When you think of investing, there are three major liquid asset classes; stocks, fixed income securities and commodities. There are also alternative asset classes such as real estate, private equity, hedge funds, derivatives, etc. Today we’ll closely look into one of these alternative asset classes: real estate.
Real estate investing alone has created scores of millionaires and even billionaires around the globe. With the rise of complementary new economy businesses like AirBnB, Home Away and Rent Like a Champion, real estate investments are even more attractive. There are numerous options in the market today to get into real estate investing. But why invest in real estate? When should you buy real estate? How to invest in a property? We’ll have a look at real estate basics, why passive investing is important and what realty investment can bring to a realtor investor.
- How does real estate investing work
- How to invest in real estate
- Evaluate real estate investments
- Calculate returns from real estate investing
- What are the associated fees of real estate investments
- Pros and cons of investing in real estate
How does real estate investing work
There are two main types of real estate investments: residential real estate investing and commercial real estate investing. The traditional way of investing in real estate is to physically buy a property. This can be done through a real estate agent or directly from the seller. Most real estate owners use agents. Real estate agents buy and sell on behalf of the buyer and seller. Buyers are businesses and individuals looking to purchase a property. Sellers include:
- Builders who sell properties in pre-construction mode, near completion, or fully build units.
- Businesses and individuals that own properties.
There are multiple ways to earn from investing in physical properties. The two main ways include earning monthly rental income and capital appreciation on your property through gains in its market value. This is especially true for residential real estate. The ways to earn from commercial real estate investing may be slightly different than residential given the use-case for those properties.
For example, in additional to rent and capital appreciation, a way to earn from commercial real estate may be by providing advertisement space or offering additional services, such as property maintenance.
Aside from buying physical properties, investors can gain real estate investing exposure through mutual funds and publicly traded real estate investment trusts (REITs) and ETFs. The ways you earn money using these investment vehicles includes price appreciation and dividends. We’ll explore these options in more detail below. As for deciding whether it is worth investing in a particular property or real estate investment vehicle in question, we’ll look at ways to value and calculate real estate investment returns further down this article.
How to invest in real estate
- Direct Real Estate Investing
- Real Estate Investment Trusts (REITs)
- Investment Mutual Funds
- Exchange Traded Funds (ETFs)
- P2P Lending
Direct Real Estate Investing
We’ve already discussed the traditional way of buying a physical property. Whether that be a commercial or residential property, it’s about acquiring a physical real estate unit. This requires huge sums of money, which retail investors may not always possess. An additional drawback of this traditional method is that real estate properties are illiquid, which basically means that it takes effort and time to convert the value of the property into cash.
These drawbacks can be eliminated with the rise of products that make it easier for you to gain exposure to real estate. An investor no longer needs to do “direct real estate investing”. There are alternative forms of real estate investing that you can now explore. Many of these ways allow you to invest in real estate online from the comfort of your home. Let’s look at some of these below:
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are special types of corporations that are required by law to invest only in real estate. They payout 90% of their earnings as dividends to their shareholders. If the rental yield (annual rental income / market value of the property) that you are currently getting from a physical investment property is lower than the yield of some high quality REITs, then you might want to explore REITs more.
REITs such as Realty Income (O) pay a 5%+ dividend yield and have consecutively grown their monthly dividend for 22+ years. REITs provide you with some additional benefits that direct real estate investing does not:
- You can invest small sums of money, as there are no minimum shares you have to buy for most REITs. Therefore, you can buy as little as one share through the particular stock exchange.
- You receive monthly / yearly income from each REIT share that’s in your portfolio.
- REITs also provide you with liquidity. You need time to sell physical real estate investments even if the market is super hot. With REITs, you can buy or sell them by simply logging into your brokerage account and buying or selling the stocks with a click of a button. This is the same to regular stock trading on the stock market.
Investment Mutual Funds
Investing in individual securities may be difficult and risky for many investors, especially beginners. This may be because of a lack of understanding on how to diversify portfolios effectively. One solution to this diversification and risk problem is to invest in real estate investment mutual funds. A real estate investment fund usually invests in a number of REITs across different industries and achieves effective diversification.
Drawbacks of these mutual funds that hold a basket of REITs include high management fees and they are generally less liquid than individual REITs. This is because, usually, mutual funds trade at their net asset value (NAV) at the end of a trading day. In contrast, REITs are traded like regular stocks on a stock exchange.
Exchange Traded Funds (ETFs)
ETFs are funds that are traded day-to-day on stock market exchanges similarly to stocks. Real estate ETFs hold a basket of real estate securities and REITs, thereby offering diversification just like mutual funds. The difference is that ETFs are more liquid, given that they trade on exchanges, and have lower management fees or expense ratios.
Most ETFs are passive, which means they track the performance of an index by investing in the same securities as the index. This means that most real estate ETFs replicate the performance of certain real estate indexes. For example, the largest real estate ETF, the Vanguard Real Estate Index Fund (VNQ) closely tracks the return of the MSCI US Investable Market Real Estate 25/50 Transition Index.
