Real estate investing is a proven path to significant wealth and, as with any investment, starting young can supercharge your potential returns. I own 11 rental properties that bring in approximately $5,000 a month in cash flow after all my expenses. But one thing I would have done differently is investing in real estate much sooner (I bought my first rental property when I was 31).
Here, I’ll cover the basics of becoming a real estate investor and everything you need to know before making your first real estate investment.
Is real estate a good investment?
Long-term real estate investments are attractive because they can provide both capital appreciation and cash flow from rental income. Although real estate prices in the United States have appreciated consistently for decades, your success as a real estate investor depends on finding good deals and managing your risks and expenses wisely.
An abundance of influencers and reality TV shows portray young real estate investors seemingly killing it. If you’re not a bit skeptical, you could easily believe that making millions from real estate is as easy as buying a fixer-upper and a few trips to Home Depot.
The truth is, making smart real estate investments is an art that requires a significant investment in educating yourself and finding the perfect deal. And a single bad real estate investment could cost you hundreds of thousands of dollars and potentially ruin your credit.
Are you ready to invest in real estate?
Before you can become a successful real estate investor, you should have the rest of your finances in order. If you’re battling credit card debt or don’t yet have a a few months’ expenses saved in an emergency fund, tend to those first.
Typically, a strong credit score is a prerequisite owning property if you plan to get a mortgage. Assuming you have the capital available for a down payment, getting a mortgage may be your largest hurdle to buying your first rental property, so it pays to give that credit score some attention.
Finally, think about how real estate will fit into your overall investing strategy. Personally, I wouldn’t go out an play the real estate game before taking full advantage of tax-advantaged retirement accounts — an IRA and, if you have one at work, a 401(k).
Ways to invest in real estate
There are several ways to invest in real estate, and each method has its pros and cons.
Direct real estate investments
When most people think about real estate investing, they likely picture buying investment property. In direct real estate investing, the investor buys a building and becomes a landlord.
As the landlord, the investor must pay for the building’s maintenance and property taxes, but collects rent from tenants. If the investor collects more rent than they pay in expenses (including any mortgage payments), the investment produces cash flow that can be income for the investor. Even if the investment is not cash flow positive, the investor may still profit if he later sells the building at a higher price.
Direct real estate investment is potentially the most lucrative way to invest in real estate, but it’s a big commitment. Investors must put their own money and credit on the line and continually work to ensure their properties are leased and maintained.
House flipping
Flipping is when an investor buys a distressed property cheaply, makes repairs and improvements, and then quickly resells the property for a profit. Flippers stand to make (or lose) tens or hundreds of thousands on each deal, making it a high-risk/high-reward investment.
Unless you have both ruthless deal-making skills and construction know-how, you might want to leave flipping to the pros (despite what you see on TV!)
Real estate investment trusts
A real estate investment trust, or REIT, is an investment fund that buys real estate on behalf of its investors. There are thousands of publicly-traded REITs that you can trade on the stock market just like any other stock or fund. There are also private REITs that you can invest in through online real estate platforms.
REITs are an attractive way to diversify a portfolio of stocks and bonds with real estate or to invest in real estate passively. REITs can provide much greater diversification than building your own portfolio of rental properties. That reduces risk, but it may also limit potential returns. You also have no say in what properties the REIT buys.
Real estate crowdfunding
Online real estate platforms like Fundrise and Ark7 make it possible to invest in real estate for as little as few thousand dollars. These platforms “crowdsource” real estate investments, collecting small amounts of money from dozens of investors to buy properties.
Unlike when you invest in a REIT, you can choose which deals to invest in.
When you invest in real estate crowdfunding, you’ll earn your share of any cash flow and your share of any capital gains when the property is sold. Your money will be tied up during the length of the investment. Your returns will be lower than if you bought a property yourself because the platform itself takes a percentage of investment returns. It’s also not necessarily lower risk; if a property needs significant maintenance or sits vacant for too long, there may be a capital call that requires investors to put up more money on short notice.
» More: Compare the best online real estate investing platforms
How to invest in real estate as a beginner
If you you want to investing real estate but either don’t have the capital, credit or desire to buy property yourself, a REIT or crowdsourcing investment is a great way to get exposure to real estate investing without risking a lot. For the rest of this article, however, we’re going to assume you’re interested in a direct real estate investment.
Understand cash flow
Some people invest in real estate for appreciation, but smart investors invest for cash flow.
Cash flow is the money you make from rental properties every month after all expenses are paid. The great thing about cash flow is it increases over time without ever eating away at your principal investment. It is like a stock where the dividend is so high that you never have to worry about the stock increasing in value to make great returns.
Cash flow will also increase over time because rents will go up with inflation while your mortgage payments stay the same. Eventually, you will pay off your loan and your cash flow will increase significantly.
