There are many ways to invest in real estate properties, each with pros and cons. Some of them are quite common, and everyone has at least a vague idea where to start with them. Others are less common, may require more work, knowledge, but may provide for higher returns. Knowing the pros and cons of the different investment types and matching your knowledge, experience, and your risk level comfort will help you pick the best option for you.
1. Owning your own home
This is the most common way of investing in real estate. Almost everyone engages in owning their own home at some time in their lives. Not everyone considers owning your home a type of real estate investment. Many real estate gurus (including Robert Kiyosaki) state that owning a home is not truly an investment as this is not an asset that provides a continuous income stream. However, we believe that it depends on strategy, your choice of property type, and the location of your property.
The textbooks define investing as something that either brings you monthly income or something that you sell later with a capital gain. In the case of buying a home to live in, you may realize the capital gain many years down the road if you actually sell the place and buy something smaller. While many people don't like the idea of downsizing, a strategic approach to buy something bigger in the beginning and in the area that shows good real estate appreciation can help bring the extra money for your retirement.
Let's say you buy something today for $300,000. In 30 years, by the time your kids move out, assuming an average annual real estate appreciation of 4%, the property will be worth $973,00. If you decide to buy something smaller for half the price, you would be left with almost $500,000 to supplement your retirement income.
We also consider this type of buying the property investment because you can access the equity in your house. This means you can borrow money against your property with a secondary mortgage, refinancing, or home equity line of equity (HELOC) at relatively low-interest rates. You can then invest this money into buying more real estate or otherwise use or invest it. This makes your home equity the asset you can use to make money.
One of the benefits of this type of investment is that you don't have to pay taxes when selling your primary residence. Specifically, single taxpayers can realize up to a $250,000 tax-free capital gain if they lived at this property for a minimum of 24 months of the past 60 months; married couples filing jointly get up to $500,000. This 24-months period also does not have to be continuous.
2. Renting out part of the home you live in
Likely one of the most common ways (along with the next one) that starts the real estate investing career for most real estate investors. There are two ways people get to this real estate investing option. Under the first way, they live in a house and realize they can give away its part (usually basement). The second way is to plan ahead and buy a bigger place to rent its part out. If you plan ahead, you can buy a slightly bigger place, counting that the rental income will cover a part of your mortgage. The key success factor here is finding a place where you can break into two parts and have the necessary amenities in each (kitchen, bathroom, washing machine, etc.). Also, for your comfort and the residents' comfort, you need to make sure that you don't interact with the renters other than collecting monthly rent. This includes a separate entrance for the rental unit. The other success factor is the choice of renters. It would be best if you found good residents that are not too noisy, pay on time, and are likely to live at your place for as long as possible. This will save you time and nerves having to move residents out and find new ones.
3. Renting out your home as you move out
Most people move from one place to another from time to time. Usually, they sell their current property and use the proceeds to buy another. The idea behind this form of investment is to hold to your old property while purchasing the new one. This works best when you have already paid off a sizeable portion of your mortgage on the first property. Then you can refinance the mortgage on the first property; this will reduce monthly mortgage payments below your monthly rent. You can then use this gain to help pay the mortgage on your new residence or otherwise use it or invest. The beauty of this investment type is that the monthly rent pays off the remaining mortgage on your old property, and you get additional passive income.
You can do this type of investment in multiple cycles, and it makes sense to think strategically about this: pay off the mortgage on your property so that rental income covers monthly mortgage payments, buy a new property, do the same, buy next...
You can also do this strategy with a duplex or other small multi-unit rental property where you reside in one of the units and rent the others.
The benefit of this approach to investing is that it is likely the easiest way to get into real estate investing. And this is one of the two most common ways most real estate investors start their career to owning multiple properties. First, you are planning to buy a new property anyway. Second, you are renting out a property that you know and likely maintained well when you lived there. You also know the exact costs it takes to manage this property, including the expenses many novice investors fail to include in their calculations, such as property tax, utility costs, costs to take out the garbage, etc. Lastly, depending on your situation, you are not going "all-in" having to find financing for your investment property since you have already paid off part of the mortgage on it.
You can read more about calculating your return and ROI (return on investment) for your rental property here: Calculating ROI for real estate investment: rental vs. capital gain ROI.
The key watch-out here is not to overextend yourself with the mortgage on the new property. Let's say you have a house worth $600,000 and still have a $300,000 mortgage on it. You plan to buy a new place for $800,000. The usual family would sell the first property, take the $300,000 in cash, and put it down towards the new property. This would leave you with a $500,000 mortgage on the new property.
