Introduction:
For a good reason, real estate investing may be one of the best investments accessible. However, getting started without a clear starting point can be challenging. Learn the fundamentals of this investment and many options for getting started in real estate investing.
The Basics of Real Estate Investing
This article is part of a more prominent real estate investing tutorial, which can be found here.
Real estate investing is a new area for many people. Unlike stocks and bonds, commonly referred to as “conventional assets,” real estate has traditionally been pricey and challenging to obtain and purchase – until lately.
However, simply because real estate investing is a new financial opportunity does not mean it should be avoided. Real estate can be profitable and reliable, earning significant returns in the short and long term. It can also augment your portfolio by providing unique benefits such as portfolio diversification and tax advantages (as discussed below).
Despite apparent benefits, investing in real estate can be daunting without a clear beginning. That does not have to be the case. In this post, you will go over the principles of real estate investing, as well as eight various strategies to get started right immediately.
So, first and foremost, what exactly is real estate investing?
What exactly is real estate investing?
When considering real estate investing, your home is usually the first thing to mind. Yes, real estate investors have many additional possibilities for financing, and they are not just physical assets.
Real estate is a fantastic investment for a good reason. Before 2007, historical housing data suggested that prices could constantly rise. With a few exceptions, the average home sale price in the United States increased annually between 1963 and 2007. When the COVID-19 outbreak began in 2020, home values fell somewhat. As vaccines became available and pandemic fears faded, property prices surged, reaching all-time highs by 2022.
The acquisition, ownership, lease, or sale of land and any properties on it for the goal of profit is referred to as real estate investing. Real estate is classified into four types: residential, commercial, industrial, and land.
Residential real estate: Residential real estate comprises single-family homes, multi-family residences, townhouses, and condos. Occupants may lease or own the homes in which they dwell. Homes with more than four apartments are usually classified as commercial property.
Commercial real estate: Commercial real estate is a property in use for business purposes. Office space, retail space, and multi-family housing are the three types of commercial real estate. Business offices (office), restaurants (retail), and huge apartment buildings are examples of commercial real estate properties (multi-family).
Industrial real estate: As the name implies, these assets are used for industrial purposes. Shipping or storage facilities, factories, and power plants are a few examples.
Land: Land is a generally untamed property with no construction on it. There are few methods to profit from land as an investment. Landowners can benefit through land use, such as agriculture, or from developing or selling their property.
Aside from property kinds, there are three basic ways to profit from real estate investments: loan interest, appreciation, and rent.
● Interest on Loans (or, in real estate lingo, “debt”)
A real estate loan is an agreement in which investors lend money to a real estate developer and receive cash via interest payments on the loan’s principal. Debt investing can offer an investor with steady cash flow.
Depending on the number of lenders, the capital stack of loans may include one or more types of debt. Senior debt, junior debt, and mezzanine debt are all examples of debt. Debt can also be bonded or unsecured. This distinction specifies an investor’s rights in the case of a property foreclosure due to loan failure.
Private equity firms, REITs, etc., employ loans as passive investments. Interest payments from real estate investments may provide a way to create passive income.
Like any other type of equity, real estate ownership allows an investor to profit from the sale of that equity.
An investor’s “prospective profit” when selling a property is represented by its appreciation or increase in value throughout time. Unlike debt investments, a sale gives a significant, single return.
Equity can be divided into two types: preferred equity and common equity. Equity ownership can be active or passive, depending on where the investment is in the capital stack.
Owners can lease their property to make cash via rental payments. Rental income, like debt investment income, can provide a consistent revenue source. Depending on how a property owner operates their real estate (either alone or through a property management business), they may keep all their earnings or distribute them with a property management firm. Depending on the investing technique, rental payments may provide the opportunity for passive income.
Each sort of real estate and investment has its range of concerns and benefits. Regardless of how you act in real estate, it is critical to choose assets carefully by rigorously testing the strengths and limitations of prospects. This due diligence process is essential to establishing whether an investment option is financially sound and whether it can satisfy your financial goals, regardless of who performs the underwriting.
When examining real estate, many investors like to utilize the predicted rate of return as a critical statistic. However, more experienced real estate investors may frequently use the capitalization rate, or “cap rate,” to evaluate an opportunity.
