The world-famous psychologist Abraham Maslow noted that “shelter” is one of the most important physiological and psychological needs of a human being. It acts as a basic foundation in the hierarchy of human needs and its satisfactory fulfillment is necessary as a starting point for human development.
Real estate is the modern term for shelter, a place we call home. Besides accommodation, real estate also provides value as an investment option. In this article, we will explain the ABCs of real estate for dummies and cover topics from the simplest to the most technical. This way, you can determine whether real estate investing is right for you.
What is a Real Estate Investment?
To answer this question, let’s first see what is an investment. It is simply a way to park your savings beneficially. If I receive an inheritance of $500,000 (or have equivalent savings from my job or business), my two-fold objectives would be to:
- Stop the money devaluation, and
- Increase its worth over time
Money devaluation is the decline in the capacity of one unit of currency and is reflected through its lower purchasing power. A simple example is that I used to spend $1 to buy a can of soda five years ago but now I pay $2 to buy the same item.
To avoid money devaluation on savings, people take some actions to stop money stagnation. The simplest form is to deposit it in an interest-bearing savings account. Each year, the interest earned on savings will approximately set off the devaluation of the currency. Although I get a periodic source of interest income to meet daily expenses, the reality is that I am back to square one at the end of each year.
That’s why many of us diversify with other assets such as stocks, bonds, and mutual funds. These assets can provide the returns we need to satisfy our second goal—to earn a positive return (i.e., to make money).
Suddenly, however, we hear rumors about an imminent recession which means that a stock market crash could wipe out all my returns from past years. Since markets move cyclically, it’s all but inevitable that a recession could render one’s stock market returns null.
What is the solution that could help in meeting my two-fold objectives comprehensively and at the same time avoid any major downturn in local and global economies? Investment in real estate is one answer that millions have turned to in order to shore up their savings against broader market volatility.
Real Estate for Dummies: Why Invest in Real Estate?
Investing in real estate means:
- There is an asset with a physical presence that you can touch, feel, and generally, we feel more confident about something that our senses can capture. We do not imply that stocks are non-visible items, it’s just that a real estate item is much more than a physical copy of your share certificate or a balance appearing on an online bank account. Owning real estate is a feel-good factor.
- Real estate is better at absorbing shocks like recession, market dips, and economic downturns. Pandemics, technological improvements, and changing global power shift may have impacts on products, services, and industries but the basic human need for shelter remain intact.
- Real estate for dummies means in its literal sense that it is an investment option for all. You don’t need to learn complex investment terms, perform the technical calculation of returns, and compute formulas for hedging.
- It bridges the generational gap and suits people of all ages. A grandson struggles in explaining to grandpa about a bitcoin but the real estate investment conversation is convenient and purposeful.
- Each year, the value of land appreciates largely which means the savings increase its worth quite well over time. Real estate property meets your two-fold objective by earning guaranteed monthly income in the form of rentals.
- It can be an alternative to paying rent which accounts for half of our monthly expenses. If the real estate we own can meet our accommodation needs, there will be a substantial accumulation of savings that can be put to better use. Since 2010, US house rentals are on their highest mark as shown below:
However, real estate comes up with its own set of (solvable) problems. Let’s take a look at the issues first and later deep dive into the solutions.
- Property transaction (buying & selling) is a thorough process and involves a series of lengthy steps. Finding the right property agent, legislative requirements, and high time consumption to finalize the deal adds to the problem.
- Transaction cost is comparatively higher in real estate with paying commissions, registration charges, and property taxes may appear exorbitant as the property price already cost you an arm and a leg.
- While you can meet your sudden emergency liquidity requirements by selling a part of your stock portfolio, selling a room out of your four-bedroom apartment isn’t a possibility.
- Real estate investment may seem to be an option for wealthy people only. You have to have a solid financial base with adequate savings to get a property. Those who do not qualify for this condition may look at stocks or other low capital requirement options.
- Rental income is attractive but it also comes with the headache of property management including finding the ideal tenant who pays on time, incurring maintenance costs, and rental contract renewals.
Plus, in conflict zones where a lot of people are displaced, real estate may become a total loss. Areas where crime is rampant fetch lower cash inflows and obviously elevate risk substantially. Therefore, always proceed with caution when investing in real estate abroad where the rule of law and judicial integrity may be compromised.
Solutions for the Problems in Real Estate Investing for Dummies
For simplicity, we can categorize the above-mentioned problems into (i) high capital requirements with liquidity issues and (ii) administrative issues. These problems can be resolved through:
- Land: Purchasing undeveloped land means avoiding unnecessary costs and hassles associated with property management. Besides reducing administrative issues, land requires considerably lower capital to deploy.
