If you’ve ever rented an apartment, you’ve been on the opposite side of a real estate investment. You were, in essence, the product. The landlord was the investor. Real estate investing is a unique, and unusual, type of investment in that it is one of the only investments where investors can play a large role in the outcome of the returns.
With most types of investment transactions, the rate of return is driven almost exclusively by external market forces. With real estate investing, the property owner can set rent rates, choose properties, and influence the market in other ways. However, not all real estate investments require you to be a property owner.
What Is Real Estate?
In its most basic form, real estate is property of some kind. It’s real property, as opposed to paper or virtual investments. Real estate is usually contrasted by investments in stocks of corporations, or trading of currency on a foreign exchange market.
Real estate profits come from two sources: rental income, and the appreciation of the property’s value. In many, but not all, real estate investments, the property includes a building of some type. For example, an apartment complex would be considered a real estate investment.
The renters provide part of the rate of return on the investment, while the appreciation of the building provides the other part. Over time, the landlord hopes that rental income exceeds maintenance expenses, and that the appreciation exceeds any mortgage on the apartment building.
Some types of real estate are simply land, with no structures. In this arrangements, the property owner adopts a buy and hold strategy, owning land with the expectation that land prices will increase. In some cases, the land owner will lease the land to developers so that they may build on it, improving it.
While real estate refers to physical property, not all real estate investors are property owners directly. Major types of real estate investments include:
- Real property
- Real estate investment trusts
- Real estate investment group
- Real estate trading
- Real property –
Real property may refer to any kind of real, physical, property. It may be land or an apartment building. These types of investments require you to become intimate with the process of buying and selling real estate, managing properties, managing tenants, and real estate marketing.
You must also be a handyman, or have the ability to manage others in the repair and maintenance of your real estate properties.
People who do this are called landlords. If you hire a property management company to take care of the bulk of the maintenance and rental collection, you are considered more of a property owner, rather than a manager.
Finally, some real estate property owners are merely landowners, and they lease or rent the land to commercial developers so that they may improve the property and conduct business.
- Real estate investment trusts –
Real estate investment trusts, or REITs, are special types of investments. REITs do not require you to own property directly. Instead, a trust (a special type of legal entity), owns the property and you buy shares of the trust. You are part owner of the trust (business). While this gives you certain rights in the business, it does not give you control or ownership of the underlying properties.
Most REITs buy either residential, commercial, or a mix of both types of real estate. The trusts must pay out 90 percent of its taxable profits in the form of dividends to investors in order to keep its status as a REIT.
By doing this, REITs avoid paying corporate income tax, which reduces its tax liability and saves money, allowing the trust to pass the savings on to you. Of course, you must then pay tax on all of the investment earnings, but there is more being paid out than there otherwise would be.
- Real estate investment group –
Real estate investment groups are similar to REITs, but they are more like mutual funds than they are like businesses or trusts. If you want to own rentals, but you don’t want to be a landlord, this is the solution for you.
A management company buys up real estate in the form or apartment complexes or condos, and then allows investors to buy them through the company as shares. An investor may own one or more units of the property, but the company is the manager of the property and takes care of all of the maintenance, rental collection, advertising, and evictions.
- Real estate trading –
Real estate trading, or “flipping,” is when investors buy homes to rehabilitate them. Then, they turn around and resell them for a profit. Real estate trading is a short-term endeavor, similar to day trading or swing trading in stocks, but for real estate.
This type of real estate investment involves special knowledge of how to rehabilitate (remodel) homes that are in disrepair, effectively making unsalable homes salable again. Most real estate traders employ dedicated marketing specialists or real estate agents, construction experts or contractors, and may have relationships with subcontractors for specialty work, like electrical repair or plumbing.
Advantages Of Investing In Real Estate
Real estate investing has many advantages. First, it’s not subject to the normal gyrations of the stock market. Many real estate investors enjoy healthy returns on their investment even when the stock market is in mid-correction.
Real estate also gives investors options. If you’re first starting out, you may want to start with a more “hands off” approach, like investing in a REIT or an investment group, while you learn more about the business.
With stocks, you must have considerable knowledge about the investments you’re investing in. With real estate, you may have little or no direct knowledge of the property. But, if you understand the basics, and you find a profitable real estate group, you can benefit from the knowledge of others.
Disadvantages Of Investing In Real Estate
Real estate does have disadvantages. The most important one is that real estate can be expensive to get into. Unless you’re buying into a REIT or an investment group, your initial outlay may be several hundred thousand dollars or more.
Real estate ties up your credit, too, and you will be limited by mortgages that you take out. In other words, banks will only lend you a certain percentage of your income, and they tend to look for a debt to income ratio of less than 40 percent. If you have bad credit, and no savings, it’s difficult to invest in real estate.
Finally, real estate can be significantly affected by the mortgage market, interest rate fluctuations and recessions. The 2008 financial crisis, for example, destroyed many real estate investors – even those that had long successful track records.
Unique Tax Consequences
Real estate enjoys special tax advantages in some countries. If you’re a landlord, you may be able to deduce interest on mortgage loans, depreciation, the cost of repairs to the property, local and long-distance travel, a home office, any employee expenses you incur, theft losses, insurance, and any legal or professional services used in connection with the property.