Real estate investing can be intimidating as a beginner.
With so many investment options, it’s tough to know where to start.
Which are beginner-friendly? Which offers the best returns? And which are worth the risk?
The answer is:
There are advantages and disadvantages to every investment. And the best option for you might not be the best option for me.
This guide will help you:
- Understand the five most common ways for building wealth with real estate
- Determine which investment strategy is best suited for your current situation
- Create a roadmap for future investment opportunities you can work towards
Let’s dive in.
1. Jumpstart your wealth with house hacking
House hacking is one of the best ways to start building wealth with real estate, even if you have limited funds.
It can take many forms, such as:
- Living in one unit of a multi-family (MF) home and renting the remaining units
- Living in one room of your house and renting out the rest of it (or vice versa)
- Living in an RV and renting your primary residence
The MF strategy is by far the most common way to house hack. In addition to renting out unoccupied units, some house hackers also live with a roommate to further boost their monthly cash flow.
MFs with four units or less are considered residential property (anything more is commercial). That means you can secure a mortgage for an MF just as you would for a single-family (SF) home.
If money is tight, you can finance your MF with a Federal Housing Administration (FHA) loan with as little as 3.5% down. You can even use future rental income to help you qualify for the loan.
An FHA loan allows you to dive into house hacking with a much smaller investment than a traditional mortgage, which usually requires 20% down.
But there are a few caveats:
- You need a credit score of at least 580 to be eligible for a 3.5% down payment.
- You must live in one of the units as your primary residence for at least one year.
Now, while a small down payment makes investing accessible if your income is limited, it’s not the best option for everyone. Less money down means higher mortgage payments. And higher mortgage payments make it tougher to create positive cash flow.
FHA loans also require mortgage insurance premiums for at least 11 years (depending on your down payment), which will bump up your expenses even more.
A traditional mortgage may be a better option if:
- You qualify for a low interest rate
- You can afford a larger down payment
- You aren’t in a rush to secure your funds
If you’re MF-hunting in a competitive market against cash buyers, you may need to consider a long-term rental loan. These loans are faster to secure than traditional mortgages with rates as low as 6.5%.
- Free mortgage. You can cover your mortgage with your tenants’ rent payments.
- Positive cash flow. When you eventually move out and rent the final unit, you should have solid cash flow.
- Beginner-friendly. You can start small, rent out rooms in your current home, and grow from there. Eliminating your monthly housing expense allows you to squirrel away money for a down payment on your next investment property.
- Potentially uncomfortable. Some forms of house hacking — like renting your house and living in an RV — require a temporary sacrifice in comfort until you save enough to upgrade.
- Potentially larger investment. House hacking with an MF involves a larger investment than an SF.
- Potentially harder to sell. Due to the sizable investment, you’ll have fewer potential buyers if you ever want to sell. Having multiple tenants could also complicate a sale.
2. Invest in single-family homes
Investing in SFs is another beginner-friendly strategy to build wealth with real estate. It’s the type of property that most people are familiar with, and as a rookie, it’s smart to stick to investments you understand. SFs are also less expensive than MFs, making them easier to finance.
They are a great stepping stone to learn the ropes and build capital for more scalable investments, like MFs.
There are many ways to invest in SFs, each with distinct advantages and disadvantages.
The fix and flip
Fix and flips are generally shorter-term investments. You buy a low-priced fixer-upper, rehab the property to add value, then resell for a profit.
- High return on investment. Build wealth quickly by finding properties priced below market value with good rehab potential.
- Quick deals. Since your goal is to buy and sell as quickly as possible, you’re less exposed to long-term real estate market fluctuations.
- Good learning experience. Flipping an SF is a great way for beginners to learn the ropes.
- Not passive. This is an active strategy requiring time-consuming work. You either have to be handy enough to rehab the property yourself or pay someone to do it for you.
- Not tax efficient. If you own the property for less than one year, your profit is considered short-term capital gain and taxed at ordinary income tax rates. If you hold the property for longer than one year, you pay long-term capital gains tax, which ranges from 0% to 20% in 2021.
- Competitive. You often have to compete with cash buyers for the best opportunities. That means you may need a short-term residential loan, which allows you to secure funding in as little as 48 hours.
- Limited supply. Since flips are meant to be quick deals, you constantly have to find new real estate properties to re-invest your earnings. You might find one killer deal with huge profit potential, but finding a new gem every few months may not be realistic.
The long-term hold
With a long-term hold, you buy a property and rent it out long-term. The rent helps pay off your mortgage, so if you ever decide to sell, you can cash in the equity your renters have built for you. You also build equity as the property appreciates in value.
Instead of selling, you could also use periodic cash-out refinancing to extract your equity and deploy it into other assets.
Another popular strategy is the BRRRR method, which can boost your cash flow even more.
