Investing in rental properties for beginners 101 – HomeUnion

Investing in rental properties for beginners 101

There’s so much more to real estate investing that even the terms “real estate” and “real estate investors” need to be defined before explaining how to make money off investing in various properties.

The education and the skills one needs to succeed as a real estate investor are broad and in-depth, but if you enjoy learning, research, and everything that property management entails, then real estate investing might be for you.

And, don’t worry, if you’re not fully onboard with all those things, you can still invest in property and make a significant profit.

What is real estate?

Real estate is more than just land and/or whatever building or structure is on it. Real estate also includes anything that’s a permanent fixture of your property. That includes fences, roads, streams, trees, utility systems on your land, etc. Real estate also includes rights that are considered inherent to a piece of land: air rights, water rights, and the mineral rights to whatever natural resources are in the ground beneath your property.

What is a real estate investor?

Given the broad definition of what real estate actually is, what it means to be a real estate investor is an equally broad endeavour. It means investing not just in properties, whether it be to generate income via rent or sale, but includes purchasing and then leasing mineral rights, investing in a Real Estate Investment Trust (REIT), or taking part in a big deal facilitated by a real estate crowdfunding platform.

What are the four primary forms of real estate?

Despite the broad range of categories encapsulated by real estate, there are four primary forms of investment:

  1. Residential: Used primarily for housing. Includes single-family homes (SFH) multi-family homes (MFH), townhouses, and condos. Homes that have more than four units tend to be categorized as commercial property.
  2. Commercial Real Estate: Commercial real estate is real estate that’s used explicitly for business. Offices, retail, homes with more than four units, and apartment buildings are some examples.
  3. Industrial: Used primarily for warehouses, factories, power plants, etc.
  4. Land: When people talk about land they’re usually talking about undeveloped property with nothing on it. There’s a limited number of ways to generate income from land that include farming, ranching, or being left untouched.

What are must know real estate terminology?

  • Net Operating Income (NOI): Your NOI is what you get when you subtract operating costs from your gross income (your gross income is how much you make before taxes).
  • Capitalization Rate (Cap Rate): This formula is used to find the value of an investment deal. Written out as a percentage, the cap rate is derived using the current market value of a property. Your cap rate is what you divide your NOI by the current value of your investment.
  • Cap Rate: Just one way to calculate property value using your rental income. It’s useful for comparing different investments but should not be used separately from other metrics. Otherwise, you get an incomplete picture. A particular good year in terms of rental income can seemingly erase a history of disappointing rent just by presenting an incomplete picture, for example. But as one of the many tools in your arsenal, the cap rate can be used to make an informed decision
  • Cash Flow: Cash flow describes both the intake and outtake of income. An investor may tabulate the monthly cash flow, which is all the rental revenue made by a particular asset, and subtract the expenses. Investors, obviously, want properties that generate a monthly positive cash flow.
  • Real Estate Owned (REO): REO properties is what you call an asset reclaimed or owned by lenders, most often banks. After a property is foreclosed, the liens and expenses are likely to be removed from a property so it can be sold faster. REO assets provide a great opportunity for investors looking for real estate that’s below market value.
  • Return On Investment (ROI): Your ROI is the ratio between the net profit, meaning the income generated after taxes, and the amount of capital invested. The higher the ratio the greater the profit.
  • Cash-on-Cash Return: Yearly gross income divided by the amount you’ve invested, expressed as a percentage.

How to Buy Your First Rental Property

Real estate is not as exclusive an investment as many people think it is. In fact, one of the biggest barriers to investment is actually not knowing how accessible real estate is. Once you know how to get your foot in the door, you can step right through it.

