Getting Started In Real Estate Investing
So you want to make a fortune in real estate ... and who could blame you? Real estate investing has made more millionaires than any other entrepreneurial activity in human history.
What do real estate riches look like to you? Can you imagine yourself owning massive apartment and office buildings or a portfolio of rental houses across the country? Flipping retail parks, strong arming mortgage banks and watching tractors break ground on new construction?
If you’re just getting started, it can seem like an intimidating prospect. But there’s no need to rush. In fact, in real estate, it pays to start slow. Rookie mistakes can cost thousands of dollars and even wipe out life savings.
But real estate investing is almost unique in its ability to predictably produce predictable cash flow with opportunities to manage risk. Beginner-level real estate investing is not rocket science.
No empire gets built overnight. By taking it slow and starting at the beginning, you’ll learn valuable lessons that will stand you in good stead on the path to financial freedom and generational wealth!
Beginner-Friendly Real Estate Investing Strategies
Forget about house-flipping, short sales, or new-construction development. There are far less complicated ways to get started investing in real estate. Here are some of the easiest ones to get into:
When most people think about “real estate investing,” they are thinking of “buy-and-hold” investing. This is the relatively straightforward process of buying a property, renting it out to tenants, and collecting rent as the landlord.
You can buy-and-hold almost any kind of property, including apartment buildings, mobile home parks, commercial strip malls, office buildings, or industrial property. However, the easiest kinds of properties for most beginners to buy-and-hold are single-family homes, duplexes, triplexes, and four-plexes.
Residential leasing is relatively straight-forward, and these properties are small enough that the landlord can probably manage them him- or herself without having to hire a property manager (although as your portfolio grows, it may be wise to hire one).
The contracts to buy one- to four-unit residential properties are straightforward. If you can get approved for a mortgage on your own house, you can probably get approved by the same banks and lenders for a mortgage on an investment property, as long as you can put in a 20% down payment.
“House hacking” refers to renting out a portion of the home you live in. House hackers might buy a house and rent out the extra bedrooms, or they might buy a duplex or fourplex, live in one unit, and rent out the other units.
There are several advantages to house-hacking over traditional buy-and-hold land lording:
● Because you live on the property, managing it requires less back-and-forth.
● Tenant rent is effectively a discount on your mortgage payment and other expenses. You could even end up erasing your housing payment entirely with your tenants’ rent.
● Because it is your personal residence, a bank may be willing to accept a lower down payment—10%, 5%, or even lower if you can take advantage of FHA or VA programs.
● Because it is your personal residence, you may be eligible for a homestead exemption on your appreciated gains if you hold the property for at least two years before selling.
We mentioned homestead exemptions above briefly, but the homestead exemption can be a part of a beginner-friendly, under appreciated method of building wealth through real estate.
Many people think of the home they own as their “biggest investment,” but many don’t treat it that way. The home you own can tend to become a money pit, even as you build equity over the decades. Homestead hacking is a way to build significant wealth quickly from your personal residence.
Many states allow you to take a homestead exemption on your personal residence. This means that, up to $500,000, the capital gains on your home’s appreciation are not subject to taxation. Some states offer no homestead exemption, some a partial exemption. Check your state’s laws.
The fastest way to build wealth off your personal residence is to buy a fixer-upper, live there for two years, fix it up, and sell it at a tax-free profit. Everyone needs somewhere to live, and this is a way to generate massive, tax-exempt wealth from your housing expense.
Of course, many people don’t want to move or fix up a house every two years, but for people more interested in building wealth than in “nesting,” homestead hacking is well worth it. The profits can be much bigger than the cost of full-service movers or light renovations.
Building Your Team
Even if you intend to be the sole landlord, no real estate investor works alone. Before you even buy your first property, it’s important to start building your team. The members of your team may include:
● Attorney. You will need an attorney to review paperwork like purchase agreements and leases, as well as to file evictions and help you limit your risk.
● Deal Finder. This might be a realtor, but many realtors have a hard time understanding what investors are looking for; they are too used to helping families find personal residences. A real estate wholesaler may be a better source of deals. Getting on the “buyers list” of as many wholesalers as you can might be to your advantage.
● Lender. Look for brokers that have connections to traditional mortgage lenders, as well as hard money lenders. If your credit is bad, you might start building relationships with private lenders who might consider the fundamentals of the deal, not just your creditworthiness.
