Most people see how real estate investing has made some very wealthy and wonder, “why not me?” It’s a great question, and it could be you if you approach it the right way with the right tools and knowledge at your disposal.
While it’s true that there are many successful real estate investors, there are some not-so-successful ones as well. Understanding your options and how to evaluate them is the key to real estate investment success.
Starting a real estate business can take many forms, from owning rental properties to trading real estate stocks and everything in between. The choices can seem almost too plentiful, leaving you wondering, “where do I begin?”Here, we will take a deep dive into the why, how, and what regarding the many ways to invest in real estate to ensure you have the correct information to help you make the best decisions possible.
Why You Should Invest In Real Estate
Before we get into pursuing real estate investments, let’s talk about why real estate investing might be a good idea. Real estate investing has provided a steady income stream, financial stability, tax breaks, and more for many Americans. It can be a great way to invest your money, with a historically consistent rate of return similar to other stocks but with less volatility.
Riding the hot and cold stocks on the market can be a roller coaster ride of highs and lows. Conversely, well-researched and executed real estate investments can offer little risk and great reward.
The versatility of real estate investing is appealing to many people as well. There are so many different ways to go about it, that everyone from a billionaire to someone with lower than average income and savings, can become a real estate investor.
How To Get Started Investing In Real Estate
There are many paths to take when looking to invest in real estate, but they all start with assessing how prepared you are. This means looking at your current financial health, making the necessary financial arrangements, and understanding how to evaluate opportunities. Here, we provide a step-by-step process for starting your real estate investing journey.
Pay Down Your Debt
Real estate investing will require some cash, debt, or both, no matter which path you choose. So, if you have a lot of outstanding loans (college loans, high credit card debt, overdue medical bills, etc.), you will want to take care of those before investing in real estate.
The key is not to spread yourself too thin financially. If you are saving for a second home, college tuition, or any other type of big purchase, it might not be the right time to get an investment property. If you decided to save money for real estate investing a while back and have built up some good starting capital, the time to start might be now.
Whether you are ready right away or need to wait, paying down your debt is never a bad idea.
Save For A Down Payment
When you think about how much money you need for a downpayment, consider that investment properties often require a larger down payment than owner-occupied homes.
For example, if you bought your current home with a three percent down payment and think you can do the same for your initial investment property, think again. Mortgage insurance isn't available for rental properties, so your lender will require a down payment of at least 15 percent.
You will want some flexibility in terms of price point when you search for investments, so try to save more than you will need. If you can just cover 15 percent of a lower-end purchase price, the number of opportunities will be significantly diminished.
Cash Or Mortgage?
If you compare financing a rental property or paying cash, you will find that both options have benefits and drawbacks. If you are interested in monthly cash flow, purchasing a property with cash might be the best route. If you are more concerned with getting a high percentage of return on your investment, a loan could be the way to go.
Let’s say you buy a rental property for $200,000 cash. After accounting for rental income, depreciation, income taxes, and property taxes, you might see something in the range of $20,000 in annual revenue. This would be a 10 percent return annually on your $200,000 investment.
In comparison, let’s say you put down 20 percent on a rental property with four percent interest on the loan that will cover the rest of the purchase price. Once you subtract operating expenses, the earnings could be in the range of $11,160. Your cash flow would be much less than if you pay cash, but your annual return on your initial investment (28 percent) would be much higher.
How To Get A Mortgage
Rental property mortgages are different from traditional, primary residence mortgages, and it's essential to know the differences before investing in rental properties.
Lenders usually charge higher interest rates on rental properties because there is a greater risk of the borrower defaulting on their loan. When money gets tight, people are more likely to stop paying their rental property loan than their primary residence home loan.
Underwriting (the process for getting your loan approved) has more stringent standards when it comes to rental properties as well. You may be familiar with the components that determine approval for a traditional loan like down payment amount, credit score, and debt-to-income ratio. These are the same variables under consideration for rental property mortgages, but the requirements for each are usually more limiting. For example, they may require a much larger down payment and a higher credit score than a lender for a primary residence home would.
Here are the requirements for a typical rental property mortgage:
Down payments for rental properties usually need to be between 15 and 20 percent of the purchase price. This is significantly more than some traditional home loans that can require much less, like three percent (FHA Loan) or nothing at all (VA Loan).
