How to Invest in Real Estate
An Overview of Why and How to Invest in Real Estate
By Joshua Kennon
Investing in real estate is one of the oldest forms of investing, having been around since the early days of settled human civilization. Predating modern stock markets, real estate is one of the five basic asset classes that every investor should seriously consider adding to his or her portfolio for the unique cash flow, liquidity, profitability, and net worth characteristics as well as the diversification benefits it offers.
In this introductory guide to real estate for new investors, I want to walk you through some of the basics and point you to more in-depth content on certain concepts so you can learn about them if you feel it is an area in which you want to become more knowledgeable. I'll also explain some of the different ways you might acquire or take ownership in real estate investments.
First, let's start with the basics. What is real estate investing?
What Is Real Estate Investing?
Real estate investing is a broad category of operating, investing, and financial activities centered around making money from tangible property or cash flows somehow tied to tangible property. There a myriad of different types of real estate investments a person might consider for his or her portfolio.
Investing in Real Estate to Generate Rental Income
In its purest, simplest form, the core concept behind real estate investing is that the investor, also known as the landlord, acquires a piece of tangible property; raw farmland, land with a house on it, land with an office building on it, land with an industrial warehouse on it, doesn't matter for our purposes at this point in the discussion.
He then finds someone who wants to use this property, known as a tenant, and they enter into an agreement. The tenant is granted access to the real estate, to use it under certain terms, for a specific length of time, and with certain restrictions, some of which are laid out in Federal, state, and local law and others of which are agreed upon in what is known as a lease contract or rental agreement.
In exchange, the tenant pays for the use of the real estate. The payment he or she sends to the landlord is known as "rent".
For many investors, this has a huge psychological advantage over investing in stocks and bonds. They can drive by the property; see it, touch it with their hands. They can paint it their favorite color or hire an architect and construction company to modify it. They can use their negotiation skills to determine the rental rate, allowing a good operator to generate higher so-called capitalization rates, or "cap rates", which we talked about a bit in Making Money from Real Estate Investing.
From time to time, real estate investors become as misguided as stock investors during stock market bubbles, insisting that capitalization rates don't matter. Don't fall for it. If you are able to price your rental rates appropriately, you should enjoy a satisfactory rate of return on your capital after accounting for the cost of the property, including reasonable depreciation reserves, property and income taxes, maintenance, insurance, and other related expenditures. Additionally, you should measure the amount of time required to deal with the investment as your time is the most valuable asset you have; the reason passive income is so valuable to investors.
(Once your holdings are large enough, you can establish or hire a real estate property management company who will handle the day-to-day operations of your real estate portfolio in exchange for a percentage of the rental revenue, transforming real estate investments that had been actively managed into passive investments.)
I'd go so far as to insist that unless you are a developer capable of adding value to a project through intelligently designed and targeted improvements, relying upon appreciation alone in real estate has a de facto degree of speculation inherent in it. The intrinsic value must come from the ability to extract purchasing power from an asset on your balance sheet; to sit back and collect streams of money even if you weren't able to sell the asset or the economy went off a cliff in a 1-in-600-year event such as 1929-1933.
As I write this in June of 2016, a good illustration of people violating this principle is property ownership in San Francisco, California. With a few notable exceptions, residential real estate in the city has reached a level that would not otherwise be possible without certain ill-conceived political interventions that are not supported by either liberal or conservative economists and the current historically low-interest rate environment. Borrowing large amounts of money to acquire a real estate investment at these prices, in that particular area, is not prudent unless you think the United States is going to go into a period of significant inflation, allowing you to effectively transfer purchasing power from the lender to yourself as you pay back the loans with depreciated dollars (when you borrow money on a long-term, fixed-rate basis, you are effectively selling short the fiat). I'd argue there are a lot more intelligent things to do with your money.
Comparing Real Estate Investing and Stocks
One of the most common questions we receive is the difference between investing in stocks and real estate. I've touched upon this topic in Real Estate vs. Stocks: Which Is Better? which explains the differences, advantages, and disadvantages of investing in real estate versus investing in common stock. It's a great place to start if you are considering adding a property to your investment portfolio.
Real Estate Investing Through REITs
One way to invest in real estate in a way that is somewhat similar to investing in stocks involves buying real estate investment trusts, or REITs, through a brokerage account, Roth IRA, or another custody account of some sort. REITs are unique because the tax structure under which they are operated was created back during the Eisenhower administration to encourage smaller investors to invest in real estate projects they otherwise wouldn't be able to afford, such as building shopping centers or hotels. Corporations that have opted for REIT treatment pay no Federal income tax on their corporate earnings as long as they follow a few rules, including a requirement to distribute 90% or more of profits to shareholders as dividends (in that sense, a real estate investment trust doesn't have the same flexibility in determining its dividend payout policy as an ordinary operating business).
One downside of investing in REITs is that, unlike common stocks, the dividends paid out on them are not "qualified dividends", meaning the owner can't take advantage of the low tax rates available for most dividends. Instead, dividends from real estate investment trusts are taxed at the investor's personal rate. On the upside, the IRS has subsequently ruled that REIT dividends generated within a tax shelter such as a On the upside, the IRS has subsequently ruled that REIT dividends generated within a tax shelter such as a Rollover IRA are largely not subject to the unrelated business income tax so you might be able to hold them in a retirement account without much worry of tax complexity, unlike a master limited partnership.
I've written about investing in REITs many times over the past decade and a half. If you're interested in learning more about these unique securities, start by checking out Real Estate Investing Through REITs. Which covers REIT liquidity, equity, how to use REITs to your real estate investing advantage, and much more.