How to Make an Ideal Real Estate Investment
Real estate can enhance an investor’s risk-return profile through competitive risk-adjusted returns. Fortunately, the real estate market has moderate volatility regarding equities and bonds.
Compared to more traditional income return forms, real estate is also appealing. This asset type often trades at a yield premium to US Treasury bonds. Treasuries and is especially appealing in a low-interest-rate situation.
There are numerous ways to invest in real estate with varying quantities of money, time allocation, capital, investment horizons, risk, and return possibilities. Some earn both money and appreciation, while others solely get income.
There are two types of real estate investing strategies: active and passive. Here are eight essential principles for investing in real estate, ranging from intense, high-effort to hands-off, low-effort.
Investing in Real Estate Actively (Doing it Yourself)
Active real estate investing needs extensive personal real estate knowledge and hands-on management or outsourcing of duties.
Active investors might work as real estate investors part-time or full-time, based on the number and character of their investment properties. They typically invest in properties with only one or a few owners. Thus they have a significant share of the workload for the success of an investment property.
As a result, active real estate investors focus on all aspects of how to invest in real estate, as well as financial acumen and negotiation abilities, to improve their cap rate and overall return on investment.
Property-Flipping
House flipping is an active and hands-on way to invest in real estate. A house flip occurs when an investor buys a home, makes repairs and upgrades to increase its market worth, and then offers it at a premium cost.
House flipping is typically a short-term investment because the longer an owner owns a home without leasing it to renters, the more expenditures accumulate. This reduces their potential return when they sell it. Investors can fix or remodel the house to boost its sale price or sell it as-is if its value in the housing market rises due to external reasons.
If you watch HGTV, you’ve seen home-flipping pros alter a house in 30 minutes and sell it for a tidy sum. House flippers in these shows buy a home they believe is mispriced, add value through improvements (such as upgrading countertops or flooring, or pulling down walls to rearrange floor plans), and then sell the home for a profit.
While house-flipping is thrilling, it also necessitates extensive financial and real estate skills to ensure that you can renovate the property within time and price limits to profit when the home is sold.
A property flip’s success — and financial burden — is entirely on the investor. To buy a house before another flipper, you must have enough cash for a down payment and good credit to acquire a home loan. It’s a high-pressure, high-stakes real estate deal that makes for great television but is only suitable for select informed investors.
Wholesaling is another property-flipping approach. When an investor commits to buying a property they believe is valued below market value, they promptly sell that contract to another investor for a profit.
Typically, wholesalers search out properties that require renovations and sell them to house flippers who are prepared to do the modifications to increase the property’s value and sell it for a premium cost.
An investor will sign a contract to get home and make a down payment. Then, they try to sell the house quickly to a house flipper for a profit. Essentially, a wholesaler receives a finder’s fee for facilitating a home sale to a house flipper. On the other hand, a wholesaler leverages their position as the contractual homebuyer to broker the deal, as opposed to regular property brokers.
Wholesaling is a risky game that also necessitates real estate and financial knowledge. It necessitates thorough due investigation and access to a network of potential purchasers to sell the property quickly and profitably. Otherwise, you risk not making a profit or losing money, like property flipping.
Rental properties also require hands-on administration, but they are a long-term investment. A rental property can be any form of property (residential, commercial, or industrial). Rental payments from renters provide property owners with a consistent income flow, usually every month. This move can give investors a constant, secure income stream, but it also necessitates a significant amount of labor or delegation of responsibility to guarantee that operations function well.
First and foremost, you must seek tenants for your property. Depending on the type of property and the tools available for locating tenants, this may be simple or challenging. You are also expected to conduct background checks on prospective tenants (if you desire) and supply tenants with legally binding lease agreements. You lose money from your investment each month that you do not have a tenant.
When you have tenants, you have a lot more responsibilities. Your responsibilities as a landlord are rent collection, maintenance services, repairs, evictions, record-keeping, and compliance with all applicable federal, state, and local regulations. Property management could be a part-time or full-time job based on the number and size of rental properties you manage.
