Real Estate, an attractive alternative asset investment.
Compared to Traditional assets like stocks and bonds, investing in real estate means you are investing in a class of alternative assets. Historically, these assets have been difficult not only to assess but also to afford.
Thanks to the American JOBS Act, however, this has changed drastically, especially for non-accredited investors.
The upsides of investing in Real Estate
With non-accredited investors now able to access this alternative asset class, you no longer need to be wealthy or have a lot of capital to invest in real estate. This means you won’t need any accredited investor status, or a lot of expendable income to participate.
The upsides to investing in real estate are many, including:
- Appreciation potential
- Portfolio diversification
- Tax Advantages
For many, however, this market is uncharted territory. Investing in Real Estate can be intimidating, especially if you’re new to investing. But this doesn’t mean you should avoid it altogether.
If approached correctly, investing in this market can be a lucrative and reliable method to generate substantial returns. It can also become a consistent income stream, while supplementing your portfolio with the unique benefits listed above.
Along this backdrop, this article can help you understand the fundamentals of investing in real estate, including a number of different ways that you can get started with immediately.
Let’s begin: What does a Real estate investment look like?
Real estate is all about owning, selling, or leasing land or property. There are primarily 3 ways you can invest in real estate:
- Residential: This is any type of housing for individuals or families. It might be townhouses, duplexes, condominiums, co-ops, a block of flats, etc. (Any housing accommodation.)
- Commercial: In this case, you use your land or property for business purposes. This includes office spaces, shopping plazas, restaurants, educational facilities, medical institutions, or even multi-family apartment buildings.
- Industrial: For industrial business purposes. Industrial classifications include: shipping or storage warehouses, factories, or power plants.
How can you earn profit from real estate investments?
If you want to make money on real estate, there are 3 ways you can earn profit.
- Appreciation: This is the increase in value of an asset or property over time. You typically assess appreciation after you sell a property. This value will depend on the local real estate market, as well as any improvements you make on the property.
- Interest from loans: Investors can also earn interest on debt investment. This is when you lend money to a real estate developer. You then earn interest as the developer repays the loan, providing a continuous cash flow for the investor.
- Rent: By owning a property and renting or leasing it out, the property owner is able to generate regular income. This income can belong solely to the renter if he/she manages the property themself, or income can be shared with a company specializing in property management.
Each of these three categories has varying degrees of reward versus risk. But no matter what type of real estate investment it is, you need to choose investments wisely. Any opportunity should be put through a rigorous underwriting process to determine if that investment is financially sound and if it can meet your financial goals.
Rate of return is one key metric many investors use to analyze real estate. And then you have capitalization rate (or “cap rate”), often the metric of choice for more experienced investors, which has become the preferred method to analyze an opportunity.
Active vs Passive Investing
Next, you need to know about both active and passive investment vehicles. There are 3 types of active investment. There are 4 types of passive investment. Let’s look at these now.
Active Real Estate Investing (You handle the work)
Active investing in real estate is not easily done. It requires firstly a great deal of knowledge about the real estate market. And secondly, either hands-on management or delegating responsibilities.
Depending on the nature of your investments and the number of your investment opportunities, how much time you need to spend actively investing will vary. Some investors do this part-time, while others with complete ownership (and responsibility), or investors who have more properties, will find active investing a full-time job.
Owing to this, active investors need not only financial know-how but also negotiation skills if they want to improve their capitalization rate and their overall return on investment.
The 3 types of active real estate investments
House Flipping:
“Flipping” is the process of buying a property at a lower price than you intend to sell it for in the future. It involves making improvements on a property and completing all necessary renovations before “flipping” (selling) the property for profit.
In this investment category, the longer you keep the property without leasing it, the less profit you earn after it has been “flipped”. The goal is to hold the property only on a short-term basis, increase its value, and then sell as quickly as possible.
The problem with investing in house flipping, however, is that you need the financial resources to manage a property for longer periods of time if necessary. With real estate, you can get locked into holding onto a property for longer than expected, making it difficult to sell at your profit target.
