Interested in real estate but not sure if you're ready for a hands-on investment? Laura covers 5 ways to invest in property to diversify your portfolio.
Julie S. says, "Hi, Laura! I recently discovered your weekly podcast and have already binged a ton of episodes and learned a lot—thanks for all you do! One of my New Year's resolutions is to be more mindful and strategic about my finances, and your podcast has been super helpful.
I would love it if you could podcast on the trend of buying a second home first, where you rent your primary residence and buy a second home for vacations or rent out. I've been considering this and wondering if your guidance, such as not spending more than 25-30% of your income on housing, would be different for an investment property. I would surpass that amount, so can I afford it? Also, I've heard that lenders don't like giving mortgages for investment properties as much as primary residences."
Kimberly C. says, "I'm a young professional starting my financial journey, and I've loved learning from your podcasts! One of my financial goals is to make passive income. You mentioned that you own some rental properties. Can you share your journey with how you obtained your first rental property and any tips you have for someone who wants to invest in real estate?"
Thanks for your great real estate questions, Julie and Kimberly. This post will answer them and review five ways you can invest in real estate actively or passively. Creating an additional income stream from real estate doesn't have to be difficult, time-consuming, or require special knowledge. Sound interesting? Keep reading.
Real estate is a unique asset because it gives you a place to live or vacation and the opportunity for investment growth through price appreciation and income. That's why every investor should have some amount of real estate in their portfolio.
But if you think you have to shell out a lot of money to buy property, you may be surprised that there are ways to own it without a significant investment of money or time. Here are five ways to become an active or passive real estate investor.
1. Own your home
Think again if you don't think being a homeowner is an investment. Not only does it shelter you, buying an affordable home is a terrific investment.
One of the best real estate tips I can give you is to buy the least expensive home in a neighborhood, not the most costly. A significant factor in how much a home's value can go up is the surrounding homes in an area. If you bought a house for $300,000 and it appreciated 3% per year, you'd have a $600,000 home in 30 years!
Another great part of owning a home is building equity as you pay down your mortgage. Each monthly payment consists of a principal and interest portion if you have a fixed-rate mortgage, but the ratio changes each month.
At the beginning of a mortgage, your payment is mainly interest–that's how amortization works. You pay slightly less interest each month and more toward your principal balance. As you slowly pay down your original mortgage balance over time, you increase your home equity (if your home's value is steady or increasing).
Going back to my previous example, if you bought a $300,000 home with 5% down, you’d have $15,000 ($300,000 x 5% = $15,000) in equity on day one. But if your home appreciates to a market value of $600,000 after paying off a 30-year mortgage, you'd have $600,000 in equity. That's quite an investment!
2. Become a landlord
When most people think about becoming a real estate investor, they probably think about owning one or more properties to rent out. You might buy single-family or multifamily homes as an active investor. This strategy requires a significant amount of upfront capital for a downpayment, needed repairs, and vacancies.
In addition to being capital-heavy, managing properties and dealing with tenants isn't for everyone. I started investing in real estate as a do-it-yourself landlord decades ago. After dealing with tenants who didn't pay rent, disappeared and left behind a house filled with junk, and set the kitchen on fire in the middle of the night, I decided to let a professional manager take over the hassles!
Turning my rentals over to a property manager was one of the best decisions I made because they raised rents and screened potential tenants much better than I could. A good manager typically charges 10% of your gross rent per property–or maybe less if you have multiple properties. So, unless you have the patience, skills, and legal knowledge to manage tenants, factor the cost of property management into your analysis.
Unless you have the patience, skills, and legal knowledge to manage tenants, factor the cost of property management into your analysis.
If you can find undervalued properties that are likely to appreciate and provide net cash flow after expenses, they can be excellent investments. And many costs, such as repairs and maintenance, are tax-deductible, offsetting your rental income.
Just remember that you'll need landlord insurance and a healthy cash reserve to cover unexpected repairs and months of potential vacancies. If you know an experienced real estate investor, partnering up with them could be a great way to share income and expenses, learn the business, and understand how to analyze potential deals.
Another tip is to work with a realtor or real estate agent who has extensive experience buying and managing rental properties. There's no substitute for having a local real estate expert on your side who understands the market where you're considering investing.
One strategy to consider is buying a multifamily property, such as a duplex, triplex, or small apartment building. If you're willing to be an on-site landlord, you could live in one unit and rent out the others.
Or you could specialize in commercial property, such as renting out a retail building, warehouse, or office space. Commercial property is generally more expensive, and the leases are more complex than residential. But they can appreciate faster than residential investments, depending on the location and features.
Business tenants want stability and are willing to sign multi-year contracts with rent escalation. Also, they're are typically responsible for renovations, property taxes, insurance, and maintenance. But everything in real estate is negotiable.
In addition, you can even structure a commercial lease to pay you a percentage of the tenant's business profits. But if the business fails or the economy isn't doing well, you could have difficulty keeping a commercial tenant and end up with a vacant building and a hefty monthly payment.
I've had a commercial property that remained empty for many months until we found the right business to move in. So, becoming a commercial landlord is definitely for those with more experience or who can take on higher risks.
Listener questions about becoming a real estate investor
Now, let's address Julie's question about buying a second home first. When you purchase a vacation or investment property that won't be your primary residence, lenders typically require at least a 20% downpayment. Plus, they usually have stricter underwriting requirements for your income and credit compared to buying a home you plan to live in.
So, whether you can afford a vacation home depends on what you plan to do with it and your finances. If you turn it into a short-term rental, such as for Airbnb, be aware that you typically must collect and remit additional taxes, such as occupancy and sales tax, to local and state governments in many jurisdictions. And managing a short-term rental on your own could be a significant time commitment.
