Advanced Money School Lesson 7: Real Estate Investing
Written by: David Weliver
Real estate is another asset class that provides a proven path to wealth. Like a business, real estate is an investment you can see and touch. Make no mistake, real estate is not a passive investment. But it can be more hands-off than business ownership.
Becoming a successful real estate investor requires business savvy, dedication, and patience. I can’t cover everything you need to know in a few thousand words, but I can definitely give you a primer.
In this lesson, I will:
- Introduce the pros and cons of real estate investing.
- Discuss what’s involved in profitable real estate investing.
- Explain how to decide if real estate investing is right for you.
To begin, let’s dive into why real estate can be at attractive investment in the first place. (I’ll also give you some reasons why you might want to avoid it!)
The real estate asset class
Unlike paper assets like stocks and bonds, real estate is tangible. That’s why it’s called “real” estate, after all. When you own real property, you can walk on your land and feel the brick and mortar.
Many people find real estate attractive for no other reason but this.
My wife’s grandfather, like many who came of age during the Great Depression, was one such investor. As he amassed a bit of wealth through his work as a physician and frugal lifestyle, he purchased nearly a dozen modest apartment units. These properties provided ample cash flow to fund his passion for sailing and a lot of generosity in his retirement.
Would he have fared just as well if he had invested in the stock market? Most likely. But investing in real estate allowed him to sleep well at night.
Let’s begin with the pros of investing in real estate.
The upside to real estate
There are quite a few advantages to investing in real estate. The first one is cash flow.
1. Cash flow
Recall from Lesson 6 how different investments provide differing amounts of cash flow. At the low end, a savings account might produce cash flow equal to 1% or less of the asset value. A dividend stock might produce 3% or 4% cash flow. A profitable real estate investment has the potential to produce a lot more than this via the rent a tenant pays you, the owner, and landlord.
As with any investment, positive cash flow is not guaranteed in real estate. Your properties may be vacant, or your expenses may exceed your rental income. With sound management and a bit of luck, however, I’ve read that a good target is a real estate investment that cash flows 8% or more.
With that figure, you can see why many investors find real estate so alluring. If you manage to invest $500,000 in real estate, you could generate $40,000 or more in annual income.
Leverage is when you use borrowed money (in the case of real estate – the borrowed money comes in the form of a mortgage) to increase the return on an investment. Without leverage, real estate would be a stable but not-so-sexy investment. You would need large amounts of cash to buy in, and you would tie up that cash for as long as remained invested.
So leverage makes real estate interesting. With mortgages, you can own $1 million in real estate while only putting up $200,000 of your own money (in some cases, less).
Leverage makes it possible for almost anyone to amass a large real estate portfolio. You can use the cash flow from some properties save for down payments on more properties. Rinse and repeat.
As a result, you don’t need to have millions in the bank, only a bit of business savvy.
In Lesson 6, we discussed both cash flow and an investment’s asset value. Real estate is a perfect example of this concept.
While you are enjoying cash flow via your tenant’s rent checks, the building itself is still worth a lot. As we know, real estate has a tendency to appreciate over time.
And you may be able to influence that appreciation. You can make improvements to the property or land desirable long-term tenants.
“Flipping”, as popularized by many television shows, focuses only on appreciation. Investors buy a property at a low price, spend money on renovations, and hope to sell the property for a profit. To me, flipping is more of a business than real estate investing. Both strategies take time, knowledge, and skills, but flipping requires more. As such, I will only mention it a few times in passing in this lesson.
Although real estate does have a tendency to appreciate, I offer a few words of caution here.
First, real estate values can and do decline. If you need a refresher, Google “2000s housing crisis.” For extra fun, add Nevada, Arizona, or Florida to the query.
Second, it’s easy to be a victim of cognitive biases when looking at real estate valuations. We all know an older relative who bought their house 40 years ago and talks about how it’s now worth four times as much.
At first glance, that kind of return on your money seems impressive. In reality, inflation accounts for most of that difference in value. The cumulative inflation rate between 1979 and 2019 was 252%. A home purchased 40 years ago for $100,000 would cost $352,145 in today’s dollars before factoring in market appreciation. That’s an inflation-adjusted average annual return of a tad over 1%. The good news is that the home did, in fact, appreciate. The bad news is that it performed worse than nearly any other kind of investment.