- Remote areas: Real estate in remote areas or suburbs can cost surprisingly lower. It may be far-off city areas or even smaller cities. Such cities may miss out on modern infrastructures like subways, social clubs, and golf courses but basic amenities are usually present.
- Commercial property: Commercial property (used for conducting business) with smaller space offers lower prices and attracts governmental incentives in some cases. The introduction of strip malls and permanent kiosks enables small capital owners to have their investment in real estate.
- Real Estate Investment Trust (REIT): This is a hybrid solution merging the benefits of both stock and real estate investment. Under this option, general public pool funds which are invested into different types of residential, commercial, and industrial properties at various locations.
Under a REIT, the investors (general public) become unit holders and get a share in the returns that properties generate. Although, the capital appreciation may not get directly to the unit holders, theoretically, they get it in the form of capital gains at the time of disposal of the units.
REITs resolves the liquidity issues while owning real estate and significantly reduces your time spent dealing with tenants and property agents. You can also gain exposure to real estate via REIT stocks, which is another excellent option within this asset class.
The huge investment return from real estate provides the much-needed motivation to the investor to handle administrative issues with a smile on their face. This is evident from looking at the average sales price of new homes sold in the United States from 1965 to 2021, as depicted below:
The “Hidden” Benefits: Tax Implications for Real Estate Investments
Beware of the “hidden” benefits of real estate to take advantage of in the form of tax savings. As opposed to hidden costs in other forms of investments, real estate may provide the following tax benefits:
First, you can reduce your rental income by deducting almost every expense incurred like home insurance premium, repairs & maintenance, property management fee, utilities, and property taxes. If you follow adequate records, you are eligible for deducting interest paid on the mortgage taken to secure the property. Moreover, if your expenses exceed the income, you may (in some cases) carry forward unadjusted expenses to later years to be deducted from that year’s income.
Second, you may avoid paying tax on capital gain at the time of disposal. If you used the property as “principal” residence as your family’s only place of dwelling, any capital gain incurred can be entirely avoided as a tax liability.
In some countries, the capital gain can be rolled over from one property to the next property until it is sold. For example, a property destroyed by fire may be eligible to transfer the capital gains (insurance claim proceeds minus original purchase price) to the replacement property.
How to Get Started in Real Estate Investing?
To initiate your first real estate investment, follow the steps mentioned below:
1) Perform research using online sources but it is your physical trips to different property sale locations that will raise your game. Visiting locations and interacting with other buyers broaden your understanding before you visit a property dealer.
2) You might have heard negative things about property dealers or real estate agents but finding the right one is easy if you look for a long-term relationship. This is achieved through a two-way channel in which both parties are trustworthy. Word of mouth is often the best way to find a great local realtor, who can then put you in contact with a mortgage broker to see what size of a mortgage you can obtain given your financial situation.
3) Once you’ve found a real estate agent, taking out a mortgage will be the next and most important step. Lenders prefer customers with the lowest risk profile while customers search for low-cost solutions. In addition to commercial banks, governmental loans for eligible citizens is also available.
A large down payment, multiple sources of earnings, huge monthly income, and default-less credit score are all the ingredients for establishing a customer profile that is attractive to the lender.
Customers look for lower interest rates, a quick approval process, and favorable terms & conditions. This includes the option of reclassification of mortgage, for example, when interest rates are rising and you have a variable-rate mortgage. Easy reclassification helps customer to convert the existing loan to a fixed-rate mortgage.
The early payment option is another thing that a customer finds attractive. This allows the customer to make large principal payments to pay off the loan ahead of its scheduled timing. Some lenders impose a penalty for early payment but this could turn away the customer to a competitor.
Good homework is required for both choosing a property to buy and entering into a favorable mortgage agreement. Time spent in these activities is never wasted.
4) Once mortgage funds are released you may go ahead to seal the property deal. Ensure that property documents are both adequate and accurate and have underwent strict legal review.
Real Estate Options with Retirement Plans
As per general regulations, funds from a 401(k) cannot be used to invest in numerous alternative assets, such as precious metals and real estate. However, you can invest in real estate by linking your self-directed individual retirement account (IRA) and 401(k). You can also set up an LLC through which you can invest in real estate sheltered within a self-directed IRA.
To understand this technical difference between 401(k)s and self-directed IRAs, I recommend you to read our guide to the 401(k) plan.
Also, if you are curious to know more about real estate investments beyond a simple “real estate for dummies” overview, visit our dedicated page for real estate investments.