Because of this, house flipping calls for extensive and prior knowledge about real estate. You also need to stay within your budget, and within your time constraints. If you do not, then you risk losing all of your potential profit, or, worse yet, losing money.
Wholesaling
Another form of house flipping is wholesaling. This is when an investor buys a property which they believe to be underpriced, and then quickly resells that property to another investor at a higher price for profit.
Often, the wholesaler is looking for a property in need of renovations. The intention is to quickly resell this property to a house-flipper who is willing to perform the renovations.
In other words, the wholesaler is looking to buy a property that can be sold to an investor who wants to use it for house flipping. The second investor will be buying the property to do renovations and increase its value before the next resale.
This investment category comes with a high degree of risk, and also requires real estate and financial proficiency. Due diligence is necessary, as is access to a network of house-flippers to find a buyer within the given time constraints. Otherwise, just like with house flipping, you have the risk of not earning a profit, or, even worse, losing money on your investment.
Rental Properties
The most common form of investing in real estate is renting a property. This investment vehicle is a long-term commitment, requiring the investor to not only manage the property but also to find and keep paying tenants.
Any type of property can be used for rental, including residential, commercial, or industrial. The investor’s responsibilities include things like maintenance, rent collection, repairs, and evictions. It also involves legal obligations that must be fulfilled for the property or the tenants.
Any type of property can be used for rental, including residential, commercial, or industrial. The investor’s responsibilities include things like maintenance, rent collection, repairs, and evictions. It also involves legal obligations that must be fulfilled for the property or the tenants
This can be a part-time or full-time job, depending on the number of properties an investor owns. It is possible to hire a property managing company, although these work on a fixed or a percentage fee. By doing this, investors can transform their active investment into a more passive investment. The tradeoff, however, is that they lose a portion of their monthly income.
Airbnb
Another way you can go about renting a property is through Airbnb. Everybody knows about this service, so let’s skip the details and get right into how it works.
With Airbnb, you register your residential address, specify whether you are renting part of the property or all of it, and then designate how long the property will be available for renting tenants. You can rent for as short of a term as 1 night, or even on a monthly basis for longer-term.
Typically, Airbnb is a replacement for hostiles and other short-term rental. Your main tenants will be travelers, tourists, and people visiting the area around your property. This is a good way to earn regular income on a property, while also requiring less supervision and less expertise to manage this investment.
Airbnb takes care of all the bookings of the property, and even arranges contracts between the investor and the tenants. Renting through Airbnb is typically a part-time job, but it can even be a full-time commitment, depending on the number of properties you have available and how much time you want to put into it.
Passive Investing (Let somebody else do the work)
With passive investing in real estate, the goal is to be as hands-off as possible with your investment. Typically, this investment vehicle involves the investor hiring professionals to handle everything.
These professionals, or real estate companies, manage all the work on the investor’s behalf. As with stocks and bonds, passive investors are only responsible for their investment and are not concerned with management.
4 Types of Passive Investing
1 – Private Equity Fund
Private equity funds involve investors pooling money together into a single fund. These funds tend to be limited liability partnerships, with a designated manager or management group who oversees and actively manages the investments.
This means investors take a more hands-off approach, and do not necessarily need to be involved on a regular basis. Because of the fact that minimum investments tend to be quite high, however, investors in private equity funds need a greater degree of financial and real estate knowledge.
Access to private equity funds is most often only for accredited and institutional investors with a high net worth. Entry minimums vary, but are usually no less than $100,000. This is because private equity funds generally have very low liquidity, limiting this market to investors who can afford to have money locked up for longer periods of time.
Also, private equity funds usually follow the “2 and 20” model, in which an annual management fee of 2% is charged, with an additional 20% fee on any profits generated by the fund.
2 – Opportunity Funds
Next, there are Opportunity Funds. This model involves investors pooling money together into a single fund that will invest in Qualified Opportunity Zones. These zones are census tracts of low-income communities, designated by state governors and certified by the US Department of Treasury.