Some real estate investors who do not wish to manage property management hire a property management business for a flat fee or a portion of profits. This approach alleviates part of the burden on an investor’s shoulders, converting the real estate into a more passive investment. However, due to this tradeoff, an investor loses some authority and a percentage of their monthly income.
Residents can rent out their homes frequently as an alternative to staying in a hotel through short-term rentals.
Short-term rentals are comparable to rental properties, except they are only offered for short periods and are limited to residential premises. Unlike traditional rentals, which firms like Airbnb and VRBO often power, short-term rentals allow you to rent out a piece or the entire home.
Residents make money by renting out their property at night, which can generate a consistent or irregular revenue flow based on the property’s demand in its market. Property owners are responsible for furnishing and preserving the rental residence.
For various reasons, short-term rentals necessitate far less knowledge and monitoring than traditional rentals. Third-party websites, such as Airbnb and VRBO allow rental property booking and generate the contract agreement between the property owner and renter. Because third-party companies manage various aspects of the rental process, short-term rental properties might be a part-time or side gig.
While short-term rentals might be a profitable solution for your spare bedroom, it’s critical to be familiar with the rules surrounding short-term rentals in your area before listing. Property managers have the authority to prohibit renters from listing a leased apartment as a short-term rental. Homeowner associations have the power to restrict short-term rentals, and certain places, such as New York and Los Angeles, already have restrictions on some types of short-term rentals. Even if you’re a short-term landlord, you should ensure you’re ready to deal with any issues that may arise when hosting short-term renters.
Investing in Passive Real Estate (The Hands-Off Way)
Passive real estate investing provides chances for those with considerable real estate and financial education and those with less or no skills to invest in real estate.
Passive real estate investors often contribute only funds and delegate real estate investment to professionals. They, like stocks and bonds, are only liable for their assets, not the fund as a whole. Passive real estate investments, in general, have a higher potential for passive income than most active real estate investments, which often involve more hands-on administration.
A private equity fund is an investment mechanism in which investors combine their money into a single fund to undertake private market investments. Typically, they are limited liability partnerships with a specified manager or management team. While the manager actively manages the fund’s assets, participants are not expected to participate regularly. However, because investment minimums are often relatively high, an investor must have the financial and real estate knowledge to comprehend and evaluate each transaction’s issues and negative rewards.
Private equity funds are often only available to accredited and institutional investors with substantial assets. Minimum investment amounts vary but are rarely less than $100,000.
Private equity funds often employ a “two and twenty” fee structure, charging a 2% yearly management fee and an additional 20% fee on any profits earned beyond a predetermined return. Private equity funds are also often illiquid, limiting them to investors who can manage to tie up vast sums of money for extended periods.
A mutual fund, sometimes known as a pooled fund, is an investment instrument formed by a corporation that combines its clients’ money and invests in their favor. Instead of personally owning assets, mutual fund investors buy shares in a mutual fund, and the fund owns the investments it buys and administers. Mutual funds can provide investors with returns in the form of dividends and capital appreciation upon the sale of fund shares.
Real estate funds typically invest in real estates investment vehicles such as real estate equities or REITs, but they can also invest directly in real estate assets. They can also specialize in real estate or provide a combination of residential, commercial, and industrial properties.
Unlike the other funds covered thus far, mutual funds often invest in publicly listed assets with substantial liquidity. Mutual funds are designed as passive investments that need capital from investors, and many have a modest investment minimum. As a result of these qualities, real estate funds provide regular investors with access to run real estate assets actively.
However, because they possess publicly traded assets, the net asset value of their shares might be heavily connected to stock market movements rather than the value of the support they own. As a result, mutual funds are one of the riskiest real estate investing vehicles.
Minimum investment amounts, fee structures, and portfolio allocation differ for every fund. According to Securities and Exchange Commission (SEC) requirements, mutual funds must devote at least 80% of their assets to the investment type represented by the fund’s name.
However, the name of a fund can be misleading, as mutual funds are allowed by law to invest across industries and asset classes. Investors must evaluate the assets that comprise a mutual fund and its costs and fees.
REITs – Real Estate Investment Trust
REIT invests in commercial real estate through equity or debt. REITs, in general, provide investors with a portfolio of income-producing real estate. Investors purchase REIT shares and get dividends from the REIT’s debt and equity investments. REITs, like mutual funds, were founded to provide ordinary investors with open access to real estate investments.
