Call it the HGTV effect: Most Americans believe there’s good money to be made in real estate investing. And they might be right: From 2000 to 2016, real estate investment trust (REIT) indexes posted average annual returns of 10.71 percent. (REITs allow individual investors to buy shares in real estate portfolios that receive income from a variety of properties.)
“People always need a roof over their heads,” says Robert Mulcahy, senior vice president at Atlanta-based Angel Oak Prime Bridge, which issues loans to real estate investors. “If you’re strategic about it, real estate investing can provide a good passive income.”
But just because there’s a big potential upside—and it looks easy enough on TV—doesn’t mean it’s the right financial move for everyone. Here’s what you need to know about real estate investing.
Real estate investing is an activity intended to earn money from purchasing and selling property (such as land, buildings or homes) or from the cash flow associated with operating that property. There are a variety of ways to be a real estate investor, but here are three of the most common.
Purchase your own home. Believe it or not, simply making a wise purchase when it comes to your primary residence can be a form of real estate investing. All that’s required is living in the home until the market heats up to a point where you’ll profit by selling.
This can happen somewhat organically—you get in early in an up-and-coming neighborhood and home values shoot up—or you can move in with plans to update and improve the home, so it’s more attractive to the next buyers.
Bonus: Many lenders are more likely to approve mortgage loans with a lower down payment when the borrower lives on the property. As you’re updating and living in the home, you can also take a tax deduction for the mortgage interest paid.
Regardless of your intent, it’s important to make sure you’re ready for the financial responsibility of homeownership and can afford all the associated costs without draining your savings or compromising other big goals, like setting yourself up for a nice retirement.
Related: How Much House Can I Afford?
Fix and flip. One step from selling your own home for a profit is purchasing properties to “fix and flip” (or purchasing a property to renovate and sell) or “fix to rent” (or buying a property, updating it and renting it out for passive income). “Most homebuyers don’t want a project, so there are lots of opportunities to earn income if you’re willing to do the updating and repairs,” Mulcahy says.
One caveat: Unlike buying a primary residence, many mortgage lenders prefer larger down payments (of 20 percent or more) for a loan on a home you don’t plan to live in, Mulcahy says.
Buy REITs: If you’re looking to dip your toes into real estate investing without managing property, you can purchase shares in Real Estate Investment Trusts (or REITs). REITs are companies that own or finance income-producing real estate, and many are traded on major stock exchanges—so you can purchase shares just like you’d purchase other stocks or stock funds. Over the last five years, U.S. REITs produced an average annual return of 8.29 percent, according to the MSCI U.S. REIT Index.
Think real estate investing may be for you? Keep these smart habits in mind.
Always have a plan. It’s important to have a strategy for real estate investing. Are you looking for short-term income or long-term growth? A house flip in a hot market may yield short-term income, but a rental in a strong market can yield long-lasting passive income.
Know the market. The smartest real estate investors never invest in a completely unfamiliar market. Even if you find a great deal, if it’s in an area where nobody wants to live, you’ll have a difficult time selling or renting it.
How can you get to know a market? Spend time walking, biking or driving around the area; talk to neighbors and shopkeepers; and research school districts and crime stats. And don’t forget to tour other for-sale properties to get a sense of the competition and learn about pricing and demand in the area.
Assemble a trusted team. To succeed in home-flipping, you’ll need a good contractor, inspector, lender and property manager (if you don’t do this job yourself), Mulcahy says. Bring your inspector and contractor to look at properties before buying so they can help you assess the work and estimate costs. That way, you can budget for the entire project before making an offer.
Build wiggle room into budgets. Especially when you invest in an old home, you never know what you’ll uncover when you start the rehab. Mold, rot and other unforeseen problems behind the sheetrock or under the floors are common. Mulcahy recommends planning on spending an extra 10 percent to be realistic.