● Home Maintenance Professionals. Properties often need repairs and renovations. Having a reliable contractor or handyman on your team is essential. You might want your contractor to walk the property with you to give you estimates on the cost of deferred maintenance. Consider contracting for emergency maintenance so your tenants have someone to call other than you if the toilet breaks at 3am.
● Property Manager. When you are just starting out, it might be valuable to manage your own properties so you understand the ins and outs of the business. However, as your portfolio grows, the job may be too big for you to handle without quitting your job and managing your property full-time. Property managers can not only take over the day-to- day tasks, but have the expertise to avoid some of the rookie mistakes you might make.
What to Look For in your First Investment Property Any piece of real estate can become an investment property, but not every piece of real estate
makes a good investment property. At the bare minimum, a good real estate investment should:
● Produce positive cash flow.
● Have a strong chance to appreciate over time.
There’s no hard-and-fast rule on how to do this, but here are some beginner-friendly guidelines:
Don’t Buy or Rehab Based On Your Own Home Preferences
Many first-time investors buy homes based on where “they would like to live.” They might choose a big, beautiful, new-construction home that they would be proud to rent themselves.
This kind of emotional connection to an investment property is usually a mistake. Beautiful properties usually sell for top dollar, making it harder to achieve positive cash flow or secure future appreciation.
Ditto renovations. It’s fine that you love granite countertops, but most tenants need “good enough,” not top-shelf.
Avoid Homeowner Associations
This rules out most condos, despite the fact that condos can be some of the cheapest and easiest properties to get into. HOAs impose restrictions and can levy extra fees that destroy your cash flow.
Many investors are attracted to the allure of the beautiful new home, figuring there will be less to repair. However, the good deals tend to be in the ugly properties, which other buyers overlook. The sellers may be motivated, strapped for cash, and need to sell fast at a discount. These properties have room to appreciate, and the cost to renovate the property is often well worth it.
Consider Infill Locations
Infill locations (that is, dense urban areas) tend to appreciate faster because the land is more valuable. In less-dense suburbs you will constantly be competing against new builds and face high turnover from discerning tenants.
Consider Smaller Units
You may think big units are more in demand, but smaller units tend to rent for more dollars per square foot, and are less expensive to clean and repair if and when a tenant moves out.
Introduction to Property Value
Property is worth what someone is willing to pay for it. The easiest way to determine what a property is worth is to see what similar properties have sold for nearby and recently.
Realtors and appraisers perform this kind of analysis all the time. You can do it too using online tools like Redfin or Zillow. Just make sure that you don’t rely on the “For Sale” price of an unsold property. Just because someone is asking for a particular price doesn’t mean they will get it. “Sold” listings are what matters, because that is what someone actually paid for it.
As you look at “sold” listings, try to pick the closest, most similar properties that have sold the most recently. If you are considering a 3bed/2bath house, try to look for nearby 3/2s that have sold recently. If either the subject property or the comparable property has different features—an extra bedroom or bath, a nicer kitchen, a pool, etc.—you should adjust the price assumptions to account for those differences. Look at as many comparable sold properties as you can.
The Income Method of Valuation
The above approach is the “sales comparison” method of real estate appraisal. When you get into bigger multifamily or commercial properties, the “income method” of appraisal starts to become more applicable, but there’s no reason not to practice it on smaller properties.
The income approach means that a property has a certain value based on its ability to produce income, usually in the form of rent and tenant fees. The two big approaches to the income method are:
● Cap rates—a percentage, usually between 4% and 10%. To get the cap rate, divide the annual net operating income (income minus expenses, not including mortgage payments) by the sale price. Investors may set a target cap rate—8%, for example, or maybe 6%—and won’t buy a property that falls below that mark when they do the math.
Cap Rate = Net Operating Income ÷ Sale Price
● Gross rent multiplier—a number, usually between 4 and 7. To get the gross rent multiplier, divide the sale price by the annual gross rent (raw income, no expenses). Investors may set a target gross rent multiplier—6 or 7, perhaps—and won’t buy a property that falls below that mark when they do the math.
Cap Rate = Sale Price ÷ Gross Rent
The income method is a huge subject, too big for a beginner’s guide. We will dig deeper in other guides, but for now, feel free to plug the numbers of the investments you are considering into these equations and see what you come up with.
Introduction to Leverage
Leveraging any investment means using other peoples’ money to fund some of the investment. In the case of real estate, this usually means buying with a mortgage.
