How to Begin Investing in Real Estate
The housing market is well on the mend, with prices steadily rising in much of the country. It may be a good time, then, to think about adding real estate to an investing portfolio.
True believers say there’s nothing like owning a second, third or fourth property. Of course, true believers tend to be those who survived catastrophes like the housing meltdown about a decade ago. Ask those who were hammered and you get another view.
One thing is clear: for a beginner, real estate is a different game. The lessons you learned with stocks, bonds and mutual funds aren’t much of a guide.
“The biggest thing someone should understand is that a real estate investment is more than an investment when compared to stocks and bonds. It should be viewed as a business,” says Donovan Ryckis, financial advisor at J Donovan Financial in Florida. “It will require time, management and due diligence above and beyond most investments.”
While that can be daunting, it has its upside, says Eric Workman, senior vice president of marketing at Chicago-based Renovo Financial, a lender to real estate investors. Unlike with stocks, you’re not casting your lot with executives you’ve never met.
“As an investor, you have complete control over all of the decisions related to the property – level of finish, items replaced and or repaired, standards of tenant quality, rentals rates, etc.,” Workman says.
Over the past year, single-family home prices have grown by 5.3 percent, while the stock market has been nearly flat, according to the Case-Shiller index of home prices. Studies have shown that, nationwide, homes appreciate at just over the inflation rate for the long term, and that stocks do better. But nationwide averages don’t mean much to the investor looking for a property in one local market.
Also, most real estate investors hope to earn income from rents as well as profit from appreciation.
“Prices have risen for the past seven-plus years, and part of what has driven that growth is the (low) cost and availability of debt and equity,” says David Becker, managing director of the equity division at Time Equities, a New York City-based real estate firm. “Interest rates remain at all-time lows, which is fueling certain asset classes like multi-family (buildings).”
Among real estate’s appeals: it often marches to a different drummer. If your stocks are down, perhaps your real estate will be up. That’s not always true, as homes and stocks plunged in tandem in the financial crisis, but it’s true often enough for many advocates.
Real estate prices tend to be less volatile than stock prices, because homes, stores and offices cannot be bought and sold with the click of a mouse.
Because real estate can be used as collateral, it’s cheaper to borrow to pay for real estate than for many other investments. And if you borrow, say, 80 percent of the purchase price, selling for 10 percent more than your purchase price means a 50 percent gain.
Buying a vacation property has an added bonus: using it yourself.
Still, there are drawbacks. That same leverage that turned a 20 percent down payment into a 50 percent gain can quickly turn into a loss if the market sours. The stability that looks so appealing when you buy can turn into a nightmare if you cannot quickly attract a buyer when you want to sell.
And the benefit of a small down payment may be offset by mortgage interest payments, taxes, and insurance and upkeep costs, while carrying costs are little or nothing for stocks, bonds and funds. The vacation “benefit” can get stale if you feel it’s a waste of money to go somewhere else. On top of all that are the headaches of dealing with renters.
“Unforeseen events are always a risk when it comes to real estate investing,” Becker says.
If interest rates rise, for example, prospective buyers won’t have as much to spend, undercutting property values. “I do not see interest rates rising overnight, but a market can quickly be turned sideways by a major negative event,” Becker says.
With those warnings in hand, here are a few options for a real estate investment.
Buy a vacation home. You get to use it yourself while hoping to make some money. Though rental income may not cover all your costs, especially at the beginning, you may profit from appreciation over the years.
“I would advise to start with vacation property rather than a fixer-upper,” says Peter Anadranistakis, president of Caliber, The Wealth Development Company, in Scottsdale, Arizona. “Get a property in a dense neighborhood, close to cafes, museums, restaurants, attractions and public transportation.”
In addition to the costs mentioned above, you may have to pay a rental manager. In some markets, commissions gobble 25 percent of the rent. If the property is not near your main home, you’ll probably have to pay a professional to deal with maintenance and repairs, even little things you would do yourself at home, such as squeaky hinges and blown light bulbs.
Vacation home markets can be especially volatile, with prices and rental income plunging in a weak economy when people shun luxuries.
Buy a full-time rental. Buying a home or condo for full-time renters means you are not limited to a vacation area like the beach, lake or mountains. You can get a property near where you live, cutting some of the maintenance costs. And you won’t have to find a new renter every week or two, though you could lose plenty of sleep with a bad renter who’s not going anywhere.
Flipping. Buying a home, fixing it up and quickly selling is reality-show staple, but most experts warn this is a risky way to get started in real estate. It takes a lot of knowledge, time and tolerance for setbacks, and it’s very hard to make money without contributing sweat equity. If you’re not handy and don’t enjoy construction work, stay away.
“It is becoming harder to find deals to flip, as spreads (between purchase and sales prices) are becoming smaller with appreciation,” says Than Merrill, CEO of FortuneBuilders, a San Diego-based training firm for real estate investors.
Invest in your own home. Remodeling, renovating and expanding can add value to the home you live in, and have an immediate payoff in enjoyment. If your home has serious need for improvement and is in a healthy market, this is probably the smartest real estate investment for a beginner nervous about being a landlord.
Be careful though, because most improvements do not add as much value as they cost, according to the annual surveys by Remodeler magazine. To make improvements pay financially, you need to choose carefully, not get carried away with personal preferences, and probably do a lot of the work yourself.
Buy real estate investment trusts. REITs are like mutual funds that own real estate instead of stocks or bonds, and they can be bought and sold in an instant. Though eachREIT specializes in a certain type of property – strip malls, apartment buildings, office complexes and so on – REITs spread the risk among a number of properties and use professional management, says Wilson Magee, director of Franklin Global Real Estate and Infrastructure Securities.
“Investors can build a real estate portfolio that has geographic and sector diversification by investing in a few selected REITs,” Magee says.
With a REIT, he says, you can buy into a big property you could never afford with a direct investment, and REIT management minimizes costs with economies of scale.
Whatever approach you take to real estate investing, most experts recommend dipping a toe rather than plunging in, so you’ll survive if things go wrong or the hassles become intolerable.