Here’s another example. Take a look at these two charts via MULTPL.com showing two versions of the Case-Schiller Home Price Index. The Case-Schiller Index shows how the average U.S. home price has changed over time.
Chart A shows home prices between 1900 and today, without adjusting for inflation. The line ascends after 1945. Chart B shows home prices over the same period, but adjusted for inflation. Here, you can see that, indeed, home values have appreciated. But the appreciation is more volatile and less dramatic, except for the 2000s bubble precipitating the crisis.
The bottom line is this. Yes, real estate appreciates. But it’s dangerous to rely on appreciation alone as an investment. Most likely, your real estate will protect you from inflation but not do a whole lot more.
This is one of the driving reasons why I am adamant that your own home is not a good investment. You spend so much money to own and maintain your home, but there’s no cash flow. Unless lightning strikes and you sell at the apex of a hot market, it’s so difficult to profit from your own home.
Most American works have at least some exposure to the stock market through a 401(k) or similar retirement account. Even if you’re not a stock market skeptic, real estate provides something different.
Stocks are far more volatile than real estate values. A widespread recession may indeed cause declines in both the stock market and real estate values. Barring such a recession, however, real estate holdings can provide stability in contrast to more routine and unpredictable swings in the stock market.
Real estate investing can provide compelling tax benefits too.
To begin, you can deduct most costs associated with owning investment properties. Deductible costs include utilities, repairs, maintenance, legal and management services, and even the cost of gas driving to and from your properties.
You can also deduct mortgage interest and a certain amount of property taxes.
Another great tax benefit of real estate investing is the 1031 exchange. If you sell a property that has appreciated, you can defer paying taxes on the capital gains from that property when you use the proceeds to buy another qualifying property within a specified period of time.
These tax benefits alone can result in significant tax savings every year, but you might be able to do even better with the help of a tax professional. For example, while most people hold investment properties within a limited liability company (LLC), it’s also possible to hold property using a self-directed IRA, thereby creating another opportunity for tax-deferred growth.
The downside to real estate
After reading those benefits, real estate investing may seem quite compelling. Of course, no investment is without risks – or drawbacks. Here are a few big ones you must consider before borrowing tens of thousands of dollars to take ownership of an investment property.
1. Diversification requires more capital
An investment property provides diversification from other asset classes like stocks – that’s a good thing. What you must consider, however, is that you could take the same $200,000 and invest in a widely diversified portfolio of paper assets or use it to buy a single piece of property.
Your investment performance is subject to the mercy of your property’s location and that rental market. It’s also subject to an infinite number of things that could happen to your property such as fire, floods, hurricanes, earthquakes, lingering structural issues, etc. Sure, insurance can help protect the underlying asset value, but not the long-term loss of rental income you may endure.
All of this is to say that it’s far riskier to own a single property than, say, to invest in thousands of properties via a real estate investment trust (REIT). On the other hand, enduring that additional risk can make owning a single property far more rewarding too.
Real estate is an illiquid investment. You cannot easily turn a building into cash. Of course, you can sell real estate or borrow against its value, but these options take time or come at a cost. That’s the definition of illiquid. When an investment isn’t liquid it doesn’t mean that you cannot exchange it for cash, it just means that it takes more effort to do so.
Illiquidity, by itself, shouldn’t be a deterrent to investing in real estate. You should simply be aware that the money used to buy property will be tied up as long as you own the real estate. If needed, you can access some of it again via secured lines of credit, but not for free.
If you want cash flow from real estate, you’re going to need a tenant to pay you rent. Tenants are people and, if you’ve been around enough people in your lifetime, you know that people can be, let’s say, “unpredictable”.
Tenants are the human factor in real estate investing. It’s not something to take lightly.
My friends who invest in real estate have seen it all:
- Tenants calling at 3 am for help silencing a chirping smoke alarm.
- Tenants starting fires.
- Tenants causing tons of damage and then suing when they don’t get their security deposit back.
- Tenants not paying rent for months and then smearing feces on the walls before moving out.
In more than one case, difficult tenants were enough to make friends of mine give up on real estate investing altogether.
You can attempt to save yourself some trouble by finding the right tenants, but it takes time and hard work. Even still, someone could have perfect credit and impeccable references and still surprise you.