Mortgages (also known as “home loans”) tend to reduce your cash flow, since you have debt service payments as an extra expense. However, they let you put less cash at risk, buy more property, and increase your exposure to appreciation.
How does this work? If you paid all cash on a house for $200,000 with no mortgage and it appreciates $50,000, you made a 25% profit. Not bad.
But if you only put $50,000 down and it appreciates the same $50,000, you have doubled your money! The mortgage doesn’t grow with the appreciation; it stays the same. In fact, it may get smaller and smaller with principal paydown. The difference goes into your pocket (after taxes).
Most banks and lenders will write mortgages on investment properties for qualified borrowers. However, they will usually only lend 80% of the appraised value if you don’t intend to use the property as your personal residence. Banks tend to lend 90% or more for personal residences.
Introduction to Cash Flow Analysis
One of the key advantages of beginner-friendly real estate investment methods is their ability to produce cash flow. Once deferred maintenance is complete, rental properties can be very low- maintenance, producing what real estate investment professionals sometimes call “passive returns.”
But it’s not that simple. A property’s cash flow isn’t the rent you collect, but the rent minus expenses. Every property has expenses, and if the expenses get high enough, the property could end up costing you money to keep, rather than making you money.
PRO TIP: Never buy a property that you calculate to produce negative cash flow (i.e. lose money every month). Even if you think the property is likely to appreciate, it’s too risky. Properties that produce negative cash flow tend to struggle to appreciate.
To reiterate, cash flow is income minus expenses. Income
The property’s income is usually the rent you collect from a tenant. It could also include reimbursements for utilities or income from pay-per-use laundry machines, as well as application fees, pet fees, late fees, parking fees, and any extra fees the tenant might agree to.
Property expenses are a little more complicated and can be hard for beginners to predict. Do your homework, and talk to as many experts as possible to get the most realistic estimates for the following expenses:
● Mortgage Payment.
● Property Taxes.
● Property Insurance.
● Repairs and Maintenance.
● Utilities if the landlord is required to pay them. For most single-family houses, tenants
pay their own utilities.
● Contract Services like lawn care and pest control.
● Property Management.
● Administrative Expenses.
● Marketing Expenses, including advertisements, realtor commissions and referral fees.
● Travel Expenses to and from the property.
● Professional Services like attorneys and tax preparation.
If you haven’t accounted for all of these expenses, you don’t yet have an accurate picture of the property’s cash flow potential. Keep checking off the list until you get there!
Introduction to Risk Management
One of the main reasons people never take the plunge into real estate investment is because they get cold feet about the large sums of money spent and borrowed in the course of the investment. It’s easy to see why they feel like they are putting their life savings on the craps table.
Unlike the craps table, however, real estate investment is not just a game of chance. There’s no way to swing a casino game in your favor, but you can reduce your chance of losing big at real estate investment by practicing risk management.
Real estate risk management is complicated and will probably require several discussions with an attorney. But here are some basics to get you started:
● Everything In Writing. Don’t take any deal as closed, any handshake as binding, until it is in writing and (preferably) reviewed by your attorney. This includes purchase agreements, leases, contractor agreements, and mortgage paperwork.
● Holding Entities. Few real estate investors hold their property in their own name. Most hold them in an “entity”—a limited liability company, limited partnership, or trust. While the investor may own or control the entity, the entity is not the investor. This has the effect of limiting the investor’s liability for things that might happen on the property, and limiting the exposure of the investor’s other assets to lawsuits that a tenant or other party might file.
● Insurance. If you buy with a mortgage, your lender will definitely require that you get property insurance. This insurance protects you from total loss in the event of a disaster like a fire, flood, or tornado. It may be worth your while to purchase “umbrella liability” insurance, which protects you in the event of a host of hard-to-predict circumstances, like a tenant lawsuit.
● Evictions. If a tenant breaks lease terms or fails to pay rent, eviction may be the only remedy. Eviction is a sensitive legal issue that has to be done right, in accordance with your state’s landlord/tenant laws, or the consequences can be dire. Beginner landlords— and even old pros—are well-advised to hire an attorney with experience in this arena to do their eviction filings. The expense is well worth it.
There’s more to learn about real estate investing than any one guide can teach. Even the most successful investors are lifelong students of the businesses—in fact, that’s what makes them successful.
But everyone starts somewhere, even titans of property. By following the principles in this guide, you can take the first steps to the wealth and prosperity enjoyed by top real estate investors.