The demand for real estate has been steadily increasing for over fifteen years. According to the National Association of Realtors (NAR), existing home sales skyrocketed 10.5% YOY in Q2 2020. There’s no denying that the U.S. real estate market is hot, and savvy investors would do well to get in on the action in order to diversify their investment portfolio.
Don’t know where to start with real estate investing? In this guide, we’ll walk you through the various aspects of investing in real estate, generating rental income, and building a real estate portfolio to supplement your retirement investing strategy.
Why Invest in Real Estate?
There are two main reasons why real estate investing is so attractive: credit and leverage. However, there are a variety of other advantages that real estate investing poses over traditional investments in stocks, bonds, and mutual funds.
Ability to Leverage
When you buy real estate, you don’t have to use your own money outright. What makes real estate investing unique is that there is a massive market of lenders willing to offer large, low-interest loans for home purchases in the form of mortgages.
You aren’t able to take out a $500,000 loan at a fixed rate of 3.5% over 30 years to invest in the stock market, but you certainly can with real estate. This opens up a world of lucrative and highly asymmetric investment opportunities for cash-strapped investors. Using leverage, you can buy $500K worth of house with only $50K (or less) in the bank.
Leverage has a multiplier effect on both your potential earnings and losses. In a bull market, leverage lets you make money with a third-party’s money; however, the same is true in a down market where you go into debt using borrowed money.
Positive Cash Flow
The income generated from a rental property provides recurring cash flow. After accounting for mortgage repayments and associated expenses, the net cash flow left over is typically positive, which provides passive income to investors. The more you pay down your mortgage, the more positive your cash flow position will be over time.
For an accurate understanding of your cash flow position, you have to calculate the cash-on-cash returns of the investment. This describes the average rent income subtracted by the loan payments and then divided by the cash already invested, for example:
- Home purchase price: $500K
- Loan value: $400K
- Cash invested: $100K
- Annual rental income: $45K
- Annual mortgage repayments: $30K
- 45K-30K= $15K annual cash flow
- $15K/$100K= 15% cash-on-cash return
Calculating cash-on-cash returns is crucial for understanding clearly what the value of your cash flow is relative to the amount of cash you invested to access the cash flow. If you maintain a positive cash flow position, the value of your liquid assets is increasing and therefore money can be reinvested into the property or invested into other rental properties.
Market Hedge & Diversifier
When you invest in real estate, whether directly or via real estate securities, you effectively hedge against inflation and the devaluing of the dollar. Generally, real estate income is positively correlated with inflation. When the dollar diminishes, landlords increase rents, which in turn increase the return on the rental investment and increase the property value.
Therefore, real estate is a suitable option if you want to manage risk in your portfolio by hedging against inflation. Real estate also provides an alternative to traditional stock and bond investing, providing your portfolio with additional insurance in case either of these markets turns south—or, more simply, to protect against a stock market bubble.
Tax Advantages Via Self-Directed IRA or 401(k)
Although real estate isn’t commonly held in tax-advantaged retirement accounts, it’s certainly possible to invest in real estate in an IRA or 401(k), provided that either account is self-directed. Whether it’s commercial real estate or single-family homes, investment properties can be purchased within IRAs or 401(k)s if the investor first sets up an LLC or another private entity in their name.
Most real estate investment strategies do not involve IRAs or 401(k)s. However, self-directed 401(k)s and IRAs that are not offered through traditional brokerages can allow your real estate investments to appreciate in value on a tax-deferred basis (e.g., you can forego capital gains taxes until the date of sale).
The Drawbacks of Real Estate Investing
Likewise, there are real disadvantages to owning residential or commercial real estate as an investment. First, as we’ve already touched on, is the concept of leverage, which can exacerbate your losses in a down market.
However, more than that, is the sweat equity that homeowners have to put into their property to sustain the investment in the long term. Many hopeful real estate investors purchase rental properties expecting it to function as a mutual fund, in which passive income is generated without active management.
This isn’t true. Unless you have a property manager or full-time management company to take care of your investment property, you have to be prepared to deal with its day-to-day maintenance as if it were a business. Note that this would cut into your potential profits. Therefore, real estate investing is an active, not passive, income-generating investment.
How to Invest in Real Estate: A Step-by-Step Guide
For many of us, buying physical real estate is the biggest financial transaction of our lives. As such, it deserves a long preparation period in which you do everything by the book—otherwise, you might end up owing more for the property than you should.