- Less house-hunting. Unlike flipping houses, you don’t need to constantly find new deals.
- Tax benefits. Rental property is considered a depreciable asset, and this depreciation lowers your taxable income.
- Somewhat passive income. Becoming a landlord is less work than fixing and flipping, but it still requires time. You can hire a property management company to take care of everything for you. But to get the lowest rates, you typically need a larger portfolio of properties.
- Decent liquidity. If you need to pull out your money, an SF is quicker to sell than an MF or commercial real estate. According to Zillow, the average home took 55-70 days to sell from the date of listing in 2020.
- Risk of vacancy. If you lose your only tenant, you eat the cost of a second mortgage until you can replace them. This makes it less stable than holding an MF with multiple tenants.
- Risk of market fluctuations. A good investment today won’t necessarily always be a good investment. If the housing market tanks and all your money is tied up in a portfolio of SFs, you may hit a rough patch.
The live-in flip
This is a longer-term version of the fix and flip. You buy a fixer-upper at below market value, live in it for two years while rehabbing, then sell it for a profit.
- Less risk. You only have one home loan to worry about, so there is no pressure to sell quickly.
- Fewer taxes. If you live in the property as your primary residence for at least two years, you don’t pay any capital gains tax on the sale.
- Sweat equity. Instead of paying others to fix the property as fast as possible, you have time to repair it yourself and cut costs.
- Slower gains. To avoid short-term capital gains, you can only do one live-in flip every two years.
- Less comfort. Depending on the work needed, it might feel like you’re living in a construction zone. And after you finish the rehab, you’ll have to walk on eggshells to avoid damaging it before selling.
- Frequent moving. Every time you flip, you need to find a new place to live.
- Loan limitations. Many hard money lenders only loan for commercial purposes. If you’re purchasing a primary residence, you’ll need to wait for a slower traditional mortgage, making it challenging to compete with cash buyers.
The build-it-from-scratch investment
Instead of competing with other buyers to find used properties for sale, you just build your own. This strategy can work for both SFs and MFs.
Before starting a new project, you need to determine whether your end goal is to sell or to hold.
The process involves finding a vacant lot (or existing property you can demolish), hiring an architect to draw up a design, estimating construction costs, getting plans and permits approved, securing financing, closing on the land, and hiring contractors.
If you want your construction loan to include the land purchase, you’ll need all this figured out beforehand. In some cases, permit approval can take months and delay the entire process. Many investors pay cash for the land to speed up the process, then they finance the construction.
Due to all the extra variables, this is more of an advanced strategy.
- Higher potential returns. Prices vary widely by location, but on average, building a new home costs less per square foot than buying a pre-existing home, according to Realtor.com.
- Fewer maintenance costs. Appliances and major systems are new and under warranty. So if you plan to build and hold, you’ll have considerably fewer maintenance costs.
- Higher risk. More variables mean more opportunities for potential problems.
- Longer process. The added extra steps and potential delays mean you’re stuck with an expensive loan longer before you can refinance into a traditional mortgage or rental loan.
- Less data. When building in a new area, you have fewer comps and less historical data to help you assess investment potential.
- Harder to finance. Construction loans have stricter lending requirements because there is no house to act as collateral. Since the lender takes on more risk, they typically charge higher interest rates. To learn about Longleaf construction loan options, shoot us a message.
3. Diversify with real estate investment trusts (REITs)
When all your investments are tied up in one property, you take on a lot of risk. All your eggs are in one basket.
That’s where REITs come in. REITs pool investors’ money together to buy different types of income-producing real estate.
They come in many shapes and sizes, investing in everything from apartment complexes and health care facilities to retail centers and timberland. Some REITs invest directly in properties and earn by renting them out. Other REITs finance real estate investments and earn interest on the money they loan. And some do a mix of both.
Defining a REIT is somewhat complicated, but investing in them is easy.
You can buy shares of publicly traded REITs on major stock exchanges, or you can invest in REIT mutual funds or exchange traded funds (ETFs), which diversifies your money even further.
There are also non-exchange traded REITs, which offer higher yields but require you to hold them for years.
When you invest in any type of REIT, you earn a portion of the portfolio’s profits in the form of dividends.
- Diversification. Spreads risk out among many properties and property types.
- Stability. Annual dividends can buffer the risk in other investments.
- Liquidity. Selling a property could take months. Selling publicly traded REITs is almost instantaneous.
- Solid long-term returns. The average return of the FTSE Nareit All REITs Index was 9.93% from 2000 to 2020. That said, historical returns aren’t always a good predictor of future returns.
- Not tax efficient. Most REIT dividends are taxed as regular income.
- Low growth potential. REITs must pay out 90% of income as dividends, so there’s not much left to re-invest into additional properties.