Finally, you should know that most (but not all) state laws are skewed in favor of tenants’ rights. This can make it difficult to evict tenants or win disputes. Although it’s another expense, it would be wise to consult a real estate attorney before buying your first income property (or, at least, before taking on your first tenant).
Having been a homeowner now for over 10 years, I sometimes yearn for the days when a landlord shoveled the snow, fixed the running toilet, replaced the broken oven, and repainted the exterior.
Maintenance is a big part of owning real estate. To take care of it, you have two choices:
- Do it yourself, or
- Hire it out.
If you want to maintain your property yourself, you obviously must live close by. Second, you need to have the skills and the time. If you have all of these things, maintaining your property yourself can save a lot of money and dramatically increase your cash flow rate.
For whatever reason, however, many real estate investors either cannot or choose not to do their own maintenance. Instead, they hire a property management company. Property management companies can do as much or as little as you want. In some cases, you can hire a company to handle all aspects of managing your rental – including screening tenants. All of this comes at a cost, of course, and these costs eat into your cash flow.
Every location and property is different. In some cases, it might be easy to pay a property management company and still make a profit. In others, there will be no way to achieve positive cash flow from a property unless you do the work yourself.
5. Responsibly and liability
As a landlord, you will have a responsibility to follow housing laws and maintain your properties according to building and fire codes. Failing to do so is not only dangerous but will open you up to significant civil (and in some cases criminal) liability.
Five years ago here in my city of Portland, Maine, there was a heartbreaking example of one landlord’s failure to take this responsibly. On November 1, 2014, six roommates – all in their mid-20s – were killed when a fire broke out in their rented house. Due to the landlord’s negligence, smoke alarms didn’t work, hallways were cluttered, and exits were blocked.
Obviously, the landlord faced all kinds of lawsuits from the families of deceased tenants and from others who were burned in the fire, but survived. In addition, he was charged criminally with manslaughter and a host of criminal code violations.
Although a jury found him “not guilty” of manslaughter, he was convicted of the code violations and spent several months in jail.
This is an extreme example of a landlord’s responsibility and liability. But something as simple as neglecting a smoke alarm battery or failing to clear steps of ice can lead to major injuries. A good attorney and proper insurance are obvious musts, but they don’t replace the care and responsibility required to maintain a safe property.
How to determine if real estate investing is right for you
Since starting Money Under 30, “should I buy a rental property?” has been one of the most common questions I receive from readers and friends alike.
Of course, I never give a simple “yes or no” answer. My response goes like this: “If you have the cash, are up for the work, and want to, then sure!”
Real estate investing can be a rewarding side hustle. For some, it can even turn into a lucrative full-time business.
Too often, however, I see people get caught up in two common myths about real estate investing.
- It’s as easy as getting a mortgage and buying a building.
- It provides truly passive income.
Here’s the truth:
- Getting a mortgage and buying a building is only part of it. You’re not going to be successful if you don’t find the right building in the right location at the right price. Almost anybody can buy a building and list units for rent. Not everybody can do it profitably.
- When your properties are humming along, filled with reliable tenants, you can enjoy periods of time with some relatively passive income hitting your bank account. But don’t mistake real estate investing for a truly passive source of cash flow.
Here are some questions to ask yourself to discover whether real estate investing might be right for you.
Are you willing to work hard when required?
Real estate investing might be more passive than working 40 hours a week. But it still requires hard work. When you’re a real estate investor, however, you’ll be working in sprints.
You will need to put in long days when you’re buying and renovating a property or filling vacancies. Turnovers will require a mad dash to find a tenant and then clean or update a unit before someone new moves in. Running real estate investments also requires careful bookkeeping at least on an annual or quarterly basis.
Real estate investing can afford you some decent stretches when all you need to do is collect the rent and make sure contractors are taking care of the routine property maintenance. But your venture may fail if you don’t rise to the challenge of doing the work when it needs to get done.
Can you stomach the risk?
When deciding how much risk to assume in your stock portfolio, it’s helpful to ask questions like “How would I feel about a 20% drop in portfolio value? What about a 30% drop?”
Someone who can psychologically endure such dramatic losses can take bigger risks than someone who gets nauseous at the thought of such a roller coaster ride.
We can apply a similar exercise to real estate investing.
Before buying a property, visualize a series of worst-case scenarios. How would you feel – and how would you respond, if:
- It takes nine months to fill a vacancy.