Below, we’ve listed our five steps to real estate investing for beginners. Although your specific investment experience might differ, these are the general ground rules that most new real estate investors abide by when they’re starting out.
Step 1: Build Your Credit Score
You won’t make it far in real estate investing unless you have a satisfactory credit score. In fact, you won’t even make it through the door. The vast majority of real estate investors rely on lenders to provide mortgages to acquire real estate. However, unless you’ve built a decent credit score there’s little hope that you will be able to secure a mortgage.
The higher your credit score, the lower the interest you will be charged on your mortgage. The lower your interest, the more money you’ll be able to keep at the end of every month and, therefore, the more profitable your investment will be.
What constitutes a passable credit score will vary from lender to lender and also by location. A passing credit score in Memphis might not fly in Manhattan. However, generally speaking, the following credit scores categorizations hold true for making a real estate investment:
- 300-550: Poor
- 551-659: Fair
- 650-724: Good
- 725-759: Very Good
- 760-900: Excellent
In most cases, the minimum credit score for buying real estate is 650. The higher your credit score goes up from here, the more likely you are to land more favorable terms for your loan in the form of interest rates and amortization.
Why Your Credit Score Matters
Your credit score, also known as a FICO score, is a holistic measure of your financial health that tells creditors (i.e., banks and credit unions) how trustworthy you are as a borrower.
A poor credit score can cost you a lot over the lifetime of your mortgage, assuming you even get approved for one in the first place. For example, a FICO score of 630 could make you eligible for a 30-year, $250,000 mortgage with an annual percentage rate (APR) of 4.5%, whereas a score of 800 could land you a mortgage with the same amortization at 3.5% APR.
In the first case, at 4.5% APR, you would owe $206,017 in interest alone over 30 years. In the latter case, at 3.5%, you owe only $154,140. Therefore, having a higher credit score, in this scenario, would save you $51,877 on your mortgage.
How to Build Your Credit Score
An excellent credit score sometimes takes many years of consistent good behavior to achieve. In essence, you accumulate a greater credit score simply by staying on top of your debts, making regular payments, and fully utilizing your credit lines. Below, we’ve listed a few actionable steps to improving your credit score for real estate investing:
- Stay on top of your bills: Make sure you’re making at least the minimum payments on your loans, credit lines, or any other outstanding balances on time.
- Watch your credit utilization: Don’t allow your credit balances to exceed 30% of your overall credit limit; sometimes asking for a credit limit increase can help you hit this target if you’re short on cash.
- Limit your number of hard pulls: Having a lender run a full credit check (a “hard pull”) can penalize your credit score, so never allow more than one or two within a couple of months’ time.
- Pay rent on time: Ensure that your rent payments are made on time, otherwise your arrears may be referred to credit bureaus that will penalize your FICO score.
- Don’t close your old credit lines: Even if they’re no longer in use, keeping a small balance on your old credit cards will help you build a positive credit history.
Improving your credit score takes time, discipline, and patience. The effort, however, is well worth it. Ultimately, it’s easier to maintain good credit than it is to rescue your credit score from the sub-600s. For further assistance, check out this excellent credit score guide by Experian, one of the leading credit bureaus.
Step 2: Build Your Down Payment
As the saying goes, you need money to make money. This maxim is as true in real estate investing as it is for any other asset type. In order to secure a mortgage to buy real estate, you need to save up a down payment of at least 5% of the property’s value.
Although it’s possible, in many cases, to qualify for a mortgage with only 5% down, this isn’t always advisable. Even if it means saving up over a longer period of time—and thus missing out on getting in the market earlier—putting down 20% will qualify you for lower interest rates, lower monthly payments, and you will be able to forego private mortgage insurance (PMI). Generally, PMI costs between 0.2% and 2% of the loan’s balance per annum.
You’re also going to need to have a steady income reported on at least your two previous tax returns. Most lenders take the average taxable income of your two most recent tax returns to gauge your income level and thus qualify you for a mortgage.
The Cost of Low Down Payments
Those who want to learn how to invest in real estate with little money often overlook the financial consequences of high-interest mortgages. Despite what some financial influencers might have you believe, investing in cheap real estate with a minimum down payment is rarely as lucrative as the investor anticipates.