Legally, opportunity funds must invest at least 90% of assets into properties or businesses within these opportunity zones. When it comes to real estate, this program was designed to promote the improvement of neighborhoods.
Because of this, the types of real estate investment are limited to the construction of new buildings, or the redevelopment of formerly unused buildings. If it is not one of these investments, the fund must invest more on improvement than the price of the property purchased, and has 30 months after buying the property to do this.
One advantage to investing in Opportunity Funds is capital gains tax incentives. When investing in an Opportunity Fund, the investor is able to defer any taxes realized on capital gains until December 31, 2026.
If the investment is held 5 years prior to this date, they can receive a 10% reduction in tax liability on their deferred capital gains. If they’ve held it for at least 7 years prior to that date, the reduction is 15%. And if 10 years, all capital gains should be permanently excluded from capital gains taxes.
With Opportunity Funds, it’s a long-term investment. Assets can be liquid, or they can be illiquid. In order to get full tax advantages, you have to invest before December 31, 2019, and hold onto that investment for at least 10 years. This is ideal for off-hands investment. But, just as with private equity fund investing, Opportunity Fund investing is typically limited to investors who can afford to lock up money for longer periods of time.
3 – REITS:
Real Estate Investment Trusts (REIT) are companies that own, and often operate, real estate that produces some form of income. REITs traditionally own many types of commercial real estate. These can include office and apartment buildings, warehouses, hospitals, shopping plazas, hotels, and timberlands.
Usually, REITs offer investors a portfolio of real estate investments. It’s like a mutual fund, providing average investors access to real estate investments. According to law, REITs must have at least 75% of its gross income from real estate, and also must invest 75% of its assets or more in real estate. Further, every year it should distribute 90% or more of taxable income to shareholders.
There are three ways to categorize REITs.
- Private REIT (Not registered with the SEC, and not publicly traded on the stock market)
- Publicly-traded REIT (Registered with the SEC, and traded on the stock market)
- Public non-traded REIT (Registered with the SEC, but not traded on the stock market)
4 – Online Real Estate Investments Platforms
The final category of passive investment is available through online real estate investment platforms. These platforms are provide average investors access to investment opportunities that would otherwise be out of reach or difficult to find on an individual basis.
What is more, real estate investment platforms give investors the chance to invest in single investments, or in a diversified portfolio of real estate. On some platforms, you can invest in only debt investments, while other platforms allow investment in both debt and equity.
Some have restrictions in place to focus on a specific city or region, and others can cover an entire country. Moreover, there can also be accreditation requirements or high investment minimums, but this isn’t always the case.
Take Fundrise for example. They pool investments of all sizes, and leverage collective buying power to provide average investors opportunities they would not usually be able to access. There’s no accreditation requirements, nor is there any restrictions based on the investor’s net worth. It also provides greater liquidity than some private markets with the option for quarterly redemption.
Conclusion
Historically, real estate has proven its value to portfolios and has a track record of sound performance. It has the potential to provide meaningful diversification to portfolios, as well as high potential returns to investors.
Just like with any investment, investing in real estate requires due diligence, as well as an understanding of the potential risks and returns that come with this market.
While there is profit to be realized, the various categories of real estate investment will call for varying amounts of time, capital, knowledge, and patience.
Depending on your investment strategy, and who you are as a person, you need to decide what type of real estate investment is for you. If you’re a fast-paced, hands-on investor, you may benefit most from active investing in house-flipping or wholesaling.
Conversely, if you don’t want to manage a property or become a landlord, you may want to look into more passive investment options in which most of the work is done for you. It all depends on your time availability, your capital, and who you are as a person. Look into the various options, decide what you can and cannot do, and always consider talking to a financial professional if just getting started.
Guest Post Written by Ben Lakoff, CFA, at Alt Asset Allocation, working to help open investors’ eyes to global investments beyond what’s offered by traditional brokers, like stocks and bonds. We exist to educate and present investment options for the forward-thinking everyday investor.