If you keep the first property for rent, your new mortgage will be a total of $800,000 (less any required downpayment). Plus, you will have the $300,000 remaining mortgage on the first property. This will result in a higher monthly mortgage payment across the two properties. This may result in banks refusing to give you the mortgage for the second property. To help get the needed mortgage, you can consider two actions:
show the rental contract to the bank that shows you will have extra income coming from the rental property. In the best-case scenario, this rent should cover the mortgage payments, condo fees, utility bills, property tax, and any other fees for your rental property.
refinance the first mortgage to the maximum possible length. E.g., if you have $300,000 left in the mortgage and 15 years left to pay it off, you can refinance this remaining mortgage to 30 years. This will reduce your monthly mortgage payments and increase the room for the second mortgage.
4. Investing and living in well-situated fixer-uppers
Another way to invest in real estate is to invest in well-located fixer-upper homes where you can buy a property, invest your time and cash to improve the property, and sell it at a profit. There are a few considerations you have to keep in mind for this real estate investing strategy:
You have to be sure you can live in the constant renovation. This may not be suitable for certain types of people and families.
You have to invest your time in renovations. While you can trade your time for cash, meaning hiring contractors to do parts of renovations, this will reduce the potential profit from your investment.
You must invest only in renovations that increase the value of your property. You have to be quite savvy in property valuation. In fact, even before you buy the property, you have to know the approximate impact cost of different renovations you want to do and their likely impact on the property value.
You have to move properties every few years.
You must actually move into the fixer-upper for at least 24 months to earn the full homeowner’s capital gains exemption of up to $250,000 for single taxpayers and $500,000 for married couples filing jointly.
When properly thought out and executed, this strategy can provide higher additional income to your family. We already discussed the benefits and income potential of this strategy in an earlier article: A fix and flip type of real estate investing. Its pros and cons. Calculating ROI for fix and flip. Here’s a simple example to illustrate the potentially significant benefits of this strategy. You purchase a fixer-upper for $275,000 that becomes your principal residence. Then, over the next 24 months, you invest $25,000 in improvements (paint, repairs, landscaping, appliances, decorator items, and so on). You now have one of the nicer homes in the neighborhood, and you can sell this home for a net price of $400,000 after your transaction costs. With your total investment of $300,000 ($275,000 plus $25,000), your efforts have earned you a $100,000 profit completely tax-free. Thus, you’ve earned an average of $50,000 tax-free income per year: I supplement your other income nicely.
One of the drawbacks of this type of real estate investment strategy that you may consider is its lack of scalability. While you may choose to buy a bigger house in a better area each time, meaning you would invest more and get more return from it, you are always invested in only one property. Also, a bigger house will mean more time spent on renovations. With other real estate investing strategies, you can scale up: buy more and more properties which eventually increases your passive income. Thus, over time, if you want to scale up and become a true real estate investing mogul, you may need to mix the fixer-upper strategy with other strategies. For example, after you fix the place, instead of selling you can rent it, and move on to the next property.
One final caution: Beware of transaction costs. The expenses involved with buying and selling property — such as real estate agent commissions, loan fees, title insurance, escrow or closing costs, and so forth — can eat up a large portion of your profits. With most properties, long-term appreciation is what drives your returns. In times when the market is not growing, consider shifting your strategy from immediate selling to keeping the home as a rental unit while you live in and renovate the next one.
5. Purchasing a vacation home
Many real estate investors eventually diversify their real estate portfolios by including vacation properties. While this type of real estate investment in some way resembles buying a property for renting it out, it is also drastically different from all other strategies for the following reasons:
You are in sort owning and managing a hotel. This means you need to actively manage 2 aspects. The first aspect is the search for renters that can rent your place for a period anywhere from 1 night to 2 weeks. The second aspect: managing your property. The property needs to be clean for your next guests, so you would need to either manage that yourself or hire a person or a company to do that for you.
With a second home, you have the range of nearly all the costs of a primary home — mortgage interest, property taxes, insurance, repairs and maintenance, utilities, and so on. If you want your property to generate income, you have to make sure all those costs are covered with the revenue you get from your rent.
You bear the risk of a low occupancy rate. Your property may sit empty between renters, which could lower your overall return. Location is key here, price is also a factor. Before you buy your vacation property, study the market for hot locations and competition, their pricing. Check Airbnb to get the statistics of occupancy rates and calculate ROI (your return on investment) using optimistic and cautious occupancy rates. Check what features of rental homes are most wanted by renters and which features can increase your rental rate.
When you’re not at your vacation home, things can go wrong. A pipe can burst, for example, and the mess may not be found for days or weeks. Unless you hire a person to watch after your home, you may end up with massive repair costs.
Should a guest cause damage to your property, you could incur excess repair costs.
Before you buy a second home, weigh all the pros and cons. Consider talking with local property managers, local real estate companies, and agencies. Finding a real estate person who specializes in vacation properties and especially who either specializes in investment vacation properties (either by finding those for their clients or by investing on their own) will help you understand the little details and get good advice to start on your investment journey.