With such little money invested upfront, the investor would have to pay for private mortgage insurance (PMI) on top of a higher APR. Over the duration of the loan, this could amount to tens of thousands of dollars in additional interest payments compared to if they had put down 20% and avoided PMI altogether.
Step 3: Pre-Qualify for a Mortgage
Just as you would if you were financing a car, it’s a good idea to go to your bank and pre-qualify for a mortgage. Then, you can shop around to find the best rate knowing that you have an offer in your back pocket. Plus, getting a pre-approved mortgage lets you show the seller that you’re serious about the purchase and that you have the means to follow through on the transaction.
To get pre-approved for a mortgage, you’re going to need several pieces of documentation that provide a snapshot of financial status, including:
- Employment verification
- A good FICO score (i.e., >650)
- Proof of assets
- Proof of income
This is an important step for any homebuyer and shouldn’t be overlooked since it’ll give you the security of a backup option. If another lender won’t provide the loan you need, at least you’re pre-approved somewhere else. It’ll also let you get the lowest price possible on your loan since your pre-approval is a bargaining chip that can lower your rates.
Step 4: Inspections and Due Diligence
Don’t walk into any real estate investment without first doing thorough inspections of the property. You should also bring in contractors who can provide you with an estimate regarding what it’s going to cost you to bring the property up to date and fix any existing issues—plus, contractors will often do this for free since they want your business.
A proper real estate home inspection allows you to discover any structural issues with the property’s foundations, insulation, plumbing, electrical system, windows or doors, and virtually any other aspect of the house for which problems might arise. Then, you can take these estimates and inspection reports to the seller to negotiate a better price.
Step 5: Close, Remodel, and Rent
Typically, closing on a real estate investment takes anywhere from 3-6 weeks. This process will be facilitated by the seller, your real estate agent or brokerage, and your lender.
Then, your next step is to hire well-reviewed and experienced contractors to renovate or remodel sections of the property that can add equity to the asset. Make sure you solicit multiple bids, so you gauge the differences in estimated prices and find the best deal.
Remember, the final cost of remodeling contracts can often end up being about 10-20% higher than expected due to unforeseen costs and changes. Make sure you account for these common price fluctuations by putting aside more than the original quote.
Last, start looking for tenants to rent out your space once renovations are complete. Simply using online classifieds like Craigslist is a great place to start for finding reliable tenants. For more in-depth instructions for securing top-tier tenants, check out this useful guide for finding and keeping tenants.
Real Estate Investing: Types of Real Estate
There are multiple types of real estate available to investors looking to expand their portfolio. While investors have the option of investing in REITs (Real Estate Investment Trusts) or other real estate securities, direct exposure is often the best option for investors who want to deeply diversify with tangible, illiquid assets.
There are four main categories of real estate that investors can acquire:
- Residential: Single-family homes, condos, townhomes, multiplexes, and duplexes.
- Commercial: Office buildings, strip malls, shopping outlets, or large apartment complexes.
- Industrial: Warehouses, production centers, storage facilities, and factories.
- Vacant: Farms, ranches, and other land without developed structures or buildings.
Most private real estate investing involves residential property acquisitions and resales. Since these investments usually have the lowest capital requirements, residential rental property is often the first addition to a real estate investor’s portfolio.
How Much Money Do You Need to Invest in Real Estate?
The upfront costs of investing in real estate vary by the type of property you want to acquire. However, typical residential real estate requires at least 5% of the estate’s value in the form of a down payment, plus 2-3% in closing costs.
For an inexpensive starter home costing $75K, you would need at least $5,625 (75*0.075) before you can consider purchasing a home. However, other startup costs such as appraisal fees and home inspections would likely add several thousand dollars onto that figure.
Should You Invest in Real Estate?
Real estate has a rightful place in any investor’s diversification strategy. Like precious metals, stocks, bonds, and other asset types, real estate investing poses many benefits to investors looking to manage risk and hold onto more of their wealth during retirement.
Even if you’re not a hands-on type of investor, property management companies can take care of the heavy lifting. When done properly, investments in real estate can generate truly passive cash flow while minimizing market risk and building equity.
Real estate investors often don’t start off wealthy. Rather, they let their assets appreciate in a tax-advantaged environment such as a self-directed 401(k) or an IRA before making a foray into real estate. Check back later for our exclusive review of the best real estate brokers for sophisticated retirement investors.
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