My recommendation is that, unless your finances are in great shape, buying a vacation home is probably too much of a stretch on your budget. For instance, do you have a healthy emergency fund equal to at least three months' worth of your living expenses? Are you investing at least 10% of your pre-tax income for retirement? And have you eliminated any high-interest debt?
Julie, if you check the boxes on those financial fundamentals, buying a second home first may be an excellent investment. If it would provide extra income or improve your lifestyle, I'd start doing your homework. Be sure to speak to a tax professional about tax obligations for short- and long-term rental income so you can factor it into your decision.
Now, let's address Kimberly's question about creating passive income. First off, I want you to remember that most mainstream investments, such as index funds, exchange-traded funds (ETFs), and being a homeowner, are passive. You don't have to buy rental properties to create a passive income stream.
I started investing in real estate by keeping my first home instead of selling it when my husband and I moved into a larger home. That's the easiest way to become a real estate investor; you move out and stick a "For Rent" sign in the yard!
Not only is it easier to rent out your old home and buy another one, but it's less expensive than financing a new investment property.
Not only is it easier to rent out your old home and buy another one, but it's less expensive than financing a new investment property. As I mentioned, getting a mortgage for a non-owner occupied property requires a larger downpayment and typically comes with a higher interest rate than for a home you'll occupy.
Just be sure your existing mortgage lender allows you to convert your residence into an investment property without paying a penalty or refinancing into a more expensive, non-owner-occupied loan. Be aware that once you switch your insurance from a homeowner's policy to a landlord or commercial policy, the lender will know you don't live there anymore. So, read your mortgage or call your lender and make sure you understand what's allowed.
However, if you want to buy a rental, do a precise analysis to ensure the going rent will cover all expenses. If you break even, your tenant is paying for your investment, which is fantastic! And if you have left-over profit, you're generating a positive cash flow. And if you keep a rental property long enough to pay it off, your net income will be mostly profit.
My biggest piece of advice is never to assume you'll have rent income every month. I've had rental properties that were vacant for long periods. You can lose money quickly if you also have unexpected repairs and maintenance after a tenant moves out.
If a rental property cash flow rollercoaster isn't a ride you want to take, don't worry. I'm going to cover passive real estate ownership options in a moment.
3. Fix and flip houses
If you love shows on HGTV like Flip or Flop, you may think that rehabbing investment properties looks easy. If you're as handy as Chip and Joanna Gaines, hosts of Fixer Upper, remodeling homes may be your jam.
The idea is to find an undervalued property in a great area that needs many updates. I've done several house flips and can tell you that knowing what a remodel will cost is more art than science.
I owned a floor covering business for many years, and you never know what's under an existing floor and subfloor until you take it out. In other words, to account for many structural and financial unknowns, you have to buy a home well below its fixed-up market value to make sufficient profit.
Flipping houses is the most active form of real estate investing because you become a full-time project manager, supervising multiple trades at once.
To be a successful house flipper, you must estimate renovation costs like a pro, and it helps if you can do some of the renovation work yourself. So, flipping houses is the most active form of real estate investing because you become a full-time project manager, making loads of decisions and supervising multiple trades at once.
If you decide to become a real estate flipper, always get a thorough home inspection, so you understand invisible potential costs. Be very clear about the estimated expenses, future market value, and how typically selling time once renovations are complete. Working with an experienced partner can help you avoid missing the mark, so you come away with plenty of profit for your time and effort.
4. Invest in real estate funds
Buying funds that own properties is an indirect or passive way to invest in real estate. You might choose ETFs or mutual funds that invest in shares of companies in the real estate business, such as builders and material suppliers. That gives you exposure to potential real estate growth without owning properties directly.
Another option is investing in a real estate investment trust or REIT. These companies invest in income-producing real estate and pay out regular dividends. For instance, they may own vacation properties, hotels, apartments, healthcare facilities, office buildings, retail centers, self-storage, and warehouses. You get real estate income without having to buy, manage, renovate, or finance any property yourself.
5. Use real estate investing platforms
If you're like Kimberly and want passive real estate income, but you don't want the hassles of tenants, renovations, or risks of losing money by trial and error, check out online investing platforms. Here are some excellent options that allow you to put your money into residential and commercial real estate without getting your hands dirty.
Awning is a real estate brokerage that helps individuals invest in single-family rentals nationwide. You work with a dedicated advisor who identifies your goals and assists you in negotiating offers, setting terms, completing inspections, finding financing, and closing deals remotely. Awning can even manage your property using vetted local property managers, giving you truly passive income. They don’t charge buyers but earn a commission from sellers, making it a fantastic service for any potential investor.
Diversyfund makes it easy for anyone to buy shares in a portfolio of high-value, multifamily real estate. You can diversify your investment portfolio like the ultra-wealthy but without net worth restrictions (such as being an accredited investor). You can start investing with as little as $500, which is an excellent opportunity.
Equity Multiple allows individuals to invest in professionally managed commercial real estate with as little as $5,000. They offer three investing approaches, including diversified real estate funds, direct investing in targeted properties, and a savings alternative for funding short-term real estate notes.
CrowdStreet gives accredited individuals access to a range of institutional-quality commercial real estate opportunities. Whether you're a real estate newbie or a seasoned expert, CrowdStreet makes it easy to diversify your portfolio with investment funds (for investing in multiple properties), individual deals, or a professionally managed portfolio. You can create a free account and browse their available deals.
RealtyMogul gives individuals access to institutional quality real estate deals, including specific properties and REITs, to create passive income for investors.
Whether your goal is to diversify your investments or create extra passive income, you can own real estate directly or indirectly using these platforms. Be sure to spend time researching their opportunities to know which investment approach is right for you.