A REIT is required by law to earn at least 75% of its gross revenue from real estate and to invest at least 75% of its assets in real estate. It must also pay at least 90% of its taxable income to shareholders annually.
Today, REITs are classified into three types based on investor access: private REITs, publicly listed REITs, and public non-traded REITs.
Private REITs are not part of the Securities and Exchange Commission and are not traded on the stock exchange. In many aspects, they are comparable to private equity funds: they are generally confined to accredited investors with a high net worth, and while minimums vary, they are usually extremely high.
Private REITs typically charge significant fees, sometimes as much as 15%. Finally, they are often illiquid, limiting access to individuals who can afford to invest vast sums of money for extended periods.
Public traded REITs are registered with the SEC and sold on the stock exchange. Unlike most real estate investments, these are very liquid, having no investment limit other than the share price, allowing investors to acquire and sell them readily. While public REITs provide the most access, they are one of the most volatile real estate investing methods since they are tied to public markets like mutual funds.
A public non-traded REIT combines a publicly-traded REIT and a private REIT. They are filed with the SEC but are not publicly traded. Accessibility can be open or restricted, and investment requirements can vary. They are typically illiquid and have significant investing fees, though this is not always the situation.
Platforms for Online Real Estate Investing
Pooled investments in online real estate marketplaces are a modern technique. They invest in real estate investment possibilities that would be hard to trace or out of reach for individuals. Real estate platforms enable investors to participate in single assets or a diversified real estate portfolio.
Some solely allow debt investments, while others will facilitate both loan and equity transactions. Furthermore, some invest in a specific city or region, while others invest across the country. Many real estate investment platforms have limitations, such as certification requirements and large investment minimums, although not all of them.
One fund, for example, pools money from over 100,000 investors of all sizes and harnesses their aggregate purchasing power to engage in real estate investment opportunities that would otherwise be out of reach for most individual investors. Since 2012, the fund’s real estate team has invested over $4.9 billion in real estate on behalf of investors. This team invests in debt and equity, commercial and residential real estate across the United States, constructing goal-based portfolios from which investors can pick. Unlike other more restrictive real estate investment platforms, the fund is open to anybody and has no certification or net worth requirements. Anyone with $10 can invest.
The fund provides investors with greater liquidity than other private market options via redemption plans, subject to certain restrictions.
What Are the Tax Implications of Real Estate Investment?
Individual concerns are considered in real estate taxes and other earnings-based taxes. Determining how much tax is required and when it is due can be difficult for each investment. Several aspects are considered, including investment vehicle, holding vehicle, and employment income.
It’s easy to understand how taxation might quickly become very confusing. However, some real estate investments can provide significant tax savings when done correctly. If you need assistance evaluating your options, consult with your financial advisor.
While particular circumstances considerably impact taxation, the principles of real estate taxes are usually clear. Real estate investment returns are generally classified as either income or appreciation. Real estate income is typically subject to income tax, whereas appreciation is taxable.
Active Investing
Several of the active and passive assets we’ve reviewed can provide income. Rental properties (both traditional and short-term) are examples of operational support that can generate revenue through rental payments. The taxation of that revenue depends on numerous criteria, but rental income is generally taxable annually and subjects to regular income tax rates.
As an active investor, the property owner can likely demand deductible expenses for adequately maintaining the property throughout the year, such as property taxes, insurance, and maintenance charges, lowering the overall taxable income. Depreciation expenditures, including property renovation costs, can also be claimed to reduce the tax burden further. However, rental property owners will almost certainly face income taxes on their depreciation recapture in addition to capital gains taxes following the sale of the property.
Most passive investments can generate income, often in the form of passive income, and this money can be dispersed in various ways depending on the investment’s structure. Dividends are given according to the number of shares owned by investors who own real estate investments via stock ownership, such as mutual funds or REITs.
Other structures, such as private equity funds, can share partnership income based on the investor’s ownership percentage in the partnership. Partnerships must deduct expenses and losses in proportion to their ownership and position in the association. Yet, the tax implications vary depending on the league.