  1. Figure out Your Finances: Before you even look at investment properties you need to look at your own budget. Check your savings, how much you can save in the next few months, and how much you could conceivably spare over the immediate years to come. Good. Budgeting skills are the hallmark of a good investor.
  2. Talk to the Bank: After you’ve made a budget, check in with a bank. Getting loan pre-approval before you even start searching for investment opportunities is a good idea. If you can’t get a loan then your real estate findings will be moot. Yes, there are a number of alternatives to getting financing through a loan, but they make the entire investment process more challenging. It’s better to start on secure footing than with a foundation that’s less certain. If you get a mortgage pre-approval, you’ll also know what your price range is, which will make your search easier
  3. Do Careful Research: Whether it’s your first property or your 100th property, research is an essential component of the investment process. Look into different markets because geography isn’t a limit on where you can invest, especially given all the technological innovation of recent years. You should also do your research using a variety of sources. It never hurts to have the perspective of multiple points of view.
  4. Choose Your Location Carefully: Once you’ve done your research, it’s time to select where your first investment will be. You may know the dictum of “location, location, location“, but not necessarily why location is so important. It’s because where you invest will impact your potential income stream, expenses, cap rate, cash-on-cash return, and more. As far as geography goes, your range can be as specific as the state, city, neighborhood, and even the portion of the neighborhood where your property rests. If you’re a first time investor, try to make it as easy for yourself as possible by going with a residential area that already attracts residents.
  5. Conduct Real Estate Market Analysis: Once your location is within range, start doing market analysis of all the places you have in mind. You should be able to name the price, rent estimate levels, best investment property type, strategy, and every other criteria you may consider.
  6. Search for Potential Properties: As already mentioned, you want to have a variety of sources to consult. Now’s the time to look into them. Newspapers, websites, mobile apps, and even jaunts around the neighborhood are all viable ways to spot investments. As are open houses, which are also great opportunities to network.
  7. Do Investment Property Analysis: Once you’ve got a few places in mind, start getting granualler in your research. Do investment property analysis for every spot on your list. That’s honestly the only route to knowing if your potential rental income will be positive or negative.
  8. Use Real Estate Investing Tools: Thanks to technological innovations, tasks that used to take up an entire afternoon can now be completed in an instant. Various calculators can be found online to generate invaluable information in an instant. These calculators dramatically level the playing field among first time and experienced investors, making it much easier for entry level investors to make sound decisions. You can use these tools to find out everything about anything, from metrics ranging from city details to property specifics.You’ll be able to discover property price, expenses, rental income, rental income tax estimates, and the cap rate for both long-term and short-term rentals.
  9. Choose a Simple Property: Right when you’re on the cusp of choosing your first investment property, tap the breaks so you can go with the simpler choice. It’s your first go at this, so you don’t want anything that’s going to eat up your finances, your time, or any of your other resources. Keep in mind, a rental can be a lot to maintain, which is why property managers are so useful. But property managers can also run upwards of 12% of collected rent, which makes them cost prohibitive for most first time investors, especially if you’re only investing in a single property.

How to Make Money Investing in Real Estate

Active Investing: These are ways of making money off real estate that require the active participation of the investor. You have to do first-hand research, network and make phone calls, go to physical locations, potentially secure funding, etc. Typically, active real estate investing is done by an individual, and requires significant business acumen.

Real Estate Appreciation: This is what happens when your property goes up in value. Your land may become more valuable because it’s scarcer or your neck of the woods gets busier. You could have also renovated your property so significantly that it’s more desirable to future residents. Appreciation, in general, is not guaranteed, so it’s not as good of a reason to invest in a property as rental income.

Cash Flow Income: This is the investment strategy that focuses on generating income through rent collection. This is applicable to more than just homes. Apartment buildings, storage units, office space, and store fronts can all generate rental income.

Short-Term Rentals: Short-term rentals are when you rent your properties for windows of time as narrow as a single night. These sorts of spaces tend to be limited to residential properties and for short periods of time. They are most often facilitated by platforms like Airbnb and VRBO, which let you rent out some or all of your home. Depending on the demand for your property, you can generate regular or irregular income just from cash flow. It’s on you, in either case, to furnish and maintain the property.

If you go the short-term route then you’ll benefit from the fact that third-party websites like Airbnb and VRBO take care of the booking and the contract agreement that you and your renter sign. That means that a lot of the weight is off your shoulders, and maintaining your rental property will resemble a part time job.

Before you dive in, however, you need to study the short-term rental laws in your area. Homeowner associations (HOAs), for example, can prohibit short-term rental, and some cities, like NYC and LA, already have restrictions against short-term rentals. Also, even if you live in an area that’s accomodating to short-term rentals, it’s a good idea to know the laws well so that you don’t encounter any curve balls.

Real Estate Related Income: This refers to the money made by people who work in real estate, like real estate agents or property managers.

House Flipping: House-flipping entails purchasing a property, making repairs to make it market-ready or to raise its value, and then selling it at a profit. House-flipping is a short-term investment since its property that’s only really held onto for as long as it takes to fix-up and sell. No tenants are sought, and the longer the house goes without being sold the more it eats into the investor’s potential profit.

House-flipping requires significant financial and real estate knowledge in order to do effectively given the budgetary and time constraints. You need the cash and/or credit to secure a loan before the competition does and you need to be able to make your repairs at an affordable rate.