- Fees. Some may charge high management and transaction fees.
4. Leverage other investors through a real estate limited partnership (RELP)
RELPs allow you to pool your money together with other investors to purchase property you normally wouldn’t be able to afford on your own — typically larger commercial rental or development projects.
The partnership includes a general partner (GP) and limited partners (LPs).
A general partner finds the deal, manages the property, and accepts liability for the loan. Limited partners invest passively.
Each RELP is unique, but many follow a common structure. For example, LPs are often offered preferred returns. That means before the GP can take their cut, LPs need to receive a minimum return.
Investing in RELPs as an LP doesn’t require special skills, but to find promising opportunities, you need to have GPs in your network. You can also find RELP opportunities online, but they often have stricter eligibility requirements. Finding deals online also means you’re trusting in a stranger.
Before signing anything, make sure you do your due diligence on the GP. Ask them questions like:
- What’s your track record with hitting your return projections?
- What were some of your best and worst deals?
- What would your most dissatisfied investor say about you?
- What evidence do you have that this property will produce your projected return?
- Are you going to invest your own money and put skin in the game?
This will give you a feel for their management skills and trustworthiness.
- Tax-efficient. Similar to holding your own rental property, you can reduce your tax liability by deducting depreciation and interest expenses for RELP properties. Capital gains and losses also pass through to each partner.
- Limited liability. LPs are not liable for the loan and only risk the money they invested.
- Good potential returns. There are no guarantees, but Business Insider recommends looking for RELPs that return 5% to 14%.
- Passive income. After the upfront work of choosing a capable GP, LPs usually sit back and enjoy the passive dividends.
- Risk of poor management. LPs depend on the GP to produce good returns.
- Not liquid. Selling a limited partnership interest for full-price is unlikely. Be prepared to go in for the long haul.
- Accredited investors requirements. Many LP opportunities are for accredited investors only, which means a joint net worth of over $1 million or an income exceeding $200,000 per year for the past two years. If you are considered a “sophisticated investor”, you may also qualify. Non-accredited investors can access RELP-like investments through platforms like Fundwise.
5. Run your own commercial real estate deals
Commercial real estate is a whole different ball game. It involves larger investments and isn’t beginner-friendly, but it’s a goal to work towards.
Commercial real estate is broken into five main asset classes:
- Industrial (warehouses, manufacturing, etc.)
- Office (single- or multi-office buildings)
- Retail (grocery stores, shopping malls, etc.)
- Multi-family (apartment buildings)
- Special purpose (car washes, self-storage facilities, churches, etc.)
There are also several smaller property types such as hospitality, land, and mixed-use properties.
Since each asset class has its own set of norms, risks, prime locations, advantages, and disadvantages, many investors choose to specialize in one type of asset.
This type of investment requires significant capital.
If you build enough wealth with residential real estate deals, you’ll eventually have enough to “graduate” to commercial real estate. Another option is to find commercial deals as a GP and fund it with your own RELP.
Either way, you need to work your way up the chain.
- Stability. Leases for businessesare generally longer than residential real estate (retail stores can lease for up to 25 years). You won’t have to worry as much about your property sitting empty. Apartment leases are often one year — similar to residential real estate — but since you have more units, you don’t have all your eggs in one basket with a single tenant.
- Better tenants. A company’s image is reflected in the space they occupy. If they’re locked into a long-term lease, they’re more likely to take care of the space, especially if they have to host clients. If you own an apartment building, you don’t depend on any one tenant’s rent, which allows you to be more selective.
- Potentially fewer expenses. Some commercial lease agreements with companies require the tenant to cover the property taxes, insurance, and building maintenance.
- Easier to add value to a property. Commercial property value is partly determined by its revenue-generating ability. So if you choose tenants carefully and optimize the property to boost revenue, it appreciates.
- Harder to fund. Since commercial real estate loans require larger loans, they have stricter lending requirements.
- Higher stakes. If a pandemic hits and your tenant goes out of business, you’re stuck with a giant bill. Also, as certain sectors go remote or move online, demand for your space may decrease.
- Long lease disadvantages. If you’re locked in a 10-year lease, you won’t be able to adjust your rates as the market moves.
- Potentially inflexible. Some asset classes have properties custom-built for a certain tenant, making it harder to replace them if they leave.
Which type of real estate investment is right for you?
As a real estate investor, there is no one-size-fits-all path.
The best choice for you depends on where you are on your journey to financial freedom, and where you want to go.
Most investors start small — whether that be SFs or house hacking — and climb the ladder from there. No matter which method you choose, compounding and building wealth takes time, and it’s important to start early in your career.
One of the first steps is to determine how to fund your investment.
The type of financing you use can make or break your deal. So if you need help assessing your options, get in touch with one of our loan officers today. We’ll get you pointed in the right direction!