As previously mentioned, the main reason is the lack of private mortgage insurance (PMI). When you pay PMI on a low down payment loan for a primary residence, the lender has some assurances if you default on the loan. Without PMI, the lender is on the hook if you stop paying your mortgage. As with all loans, the more risk you pose to the lenders, the more they want to see you pay upfront.
Debt-To-Income Ratio (DTI)
This shows lenders how much of your monthly income goes toward paying off your existing debts. They will want your DTI to be in the 35 to 45 percent range to approve you for a loan to purchase a rental property. Since you likely already have a mortgage for your primary residence that is more likely to get paid than the new mortgage, DTI percentage requirements are significantly higher for buying rental properties. An FHA loan, by comparison, can sometimes be approved even with a DTI as high as 55 percent.
Lenders also want to see you have significant savings in relation to the loan amount. While DTI is important to determine your monthly financial stability, what happens if you have a loss of income or some unforeseen expenses like medical bills? Like, say, if a global pandemic hit and employment rates dropped dramatically.
Before investing in rental properties, you are going to want to make sure you have enough savings to cover three to six months of mortgage payments. That way, if a financial tragedy befalls you, at least you will have some time to adapt before defaulting on your mortgage.
Some lenders for primary residence homes might approve you for a mortgage loan with a credit score as low as 580, maybe even lower. This won't happen with rental property mortgages, though. Lenders will want to see a credit score of at least 620. This is the very minimum, and the terms for a loan will be much better if your score is at 740 or higher.
Do Your Homework To Find The Best Rates
Get quotes from at least three different lenders to ensure you get the best possible terms on your rental property loan. Each mortgage company uses its own rating system to determine approval, interest rate, and other loan terms. That means you will get different quotes from different lenders. Review them all carefully and ask each mortgage company if they can beat the additional quotes you have from other lenders before deciding.
Determine Your Operating Expenses
Your operating expenses refer to all the ongoing costs you will incur to keep and maintain your rental property. Examples include utilities, property taxes, repair costs, cleaning fees, and legal fees. This amount can vary depending on the property and will likely be between 30 and 80 percent of your gross operating income.
Let’s say, for example, you charge $3,000 in rent per month, and your expenses every month are $1,200. That would put your operating expenses at 40 percent a month. Much of this will be estimated until you look at the financials on a specific property. Still, if you figure about a 50 percent operating expense initially, that’s an excellent place to start. This also makes it easier to calculate.
Estimate Your Return On Investment (ROI)
As with any investment, the ultimate goal is a high ROI. Think about what return you like to get on your stocks as a starting point. If you aren't an inverter, consider using what many real estate investors refer to as “the one percent rule.”
The one percent rule measures the price of a rental property in relation to the gross income it will generate. So, if you buy a property for $250,000, the monthly rent needs to be at least $2,500.
Keep in mind that repairs or renovations need to be included as well. So, using the same property example as before, let’s say you need to do $20,000 in repairs and updates before renting it. That brings the total cost to $270,000, so to meet the one percent rule, you would need to charge a monthly rent of at least $2,700.
Expect The Unexpected
Even when we try to prepare for every scenario, unexpected things happen. Keep this in mind as you consider buying your first rental property. Things like bursting pipes and overflowing toilets come with additional unforeseen expenses. Put away 20 to 30 percent of your rental income, so you have a reserve of funds to pay for these things if, and when, they happen.
Find The Best Location
Look for cities that have transient populations like college towns. Students only live there for a few years, so they aren't likely to buy a home. This means there will always be a high demand for rental properties. For you, that means never having to look long for a tenant and enjoy the higher rental rates that accompany high demand.
Look at the population of the cities you are considering buying rental properties. Is it increasing or declining? Fewer people means fewer renters, so focus on solid year-over-year population growth locations. Consider the job market as well. If employers are creating more and more jobs each year, it’s a good bet that more employees will flock to that city, which of course, means they need a place to live.
Decide If You Want To Be A Landlord
Remember the bursting pipes and overflowing toilets we mentioned earlier? As a landlord, that’s your problem to take care of for your tenants. This means being on call to come to your property and take care of any issues that arise. Think long and hard before deciding that the financial benefits are appealing enough for you to take on this extra work.