Wholesaling: This is when you purchase a property that you believe to be below market value and then quickly sell it to someone else at a higher price for profit. Often, wholesalers sell their properties to house-flippers eager to perform repairs and sell the property for even more money.

The wholesaler will sign a contract to purchase a home and put down an earnest money deposit, which is money given to a seller that demonstrates the buyer’s intention to buy a home. It gives the buyer time to get financing, conduct a title search, appraisal, inspection, etc before the closing.

Basically, a wholesaler is hoping to make money off a finder’s fee for having found a property for a house-flipper. Unlike a regular traditional property broker, a wholesaler uses their place as the contracted homebuyer to secure the deal. Wholesaling, like house flipping, requires real estate and financial know-how. You have to be able to do a lot of research quickly and have access to potential house-flippers who’ll buy the home quickly. The longer a wholesaler holds onto their property the less money they stand to make.

Ancillary Real Estate Investment Income: This refers to methods of generating income such as vending machines, laundry machines, etc.

Passive Real Estate Investing: Passive real estate investing tends to entail providing the capital for an investment and then taking a hands off approach while professionals use the money to generate income.

Private Equity Fund: This is when a group of investors collectively put their money into a single fund to make investments in the private market. These investments tend to be limited liability partnerships where a particular manager or group of managers take control. Investors don’t even have to be actively involved in the management of the fund. It is useful, however, for the investors to have the business acumen necessary to understand how the fund is actually being managed. In part, this is because the minimum threshold for an investor is oftentimes quite high.

Opportunity Funds: This is when one or more investors pool their resources into a single fund to make use of Qualified Opportunity Zones, which are census tracts of low-income housing that have been selected by state governors and earned designation by the US Department of Treasury. These areas were created to encourage investment in areas experiencing economic hardship in the US.

By law, an Opportunity Fund has to invest at least 90% of its assets into real estate or businesses within Opportunity Zones. Since these initiatives were designed to encourage improvements of neighborhoods, the types of real estate opportunities themselves are bound to the construction of new buildings, the redevelopment of previously unused buildings, or the Opportunity Fund must make improvements to a building that’s greater than or equal to how much was paid for it within 30 months of obtaining it.

Real Estate Mutual Funds: Another pooled fund, real estate mutual funds offer investors the opportunity to make a profit by turning their resources over to a manager or group of managers who will invest on their behalf. Mutual funds generate income in the form of dividends paid out to shareholders and appreciation at the time of sale.

Real estate funds make their money by investing in instruments that own real estate, like real estate stocks or REITs, but can also invest into real estate directly. As far as what type of real estate these funds invest in, every opportunity is on the table. Unlike other funds, however, mutual funds tend to invest in publicly traded assets, so they are highly liquid. They only really require a capital investment and tend to have low investment minimums. This way, real estate funds are great entry points for first-time investors, but are also of interest to big-time players as well.

Keep in mind, though, since mutual funds hold publicly traded assets, the value of their shares may be closely tied to the movement of the stock market rather than the actual value of their underlying assets. That makes real estate mutual funds a volatile investment opportunity.

Make sure to conduct your due diligence. From fund to fund, investment minimums, free structures, and portfolio allocation may vary. The Securities Exchange Commision (SEC) requires mutual funds to dedicate a minimum of 80% of their assets to the investment type that is implied by the fund’s name. The fund’s name, however, can be deceptive, and mutual funds are legally permitted to invest across industries and asset classes. So, investors need to have the requisite knowledge to discern between the different types of costs and fees that come with the real estate mutual fund territory, as well as the assets their investments contain.

Real Estate Investment Trusts (REITs): A REIT’s structure shares similarities with mutual funds in that they pool their resources together to purchase real estate either to create an income stream or to sell. REITs tend to focus on one or more types of investment, like office buildings, apartment complexes, or self-storage units.

REITs typically pay high dividends, so they are frequently invested in by retirement funds or those who want to reinvest their regular income to grow their investment. Most REITS are publicly traded and anyone can buy shares of them just like any other stock. Some REITs, however, are private and only available to accredited investors. Because non-traded REITs aren’t easily sold and may be hard to value. New investors are advised, for this reason, to work with publicly traded REITs.

Online Real Estate Investment Platforms: These platforms allow individuals the opportunity to make investments they may otherwise have been unable to make. They make it possible to invest in both individual properties or to create a diverse portfolio. With these platforms, you can invest in everything from debt to equity. Some focus on specific regions or cities while others provide access to the whole country. Some platforms do, however, have restrictions such as accreditation requirements and high investment minimums, while others do not. By pooling investments from thousands of individuals, investing platforms can leverage collective buying power to make investments that would otherwise be out of reach for many participating individuals.