- You need to discount rent 30% to fill your units.
- You discover a major mold issue that will cost $30,000 to remedy.
- Your building is destroyed in a fire. Insurance will cover rebuilding, but you will lose two years of rental income.
- A tenant injures himself and sues you, costing $20,000 in legal bills.
Do you have ample cash flow reserves?
Having enough money to buy something is not the same thing as being able to afford something.
If you go out and buy a $200,000 rental property as soon as you have $20,000 saved up to make a down payment, you could be in trouble. If you use the last of your cash to buy the real estate, how are you going to afford to paint, replace appliances, and fix the leaky roof? How will you make your mortgage payments if it takes longer than you anticipate to get a tenant?
Now, I’m not saying you need to be 100% debt-free and swimming in cash to invest in real estate. Many successful real estate investors use financial leverage to their advantage. Borrowing money is part of the game. However, I would strongly recommend budgeting ample cash reserves before you invest in real estate. That means cash on hand to deal with unexpected maintenance issues, but also a large enough buffer to cover the mortgage if you have vacancies or a non-paying tenant.
The smart way to start buying real estate as an investment
So, after all that, you want to invest in real estate. To do so wisely, move slowly and take every opportunity to learn.
Years ago, a friend of mine, Arthur Garcia, documented buying his first rental property in a couple of articles for Money Under 30. I still love this article on Arthur’s formula for finding properties, in particular, because it so succinctly outlines the metrics you need to hit to be successful as a real estate investor.
As Arthur drives home in this article, you should not even consider buying an investment property before doing a lot of homework. This lesson presents many of the things you need to think about before buying, but is not a comprehensive primer on buying an investment property.
There’s a ton of information on the web and many good books on the subject. Bigger Pockets offers a suite of educational products to help all kinds of real estate investors. There are forums, courses, books, and tools for finding, buying, and managing properties.
One word of caution: like any kind of financial subject, real estate investing tends to attract more than in its fair share of snake oil salesmen hawking get-rich-quick schemes. In the worst cases, you could end up shelling out thousands for a course that just teaches what you’re reading here.
There are legitimate courses out there, but there are also scams. Do your homework before you buy!
Find a property you can manage yourself
This flies in the face of the idea that real estate investing can provide passive income. But I think you should start with a small property close to your home that you can mostly manage yourself.
I’m not saying you need to be a jack-of-all-trades who can install a new electrical circuit or shower. Of course, you can hire contractors for stuff like that. I’m just saying that you should clean your own units, arrange for your own lawn mowing and snow plowing, and advertise for and interview tenants yourself. And you should give your phone number to your tenants in the event of a problem. At least in the beginning, you should be the one they call.
There are two reasons for this. One, it’s experience. The better you understand what goes into managing a property, the smarter you’ll be about how you (or someone else) manages your properties in the future. Secondly, doing all this work yourself will save you a lot of money. This makes it more likely that you’ll be profitable.
Look, there’s always a chance you’ll make some mistakes on your first investment property. Those mistakes can get expensive. If, however, you’re watching costs wherever you can, there’s a better chance that you can endure those mistakes and have a successful long-term investment.
Getting a mortgage for a rental property can be a headache. It’s possible, but there are even more rules to follow than when getting a mortgage for your primary residence.
For example, lenders may require a higher down payment of 25 or 30% for multi-family properties. The required down payment may also increase if you already have multiple mortgages on income properties.
Establishing a relationship with a good mortgage broker is a must, as he or she can walk you through the complications of the process and ensure it goes as smoothly as possible. Remember, however, that the broker has an incentive to originate a loan whether or not it’s in your best interest. You have to look out for yourself. Be patient. Don’t accept a higher interest rate, unnecessary closing fees, or other costs just to get the deal done. Be prepared to walk away. There will be other opportunities down the road.
And remember that when interest rates go down, you can also find deals to refinance for no points and closing costs. Remember that you can bargain with banks – even though they will never advertise that fact.
Find the right tenants
Earlier, I shared some tenant horror stories that might cause even the most motivated prospective investor to think twice before buying a rental property.
Most people are decent, but some people suck. Your goal is to find the decent people to be your tenants.
The problem is, judging someone’s character isn’t a perfect science – especially when you only have a brief interview and a reference call to go on.
