Buying real estate is about more than just finding a place to call home. Investing in real estate has become increasingly popular over the last 50 years and has become a common investment vehicle.
Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than investing in stocks and bonds. In this article, we'll go beyond buying a home and introduce you to real estate as an investment.
Real estate investing is a broad category of operating, investing, and financial activities centred 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.
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.
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.