Real Estate Investment Groups (REIGs): REIGs purchase or build a group of assets and then sell them to investors who rent them out. Given the high level of expertise of the people who run REIGs, they can help investors find residents and act as property managers (for a fee that ranges between four and 12% of collected rent).

Common Investing Traps to Avoid

Banking on Short-Term Appreciation: What compels many people to hop into real estate investment is seeing others make money when their assets quickly go up in value. But that’s not really what real estate investment is all about. If you invest in real estate over the long term, you’re likely to have a positive ROI. And if you really know what you’re going to do in the arena of house flipping then you can also make a profit. But trying to make a short-term profit in real estate solely because of short-term appreciation is a big risk. It’s not impossible, but it’s incredibly challenging. You’re better off making use of a different investment strategy.

Feeling over thinking: It’s easy to invest emotionally into a property, especially when you’re first starting out. But that’s not a mindset that’s going to help you get a good deal. You need to be rational and business minded. And even if something seems like a good deal at first, which may spark excitement, make sure to dig deep with your research.

Buying at market value: If you purchase at market value you’ve left yourself with less room for profit. Part of the way you find success as a real estate investor is by finding great deals or purchasing properties that require repairs and are below market value.

Being Uneducated: Real estate investment is 100% something that requires knowledge to be successful in. Money may be hard to come by, but it’s not impossible to find. And if you have a good deal it gets even easier to find ways to fund your income. But first and foremost is having the tools to find a good investment. Afterall, where is your money supposed to go if you don’t know where to put it?

The more you know about real estate the better. A below-market investment will likely still be a good investment next year because you can collect income, build equity, etc. So do all the math. No matter how good a deal may appear, you have to know as much as you can. That may include estimating income streams, calculating the potential cost of repairs, and scoping out buying demand on the market.

Not Having Savings: If you can weather the storms of real estate investment you are almost certain to profit. You just need to have the money to cover emergencies. Part of the way this goal is accomplished is by not investing when you don’t have savings and by factoring emergencies and vacancies into your budget. Don’t have enough money to maintain your investment in the face of a vacancy? Then, guess what, you don’t have enough money to invest. And when you have money in reserves, you have the leverage to negotiate the best deals for yourself. You can hold out until you find the right sales price, tenant, and make all the necessary repairs.

Investing too much of your own money: Not only do you want cash reserves, but you also don’t want to spend all of them. Obviously, if you spend all of your reserves that you wouldn’t have any reserves. But there’s a difference between using your savings to buy your investment and still having savings while you invest. This is why it’s a good idea to keep your personal finances separate from your business’s finances. Always keep as much as you can in your business savings account so you don’t have to dip into your emergency personal savings, retirement account, primary home equity, etc.

Wanting Too Much: When it comes to flipping houses, you shouldn’t expect to make a huge profit. If it costs $10,000 to repair a property, which it easily could, then the person making the investment wants to make at least $20,000 in profit. Remember, the person doing the rehabbing is taking a huge gamble on your project because there’s no guarantee the house will sell quickly enough. So, you should be content making $2,500 on the deal and move on. The same goes for other real estate investments, where success is measured not by immediate, large gains but by consistent income over time.

Always Have A Few Ways Out: You should always be prepared for this to go sour because things can always go sour. There’s a lot of unknown unknowns.. For this reason, it’s wise to have multiple plans in place if things go belly up. For example, if you’re trying to flip a house and can’t, try wholesaling.

Not Treating Real Estate Like a Business: Your real-estate investment is like a business or career. It takes years for such endeavors to be successful. Like anyone who says they’re going to dedicate a year to writing or acting and then quit if they don’t make it, you’re setting yourself up for failure if you’re not willing to commit yourself for the long haul. As they say, it takes ten years to become an overnight success. Give yourself time to see if real estate is right for you before you ever even buy your first property. And you get started working at it hard because hard work is what it will take to succeed.

Investing Alone: This doesn’t mean not being the sole provider of capital. This means not having a strong support network. You need to have professionals of all sorts you can call up from everything from repairs to legal consultation to good old fashioned advice.

Pros of real estate investing

Less risk than stocks: Real estate isn’t as volatile as the stock market. You’re highly unlikely to experience an immediate spike in the value of your investment, but you’re also more likely to experience a continuous incline.

Steady Income Stream: When your rental property is properly secure, you’ll have a regular cash in-flow.