Furthermore, U.S. equal housing laws require that landlords not discriminate when leasing. Hopefully, it’s obvious that you can’t refuse to rent somebody based on their age, race, religion, sexual orientation, etc. But you really have to be careful not to let your preferences for ideal tenants turn into a violation of nondiscrimination laws. For example, I’m sure many landlords would prefer a quiet retired couple to a couple of 21-year old college bros. Likewise, I once had a landlord who told me he didn’t like to lease to families with young children because he lived in the unit downstairs. Legally speaking, landlords must be careful how they select tenants.
You can require that tenants not smoke or have pets in your ad and lease, but you can’t legally demand much else from your tenants. And enforcing even basic restrictions like no smoking or pets can involve long court battles.
All that you can do is be patient and deliberate about finding tenants. Advertise your vacancy among family or friends before posting it on Craigslist. Require references (and CALL them!)
And the golden rule: pay $25 to run a credit check – it’s worth every single cent of the cost because credit checks tell you a lot about your future tenant’s past relationship with money and bills.
Consider using a service like Cozy, which can streamline your advertising, application process, and even rent collection.
But, whatever you do, take the time to show your apartments and interview prospective tenants yourself. Then trust your gut.
My mantra for this unit: your gut feeling is almost always correct.
Know your exit plan
One of my favorite bits of business advice is the second habit in Stephen Covey’s famous “7 Habits of Successful People” – begin with the end in mind.
To my constant surprise, I often see otherwise successful entrepreneurs failing to follow this advice. They get stuck going through the motions just to finish the project or grow revenue month-over-month or year-over-year.
Although the fact they are still successful is proof that you certainly do not NEED to do this in order to be successful. But I think you will be that much MORE successful if you do, in fact, think about the end before you begin.
In real estate, this means having an exit plan.
Now, your exit plan could be to amass a portfolio of properties to hold until you die so you can live on the cash flow. If that’s your goal, you should be certain that any property you buy meets your criteria to hold for a lifetime.
More realistically, if you just want to try out real estate investing, you might come up with some kind of business plan to inform your future decisions.
For example, you might say that you will hold a property for five years and then decide whether to continue as-is for another five years, sell your property, or even invest in another one. Alternately, you might decide to continue unless you have two years in a row of negative cash flow, in which case you’ll exit the investment. Or, you could decide to hold your property until the value has appreciated X%.
The specifics don’t matter as long as you have criteria in mind to inform when you will exit (or scale) your investment.
Real estate crowdfunding and other alternatives
If you like the idea of investing in real estate but do not have the time, money, or motivation to buy and manage your own rental property, you still have some options.
In this last section let’s take a quick look at some alternatives to the traditional landlord/tenant model.
Sublets, roommates, and Airbnb
In a moment, we will explore some investments that do not involve physically owning property. First, I want to explain that you don’t need to be a landlord in the traditional sense to make money from your property.
At the risk of being obvious, renting out a room in your home, or taking on a roommate in your apartment is the most basic way of obtaining cash flow from your real estate.
No, it’s not really “investing”, but it can dramatically reduce your monthly housing cost. Consequently, it might help you be able to save up the down payment needed to buy another property as an investment. (I’ve known some real estate investors who started this way!)
What about Airbnb?
In some cities, real estate investors have discovered renting their units on Airbnb is significantly more profitable than renting them to a long-term tenant. In places suffering from housing shortages, this is a real problem, because it takes even more housing inventory off the market. This not only makes it more difficult for tenants to find a home, it also drives up rents. Consequently, many cities are enacting laws limiting short-term rentals or banning them entirely.
Turning a short-term rental into a profit center depends mostly on your property’s location. A beach-front condo or NYC one-bedroom might be a gold mine; a single-family home in a random suburb not-so-much.
And, even if you have a desirable property, going the short-term rental route has pros and cons. More money is a major pro. If you take an apartment you could rent for $2,500 a month and instead rent it for $400 a night, you’re looking at pulling in way more cash if you can manage to rent it just 10 nights a month or more. Another upside is that you know you’re going to get paid – as long as rentals are pre-paid through a service like Airbnb you eliminate the prospect of a tenant stiffing you.