I've also written some more targeted essays on REIT investing you may want to read such as Investing in Hotel REITs Can Be an Affordable Way to Buy Hotels. On that topic, let's talk about the different types of real estate investments you can make.
The Different Types of Real Estate Investments You Can Make
I break down the major categories into which different real estate properties are likely to be organized as each has unique benefits and drawbacks, economic characteristics and rent cycles, customary lease terms and brokerage practices. For a brief recap here, real estate properties are ordinarily categorized into one of the following categories:
- Residential real estate
- Commercial real estate
- Industrial real estate
- Retail real estate
- Mixed-use real estate
You can also get involved on the lending side by:
- Owning a bank that underwrites mortgages and commercial real estate loans
- Underwriting private mortgages for individuals, often at higher interest rates to compensate you for the additional risk, perhaps including a lease-to-own credit provision
- Investing in mezzanine securities, which allows you to lend money to a real estate project that you can then convert into equity ownership if it isn't repaid (these are sometimes used in the development of hotel franchises)
There are sub-specialties of real estate investing including:
- Leasing a space so you have little capital tied up in it, improving it, then sub-leasing that same space to others for much higher rates, creating incredible returns on capital. An example is a well-run flexible office business in a major city where smaller or mobile workers can buy office time or rent specific offices.
- Acquiring tax-lien certificates. These are an esoteric area of real estate investing and not appropriate for hands-off or inexperienced investors but that, under the right circumstances, at the right time, with the right sort of person, generate high returns to compensate for a headache and risk involved.
Then, of course, there is the most common real estate investment a typical person will make in his or her life, which is home ownership.
Investing in Real Estate Through Home Ownership
Those of you who have read my work realize that I don't view the acquisition of a home quite the same way most of society does. Instead, I view it as a blend of personal utility and financial valuation; that thinking of it as always being a good investment is not necessarily prudent. To be more direct, a home isn't an investment in the same way an apartment building is. Rather, at its very best under the most ideal of circumstances, a home is a forced savings account that gives you a lot of personal use and joy while you reside in it. I talked about this more than a decade ago in a piece called The Great Real Estate Myth.
On the other hand, as you approach retirement, if you take a holistic view of your personal wealth, ownership of a home, outright, without any debt against it, is one of the best investments a person can have. Not only can the equity be tapped in certain transactions, including reverse mortgages, but the cash flow saved from not having to rent, in most circumstances absent unusual market forces or conditions, results in net savings, the profit component that would have gone to the landlord effectively staying in the homeowner's pocket. This effect is so powerful, even back in the 1920s economists were trying to figure out a way for the Federal government to tax the cash savings over renting for debt-free homeowners, considering it a source of income. This is a different type of investment, though -- a strategic one. Were the economy to collapse, as long as you could pay the property taxes and basic upkeep, no one could evict you from your home. Even if you had to grow your own food in a garden, there's a level of personal safety there that matters. There are times when financial returns are secondary to other, more practical considerations. Whatever you do, though, don't sacrifice your liquidity to try and build equity in your real estate investments too quickly as that can lead to disaster including bankruptcy.
If you are saving to acquire a home, one of the big mistakes I see is new investors putting their money into the stock market, either through individual stocks or index funds. If you have any chance of needing to tap your money within five years or less, you have no business being anywhere near the stock market. Instead, you should be following an investment mandate known as capital preservation. To learn more about this, read The Best Places to Invest Down Payment Money.
Risks of Real Estate Investing
A substantial percentage of real estate returns are generated due to the use of leverage. A real estate property is acquired with a percentage of equity, the remainder financed with debt. This results in higher returns on equity for the real estate investor but if things go poorly, it can result in ruin far more quickly than a portfolio of fully-paid common stocks, even if the latter declined by 90% in a Great Depression scenario as no one could force you to liquidate (a reason I preach against the dangers of investing on margin and opening cash accounts rather than margin accounts). The most conservative real estate investors insist upon a 50% debt-to-equity ratio or, in extreme cases, 100% equity capital structures, which can still produce good returns if the real estate assets have been selected wisely. Billionaire Charlie Munger talks about a friend of his prior to the 2007-2009 real estate collapse, a very rich man out in California. He looked around at the high valuations on his properties and said to himself, "I'm wealthier than I would ever need to be. There's no reason for me to take risks for the sake of more." This friend sold off many of his properties and used the proceeds to pay off the debt on the remaining ones he thought the most attractive. As a result, when the world collapsed, the real estate markets were in turmoil, people were losing their properties to foreclosure, and bank stocks were collapsing, he didn't have to worry about any of it. Even as rents dropped due to tenant financial difficulties, it was all still surplus cash and he was armed with funds that kept replenishing themselves, letting him take advantage of buying up the assets everyone else was forced to sell. Munger remarked, "There's a lot of wisdom in that approach." Stop trying to get rich so quickly and be content to do it the right way. You'll have much less stress in your life and it can be a lot of fun.
Some Final Thoughts on Real Estate
Of course, this is only the beginning. Real estate investing takes years of practice, experience, and exposure to truly appreciate, understand, and master. To provide one illustration, many inexperienced real estate investors go out and buy properties themselves. This is foolish. Instead, they need to establish something like a limited liability company to buy the property, shielding them from personal catastrophe if something goes wrong. You get to the point where having operating agreements drafted becomes second nature. You may even decide to set up your own real estate holding company once your net worth is sufficiently large enough to justify the administration costs and efforts.