Good Tax breaks: The tax code has a lot of advantages for real estate investors built into it that let you make plenty of deductions, like depreciation, which lets you deduct the cost of your asset minus the cost of land (because you can’t depreciate land) and any maintenance you conduct on your asset as well.

Tends to be a solid long-term investment: Over time, most properties appreciate in value. While this shouldn’t be your primary motivation for investing in real estate, it’s certainly a benefit.

Cons of real estate investing

Potential returns aren’t as high as the stock market: The S&P 500 went up 600% between 1991 and 2019, but housing prices only went up around 160%. Appreciation isn’t your main reason for getting into real estate investment, but this is something to keep in mind.

Real estate investment is resource intensive: The barrier to investing in real estate is greater. While there are plenty of opportunities to get a loan, you don’t want to be living paycheck to paycheck. You need cash in reserve to use for the purpose of leverage, to conduct repairs, to survive vacancies, for emergencies, etc.

Real estate isn’t liquid: Unless you’re investing in a REIT or some sort of publically traded fund, it’s harder to turn your investment into cash.

Tenant and building maintenance is hard: Dealing with tenants (finding them, interviewing them, drawing up contracts, etc) and managing a property (repairs, emergencies, keeping up with local zoning laws, etc) are resource intensive endeavours. That’s why property managers are so useful, but if you have only one asset a property manager may not be worth it because paying them will eat up too much of your monthly income.

What are the Tax Consequences of Real Estate Investing?

You’re likely going to want a financial advisor for your real estate investment taxes because they can quickly get complicated and also require a great deal of knowledge in order to be fully beneficial. Each investor’s taxes will be different, and impacted by a variety of factors such as investment type, the amount of income generated, the lifetime of the investment, the investor’s other forms of income, etc. In broad terms, however, real estate investment profits will take two forms: income or appreciation. Income is subjected to income taxes and appreciation is subjected to capital gains taxes.

Income Taxes

Active Investments

Income earned through rental properties, either long term or short term, is taxed annually and subject to ordinary income taxes. As an active investor, you’re likely to be able to claim a lot of deductions (repairs, property taxes, insurance, etc). You also get depreciation. It’s important to note, however, that if you sell your property, you’ll have to pay depreciation recapture, which is a tax on the amount you subtracted performing depreciation. It’s also a tax that you pay whether or not you take advantage of depreciation, so it’s something you want to be familiar with for sure.

Passive Investments

If you’re investing in a mutual fund or REIT, then your income will take the form of dividends based on the number of shares you own. A private equity fund, on the other hand, can distribute income based on what percentage of the fund you own.

If you’re investing in a mutual fund or REIT, then your income will take the form of dividends based on the number of shares you own. A private equity fund, on the other hand, can distribute income based on what percentage of the fund you own.

Capital Gains Taxes

The structure of your investment will make a significant impact on how you’re taxed when you conduct your taxes. When you’re a partner you’re taxed on your tax return and not at the partnership level.Meanwhile, if you invest in a REIT or mutual fund then you’re taxable only at the investor level and not the fund level as long as those funds meet the legal requirement to be deemed the particular structure they aspire to have.

Short-Term-Capital Gains

Short-term capital gains are thought of as part of your yearly income. Your income tax bracket determines the rate at which your gains are taxed. If you buy and sell a property within a 12 month period, your earnings are short-term capital gain. Any appreciation of your shares of a REIT or the percentage of your partnership that you sell within a year will also be treated to short-term capital gains taxes.

Long-Term-Capital Gains

Your long-term gains are taxed, but likely at a lower rate. Taxpayers at or below the 12% marginal income tax bracket will usually not pay any long-term capital gains at all; those in the 22% to 35% income tax brackets will typically pay 15%; and those in the 37% tax bracket are most likely to pay 20%

If you sell an equity real estate investment of any kind that you’ve owned for over a year, you will pay long-term income tax on it.

You can do a 1031 exchange to defer paying capital gains taxes. That’s when you use the profits made from the sale of one property to buy another of equal or greater value within a predetermined amount of time. An opportunity fund can allow you to defer, reduce, and potentially even eliminate your capital gains entirely on particular gains.

Bottom Line
Now that you’ve got a taste of what real estate investment has to offer, there’s a good chance you may want to dip your toes into investing in a property directly or getting shares in a REIT. If so, start doing your research and see where the best place to direct your time, money, and other resources are. And while you’re supposed to keep your emotions out of your decision making, it’s okay to get excited about real estate investing. Real estate investing is exciting.

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