On my rentals, I am seeing 20% cash on cash returns, which is not always easy to do, but possible depending on your location and amount of money you have to invest. Those returns do not include the tax advantages of rentals, equity pay down and possible appreciation which all increase your ROI. Here is a great article on how to calculate cash flow properly.
Understanding the cash flow you need to make a real estate investment worthwhile is the first step. You need to look at property prices in your area, figure what the mortgage payments and property taxes will be, and then look at the the rental market and what you can expect to collect.
Many investors use the 2% rule, a rule of thumb that says the monthly rent you collect should be equal to or greater than 2% of the purchase price of the property. For example, if you buy a property for $200,000, you would need to be able to collect at least $4,000 a month in rent. Hopefully, you can quickly see how that’s not necessarily an easy rule to satisfy.
Decide how you will make your property purchases
They say cash is king and, in real estate, that’s certainly true. If you’re fortunate enough to be able to buy a property in cash, you’ll avoid the red tape of the mortgage process, be able to close faster, and get to positive cash flow more quickly because you aren’t making interest payments.
If you need a mortgage, understand that most banks will require an investor to put at least 20% down on a rental property.
That is a lot of money to most people, especially when you consider a property may need repairs, you have to pay closing costs and you want to have money in reserve in case something goes wrong. It can easily take 30% or more of the purchase price in cash to comfortably purchase a rental property.
If you buy a primary residence that you will live in, you can put no money down with certain loans (USDA, VA) and almost certainly buy a home with as little as 5% down. Although you can’t rent out a home that you buy as an owner occupant right away, you can rent it out after you have lived in the home a certain amount of time (usually one year). This is how many people I know got started in real estate investing at a young age — they bought a single family home or condo, lived in it for a year or two, rented it out and bought a second home to live in.
Another option is to buy a duplex or other multi-family property and live in one unit and rent the other(s). You can also buy a multifamily property that is between one and four units and live in one of the units to qualify as an owner occupant. After you have lived in the unit for 12 months, you can rent out the entire building and repeat the process.
When you are younger, it is much easier to move into a house that you want to make a rental property. When you have a family it is tough convincing your spouse and kids that you need to move every year and into a house that may not be up to their standards.
Finding a good rental property
It is not easy to find rental properties that generate the returns I get, but I am not an aberration either. Many investors get higher returns than I do, but they have put in a lot of time and effort learning their market, learning about real estate, and learning about rental properties. The older you get, the less time you have with more job commitments, more family commitments, and more hobbies you discover. There is less time to learn about real estate, your market, and how to make money in this business the older you get (unless you get to retirement age).
I also fix and flip about 10-15 homes every year so I specialize in getting great deals on real estate. I buy most of my deals off the MLS even with rising prices and a lot of competition.
Here are a few tips on getting great deals:
- I am a real estate agent, which helps me get great deals and lets me act very fast. I am not saying all investors should be agents, but it sure helps!
- If you aren’t an agent spend a lot of time finding a great agent that will act fast for you and find you deals.
- Spend time researching prices in your market and rental rates so you know what a good deal is.
- Do not depend solely on a real estate agent to find you good deals. Many agents are not investors and won’t know what you are looking for.
- Join a real estate investing club in your area to meet other investors and learn what they are buying and how.
Understand the risks
There are definitely some risks and work involved with owning rental properties. The biggest mistake I see investors make is buying for appreciation with negative cash flow.
It is great if my houses appreciates, but I love the cash flow. With cash flow, I have money in my pocket that I can use to buy more properties, invest somewhere else, or spend on something fun. If you have negative cash flow, there is a great chance things will end badly.
The problem with negative cash flow is most investors underestimate the money they will have to spend on their rental properties. There is also no guarantee the market value of your property will rise or when it will rise. Given enough time, real estate will probably appreciate, but it could also go down in value before that happens. How long can you continue to pay money into a property every month? Eventually, people run out of money and are forced to sell, sometimes for less than they bought a property for. If you have positive cash flow, you won’t have to sell and you won’t want to sell, because it is putting money in your pocket.
Another issue that people forget about is maintenance. You have to budget for maintenance items every month. I figure 10% to 20% of my monthly rents will go to maintenance, depending on the age and condition of a property. If you don’t account for maintenance you may not make any money on your rentals.
On my rentals my average mortgage payments range from $400 to $600 including taxes and insurance and my rents range from $1,100 to $1,500 a month. After accounting for possible maintenance and vacancies, my cash flow is about $500 a month.
It takes time to manage a rental property as well. You will have to find tenants, create a lease, account for expenses and income properly and make sure everyone pays on time. You could also hire a property manager to do all this for you for about 8% to 10% of the monthly rents, but you have to budget for that expense as well.
Conclusion
Rental properties can be an awesome investment that allows you to retire early. It is not a get rich quick scheme and it is not easy to do. Real estate investing takes time, flexibility, and ambition to make it work well. The sooner you get started, the easier it will be and the better off you will be later in life.