Because most passive real estate investments are not controlled directly by the owner, the investment structure can have significant tax ramifications for investors. For example, income earned in a partnership is taxed on the individual investor’s tax return rather than at the partnership level. Similarly, income delivered to REIT and mutual fund investors is taxable only at the investor level and not at the fund level, as long as the funds meet the required conditions to qualify for the chosen structure.
Mutual funds and REITs have an added benefit. At the beginning of 2018, investors who receive income distributions from pass-through entities like mutual funds and REITs can reduce up to 20% of eligible business income annually. Offerings like REITs, featured in various investment programs, can provide investors with exposure to this income tax benefit.
Capital Gains Taxes
Appreciation occurs when an investor sells a stock investment, whether active or passive. When that investment is sold, any appreciation returns are deemed capital gains and are subject to capital gains tax.
The ownership length affects the tax rate on an equity investment. Returns obtained on an investment purchased and sold within one year are classified as short-term capital gains, whereas returns earned on an investment kept for at least one year are classified as long-term capital gains.
Short-term capital gains are taxed at standard tax rates since they are included in your yearly income. Your earnings will be deemed short-term capital gains if you acquire and sell an active investment, such as a rental property, within a year. Similarly, any appreciation will be liable to short-term capital gains taxes if you buy and sell REIT shares or depart a partnership within a year.
A short-term capital gain occurs if an asset is sold after it has been owned for a year. While long-term capital gains are typically taxed at a lower rate than pay or wages, short-term gains are not taxed at all. They are liable to regular income taxation.2
Short-term gains are taxed like average taxable income in whichever marginal income tax category you fall. There are now seven federal tax brackets in the United States, with rates ranging from 10% to 37%.
Long-term capital gains are taxed differently than short-term capital gains. Adjusted profits, like short-term gains, will be taxed at a lower rate. Long-term capital gains taxes are usually not levied on taxpayers with incomes at or below the 12 percent marginal tax level.
Those in the 22 percent – 35 percent income tax brackets will typically pay 15% capital gains tax, while those in the 37 percent income tax bracket would typically pay 20% capital gains tax.
Any profit made on the sale of an equity real estate investment, whether active or passive, after a minimum of one year of ownership is liable to long-term income taxes.
Many factors, including the investment vehicle used to generate the capital gains and how the capital gains are used after they are recognized, can cause capital gains taxes to be postponed or decreased. For example, rolling over capital gains into a 1031 Exchange can defer tax responsibility if one investment property is exchanged for another similar one. Still, it cannot lower or erase your tax liability permanently.
Real estate has a track record of long-term stability. Real estate investing can generate big returns while adding significant diversification to your portfolio. When handled properly, it can be a vital source of cash flow in your investment portfolio and its long-term appreciation possibilities. Still, one disadvantage of real estate investing is illiquidity.
A real estate deal can take several months to close, unlike a stock or bond transaction, which can be finished in a snap. Even with a broker, finding a counterparty can take several weeks. Naturally, REITs and real estate mutual funds provide superior liquidity and market pricing. However, because they have a far stronger correlation to the entire stock market, they come at the expense of more volatility and weaker diversification benefits.
Real estate investments, like any other, need you to understand and analyze the risks and potential rewards before you begin. Each type of real estate investing necessitates a distinct set of resources.
Fast-paced, high-risk house-flipping businesses may make the most sense for you if they align with your objectives, resource availability, and character. You can still profit from real estate’s diversification and income potential if you lack substantial expertise and experience or a strong desire to become a landlord. Passive investment solutions, can allow you to invest in real estate without the continuing obligations that active investors face.
Does the fund that you plan to invest into provide access to private market real estate and diversity within a certain asset class? Depending on your objectives, you can invest in portfolios containing hundreds of real estate assets diverse across commercial and residential property types, debt and equity investment structures, and geographically around the United States.
Before making investment decisions, examine your complete financial condition, especially if you’ve never created a financial plan. The first step toward successful investing is determining your attitude towards risk tolerance, which you may do on your own or with someone. There is no 100% certainty that your investments will grow. However, suppose you learn the facts about saving and investing and implement an educated plan. In that case, you should acquire financial security and reap the rewards of money management over time.
******************************
Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.