular variant to traditional real estate investing is doing so using a real estate investment trust (REIT). An REIT is a lot like a common stock or an ETF. It is essentially a fund that is traded on the open market but it is comprised of real estate investments. The portfolio of an REIT can consist of rental properties, land, houses, apartment buildings, commercial rental space or virtually any other facet of the real estate market.

For investors who want to take advantage of growing real estate markets or strong rental markets without assuming the risks of low liquidity, REITs can be an ideal solution.

REITs provide steady income. Real estate investing has less variables than investing in stocks, and it is therefore more stable. The enemy of real estate investing is an economic downturn or a localized downturn that affects property values. These things can often be predicted. In comparison, a drought, an employee strike, a hostile takeover, or other things that affect stock prices are far more difficult to foresee. A well-designed REIT portfolio will have a diverse offering of rent-producing properties and appreciating real estate. If the appreciation is lackluster, the rental income can offset it and vice versa.

REITs are liquid. If you purchase a home, to sell it for a small profit or to break even takes months of hard work. It takes at least as long to offload a property that’s losing you money. However, with an REIT, selling your shares is as easy as selling a stock. It’s the same with buying shares of an REIT.

REITs present convenient diversification opportunities. The more diverse your portfolio, the more insulate you are from adverse market fluctuations.  Some of the elements that cause stock prices to drop have little effect on a REIT. A bond investment could also be easily offset by an REIT. If you purchase a municipal bond based in one location, you can buy shares of an REIT in another location with a different economic contributors. If the value of your bond starts to drop, no problem, your REIT will likely remain unaffected.

Property Appreciation & Depreciation

Whether you’re invested in properties you own and/or manage or an REIT, it’s important to understand the principles behind property appreciation and depreciation. Your bottom line, and, as importantly, your liquidity is directly impacted by the ebb and flow of property values.

When a property appreciates, its inherent value increases. Think of Tickle Me Elmo as an example. This toy, although cute, was certainly not worth $500, $600 or even more—at least not until a lot of people wanted it. As soon as the need arose, the price skyrocketed. Did it make sense to a lot of people? No. But it didn’t matter because the demand was there. It’s very similar with real estate. In the Bay Area in California, particularly near the cities and their suburbs, it isn’t uncommon to find a 2,500 square foot home selling for $3,000,000—or more. The same building, if transported to a beautiful lot in North Carolina, would fetch a fourth of the price. The basic reason why is simply because people want that house. The reasoning behind that desire is slightly more complicated but simple to understand.

Property depreciation is when the value of a property goes down. And just as it’s the opposite of appreciation, its causes are the inverse of those behind appreciation as well. All over the United States, there are examples of property depreciation. More often than not, these are the result of a shift in the job market. When an industry leaves an area, the jobs go with it. Hence, fewer people want to live there and property values drop as a result. The same goes for the disappearance of conveniences and the appearance of what some would consider to be undesirable neighbors.

As you can see, it’s not as cut and dry as it looks on TV. But that’s the nature of investing, and real estate investing is one of the more lucrative and stable investments out there. The profits are fairly predictable, and as long as you’re more realistic than optimistic, you will only invest in good deals.

Location

A home itself is a flexible asset. You can improve its appearance with a little bit of time and money. The area in which the home is does not have the same flexibility. Therefore, a very simple, basic home in a great area will have a higher property value than its inverse: a beautiful home in an undesirable area. You can change your home, but you can’t change the area.

Also, some aspects of where the home is have straightforward, concrete value. For instance, the cities and the suburbs of the northeast U.S. have thousands and thousands of jobs in a wide array of industries. Hence, their value is high. Property appreciation can happen anywhere where there are new jobs either present or on their way. People also want certain types of neighbors. Fair or not, this affects how much a property is worth. When the people you want to live next to are in the house next door, down the street, and around the corner, you’re much more likely to purchase the property. People are also attracted to conveniences. This is why an apartment complex with a supermarket has more value than one that’s even a short drive away. Buyers like convenience. If conveniences increase in an area, the value of the properties are going to rise.

You can benefit from property appreciation by identifying trends in the above areas. Whether found individually or in combination, their emergence will increase the value of a property you already own or are considering purchasing.

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