If you're handy and don't mind the occasional fix-it job, being a landlord might be a breeze. If you are not a DIYer and shutter at the thought of unclogging a toilet, then think twice. You can also hire a property manager to handle these issues for you, but you will need to budget between 5 to 10 percent of your gross monthly income to pay for their services.
Great Strategies For Investing In Real Estate
The avenues into real estate investing are plentiful. This variety can be exciting and overwhelming at the same time. Getting a good understanding of all the various ways real estate investors build wealth is critical. Think about how each of the following strategies might work for you. Some will work for more experienced investors, while others are simple enough for novices. There are even options that don't require owning real estate at all.
Short Term Rentals
Sometimes the easiest way to start investing in real estate is to use the primary residence you already own. This can mean renting out all or part of your home to short-term renters. For example, if you live in a college town with heavily attended football games, you might be able to pay your monthly mortgage just by renting out your home for a weekend or two each month. Locations near concert venues, festivals, and other well-attended events offer the same promise.
The number of online real estate platforms available to market and rent your home continues to grow, with Airbnb, VRBO, and Vacasa leading the way. They offer a suite of digital tools that allow you to turn unused space in your home into rental revenue. You can even do this if you are renting an apartment and have not bought a home yet. Short term rentals are a great strategy for people considering investing in real estate at a young age.
You may also consider purchasing a property to generate short-term rental income. It’s a good idea to work with a real estate agent that understands the vacation and short-term rental property markets you are looking in. Homes near lakes or tourist attractions are just a few examples of properties that might be good for this type of endeavor.
Short-term rentals offer higher initial returns, as the daily rate will almost assuredly be higher than a longer-term monthly or yearly rental. It will be more work, though. Marketing, cleaning, and maintenance will all cost more for a short-term rental than a long-term one. Review the cost difference compared to the rental income before deciding which option will be more profitable.
If you decide to go the short-term rental route, be sure to check local city ordinances. Many cities are passing laws that prohibit or restrict these types of short-term rental income opportunities in specific areas.
Long Term Rentals
Compared to short-term rentals, long term rentals offer more consistent rental income and less work. When a tenant has a lease for six months or a year, you are guaranteed to get that income. When you are renting out by the day or week, you might find the property vacant and not generating revenue for extended periods.
Work with a real estate agent to analyze the rental real estate market in the areas you are interested in. The criteria will be similar to short-term rental opportunities with a few slight differences. For example, you don’t need to worry about the quality of nearby schools for short-term rental clients, but long-term renters might be interested in this.
Another difference between short and long-term rentals is the inspection your local municipality may require. This can be costly for rental property owners if the inspector finds many items that need to be replaced or repaired before the property can be rented.
Have you watched HGTV lately? If so, you probably think flipping a house is pretty straightforward and lucrative. Well, it can definitely be lucrative. Easy? Not so much. Finding properties, determining improvements that will increase the price, doing the work, and selling them is no walk in the park.
This should not deter you completely, as the ROI for flipping houses can be in the 30 to 70 percent range or even higher. Compared to rental properties, the short-term financial gain is significantly higher when flipping a house.
The risk is real, though. What if the improvements cost much more than you think? What if the estimated value increase is off, and you can’t sell it for a profit? These are questions to consider as you evaluate possible houses to flip.
Purchasing land can be profitable in a variety of ways. You can just hold on to it as the value goes up, divide it into smaller lots to sell, develop it by building houses to sell, or have it re-zoned for a completely new purpose.
If you plan on holding land, make sure you talk to your real estate agent about land value trends in the area. If parcels are increasing in value year over year, it might be a good investment. If land values are trending down, stay away.
Sometimes large parcels of land can be divided into smaller lots to increase their value. For example, if you buy a 40-acre lot that costs $1,500,000, you may be able to split it into ten four-acre lots and price them at $200,000 per lot. This brings you a profit of $500,000 on the land. Keep in mind that splitting land does come with some costs, including new driveways and local re-zoning fees.
You could also purchase land and then reach out to real estate developers or develop the land yourself. If that 40-acre parcel can have 20 houses on it that sell for $300,000 each, that’s $6,000,000. Even after you take out the construction costs, that’s a hefty profit.