The downside is that an Airbnb can be more work, as you’ll need to communicate with guests and coordinate turnovers multiple times a month. In addition, you have a lot more people revolving through your rental. That means more wear-and-tear and also a higher possibility of sketchy guests doing sketchy stuff.
Real estate crowdfunding
Real Estate “Crowdfunding describes numerous platforms that allow individuals to invest in partial shares of commercial properties.
Crowdfunding is not new, but over the last 10 years, companies like Streitwise, Crowdstreet, EquityMultiple, Fundrise, and RealtyMogul have made such investments available to individuals with very little money overall.
When you use one of these platforms to invest, you select from among available investment opportunities. There are different kinds of investments.
With a syndicated debt investment, you are lending money (along with others) to developers or property owners. Your gains come in the form of interest paid on the loan, but you do not receive any profits from the real estate project itself. This is not a low-risk investment by any means, but your loan is secured by a mortgage, providing downside protection.
Equity investments give you a piece of project profits if there are any. These investments have limited downside protection but can reap big gains when they perform. Some platforms also offer preferred equity deals that give investors a fixed quarterly return with the opportunity for a fixed portion of profits at the deal’s conclusion.
This kind of deal provides a balance between risk and reward:
- The obvious advantage of these platforms is that you can invest in real estate from your couch as easily as you can buy a share of stock. You point and click, transfer your money, and wait for returns.
- The disadvantage is that you’re making high-risk investments that you can’t see up close and actually visit. In addition, you’re accepting less of a return for the risk because of all the fees taken out by the platforms.
In real estate, there are great deals, terrible deals, and everything in between. To be successful (read profitable) it’s critical to have the right deal on the right property at the right time. When you invest with a crowdfunding platform, you’re trusting their teams to vet your investment.
The second thing you must understand is that investing in a crowdfunding platform is convenient. It allows you to participate in a multi-million-dollar deal with as little as $10,000. And, just as you pay a fee and gratuity for the convenience of having tacos delivered, you’re going to pay for the convenience of these deals in the form of a reduced return.
The bottom line? Real estate crowdfunding is an interesting opportunity to learn about commercial real estate investing while providing some diversification from stocks and bonds. At the end of the day, however, you don’t actually own real estate, you own a paper asset that’s distantly backed by real estate. Invest accordingly.
You can think of Real Estate Investment Trusts (REITs) as larger-scale crowdfunding deals. A crowdfunding deal might pool 20 investors’ money to make a $1.5 million investment. A REIT, on the other hand, might have tens of thousands of investors in a vast real estate portfolio worth many billions.
Just like with crowdfunding sites, there are different types of REITs. Some focus on holding income-producing properties while others lend money. You can choose REITs that are broadly invested or ones that specialize in a certain kind of property such as office buildings, shopping centers, apartments, hotels, etc.
The large advantage REITs have over crowdfunding deals is that some REITs are available as exchange-traded funds, meaning you can trade them in any brokerage account. This provides liquidity that’s not typically available with real estate investments. When you invest in a crowdfunding deal, for example, your money will be tied up until the deal is fully repaid. Depending on the kind of deal, that could be months, or it could be many, many years.
REITs – especially those you can easily trade-in your brokerage account – offer the easiest and safest way to get exposure to real estate. They offer diversification from stocks and bonds, but you should still consider them a paper asset, not a real estate asset. REITs are a good option for investors who do not meet the income or net worth requirements to invest in a crowdfunding platform or who are uncomfortable losing liquidity for many years when investing in individual real estate deals.
Lesson 7 wrap up
Owning investment real estate is never easy, but with some smarts, hard work, and perhaps a bit of luck, it can pay off handsomely. I have friends who make their living exclusively from a real estate portfolio and friends who have tried it only to sell all of their properties and say “never again.”
I encourage you to complete this Real Estate Investing Decision Matrix Quiz; it’s really quick.
I’ll end here – in the interest of full disclosure – to say that I’ve never owned an income property because, quite frankly, I find even taking care of my own house to be a pain in the neck. That said, now that I’m a bit older and have built some wealth that’s mostly invested in the stock market, I find myself considering diversifying with some real estate.
As you can probably tell, I believe investing in real estate is entirely a personal decision. There’s no right or wrong answer. If you take the plunge and buy property, just make sure you’re prepared with plenty of education ahead of time and be sure to run your real estate plan by someone you implicitly trust.
Second opinions are always worth a million bucks.