Rezoning is another possible strategy when it comes to land investing. Let’s say you buy a parcel that is zoned residential but is in an area where a commercial enterprise, like a restaurant or office building, might thrive. Asking the local municipality to change the zoning may result in a better ROI than using it as a residential investment property.
Commercial Real Estate
Usually reserved for the more experienced investor, this is where the big profits in real estate investing can be found. Commercial real estate refers to retail centers, hotels, office buildings, and warehouses. Residential multi-family buildings with five or more separate living units are also considered commercial properties.
The expertise you need for commercial real estate investing is more robust than residential. Zoning codes, additional legal documents, and complicated rental contracts are just a few of the things you will need to navigate. The returns are higher, as commercial enterprises can be charged much higher rents than residents, but the cost of acquiring the property will also be higher.
Real Estate Owned (REO) Properties
When an owner goes through the entire foreclosure process without the loan being settled or the property being sold, possession of the property goes back to the mortgage company that holds the loan. These are called bank-owned properties or REO properties. Real estate agents specializing in REO properties can help identify these properties for you. In addition, there are several online sources, such as RealtyTrac, where you can search for these types of properties. In most cases, you can search online by city, state, or ZIP code.
Negotiating with a mortgage broker can take more time because they are not homeowners. When someone sells the home they live in, they devote a great deal of attention and time to it. When a mortgage broker sells a home, it represents a small portion of their business and day-to-day responsibilities, so it takes longer for them to respond to offers and move transactions along to the closing table.
However, the options you can negotiate with are more plentiful. For example, if you get a loan to buy the house through the same mortgage lender that holds the loan on the foreclosed home, you may be able to get a lower sales price and interest rate. This isn't true in all cases, but most lenders will accommodate.
REO properties can provide significant ROI when you buy them for a dramatically reduced price and then sell them for a hefty profit.
Real Estate Stocks
This method of real estate investing is not often discussed but can be a great low-cost way to get into the business. The types of stocks related to real estate that you can buy are abundant - just like any other stock. You can invest in home improvement suppliers, construction companies, real estate agencies, government-backed mortgage buyers, and much more.
You can also invest in mutual funds that offer a portfolio of real estate-related stocks. As with all stocks, these provide significant financial upside with considerable risk.
Real Estate Investment Trusts (REITs)
These are real estate investment groups that allow investors to pool their resources to invest in a portfolio of properties that they might not be able to buy individually. RIETs pay dividends by renting or selling the properties they own.
You can find hundreds of publicly-traded REITs to choose from, with varying levels of potential risk and reward. Much like stocks, you can balance short and long-term risks, being as aggressive or conservative as you want.
This involves buying mortgage notes and then collecting the payments. Essentially, you take on the role of the bank. This can have a wide range in terms of risk and reward.
You can buy a performing loan (one that is being paid) and simply collect the payments from the homeowner. Or, you can buy a non-performing loan (one that is not being paid) at a discounted rate and negotiate new payment terms with the homeowner. If payment terms can’t be negotiated, you can take possession of the property.
If your starting capital for real estate deals is low, mortgage debts may be an excellent option to consider since they are less expensive than buying a property outright.
Real estate crowdfunding platforms provide access to commercial real estate previously unavailable to most people. You can sign up for any number of crowdfunding platforms, research possible deals, and be ready to make an offer when the deal is made available to investors.
While most deals require tens of thousands of dollars, some platforms are privately built by REITs where you can invest as little as $500. Keep in mind that most real estate investment opportunities on crowdfunding platforms require you to invest for many years. Moreover, there could be severe fees or penalties if you try to pull out of a deal early.
Summary: When It Comes To Real Estate Investing, Knowing Is Half The Battle
Real estate investment is an excellent way to increase your income and move toward more financial freedom. Whether you are a seasoned pro looking to grow your real estate business or just dipping your toes into the real estate investing waters, there are plenty of options that could work for you.
Enjoying success when you invest in real estate is all about being in the know. Knowing the loans to investigate, knowing the type of real estate that will be profitable, and learning about the various financial and technological tools that set you up to be profitable are parts of the bigger puzzle.
Now that you understand how and why to invest in real estate, keep researching the best options for your specific situation, never stop learning, and eventually, you’ll begin building your real estate business.