P2P Lending
P2P lending is a rather new way of participating in real estate investments. However, there are some crucial differences in comparison to the previous mentioned ways of investing in real estate. When you invest in real estate, you usually become the direct or indirect owner of the property, but P2P lending is different.
When you invest in P2P lending you basically invest in property loans (usually short-term). That means you, as investor, lend money to others who then buy real estate. In return you get paid attractive interest rates on a monthly or yearly basis while the loan itself is backed by the property. This comes close to the business model of traditional banks. For example a marketplace for short-term property backed loans is EstateGuru.
How to evaluate real estate investments
Sales comparison, cost approach and income approach are the three most common methods used by real estate investors. These methods are used to value investment properties and spot real estate investment opportunities. Whereas, if you are trying to evaluate an investment in a REIT then the traditional P/E ratio doesn’t work here. You have to evaluate it using the P/FFO (price / fund flow from operations). Let’s look at each in more detail below:
Sales comparison approach
With this approach you derive the value of your property by comparing it to similar properties that have been recently sold. For example, let’s say you own a detached residential property within a community. To determine its current value it’s ideal to compare it to another very similar detached residential property that has been recently sold within that same community. This will help determine the value of your property. Obviously, properties usually are not identical. Therefore, part of this approach needs to compare property features, such as:
- Whether both properties have a garage, fireplace, pool, jacuzzi, etc.
- Number of washrooms and bedrooms
- Square footage of the house and land
- And many other features
You can then adjust the price of the sold property based on the comparison of these features and deduce what the value of your property is. The more features your property has, the higher the price adjustment up, and vise versa.
Cost approach
With this method you separately value the land and the building. Essentially the calculation here is the cost of land plus the cost of building a house, minus depreciation of the building. This method makes the assumption that any buyer would rather invest in a property that’s already constructed on land, rather than purchase comparable land and build a comparable property on it.
Income capitalization approach
With this method you calculate a property’s net operating income (NOI) and divide it by a capitalization rate. To calculate the net operating income you have to determine the potential gross income that the property can generate. Then subtract that amount by a presumed vacancy and operating expenses. The capitalization rate is the rate of return investors hope to get from the property. So if a property’s NOI is $20,000 and the capitalization rate is 8%, then the value of the property is $250,000.
REIT valuation
P/FFO or price/fund flow from operations is the most preferred valuation method for publicly traded REITs. FFO in this valuation method is calculated on a per share basis. To calculate FFO, you have to take the net income and add depreciation and amortization, as well as subtract gains on the sale of property. To calculate FFO per share you simply divide it by the number of outstanding shares for the REIT.
So if the share price of a REIT is $20 and its FFO per share is $2, then the P/FFO is 10. If a comparable REIT’s P/FFO is 12, then the former REIT with P/FFO of 10 is considered a better investment opportunity. This is because it’s considered undervalued compared to its peers.
Calculate returns from real estate investing
Rental yield and property price appreciation are the two main sources of return when you own investment properties. Let’s go through an in-depth example and see how to make money in real estate. Keep in mind this example ignores personal income taxes:
Annual rental income and operating cost assumptions
| Rental Income | $30,000 |
| Property Maintenance | $2,000 |
| Property Management Fee | $2,400 |
| House Insurance | $1,200 |
| Property Tax | 0.77%, which is $2,695 in the first year |
Given these assumptions, the first year net operating income is equal to $21,750. The calculation is as follows:
NOI = Income - Operating Costs NOI = 30,000 - (2,000 + 2,400 + 1,200 + 2,695) = 21,750
The cap rate that can be derived is equal to 6.20%. Here’s the calculation:
Cap Rate = NOI / Property Value Cap = 21,750 / 350,000 = 6.20%
Let’s dive a little deeper into this property investment example and calculate net worth increase and cash flow. Here are additional data points we need to look at:
Mortgage Assumptions
| Purchase Price | $350,000 |
| Downpayment | 20%, which is $70,000 |
| Mortgage Interest Rate | 3% |
| Principal Amortization | 30 years |
| Monthly Mortgage Payment | $1,180.49 |
| Annualize Mortgage Payment | $14,166 |
| First Year Interest | $8,400 |
| First Year Paid Principal | $5,766 |
| Second Year Interest | $8,227 |
| Second Year Principal | $5,939 |
Other Assumptions
| One Time Expense: Closing Costs | $8,000 |
| Inflation Rate | 3% |
Cash flow is basically all the incoming cash minus all the outgoing cash. Calculating the first year cash flow in this example gives us a slightly negative number of -$461. The formula looks like this:
First Year Cash Flow = Incoming Cash - Outgoing Cash First Year Cash Flow = 30,000 - (14,166 + 8,000 + 2,000 + 2,400 + 1,200 + 2,695) = -461
The main reason for this negative cash flow is due to the one time closing cost expense in the first year. Let’s calculate the second year cash flow to get a better sense of how much cash flow you can achieve through passive real estate investing. Keep in mind the inflation rate to determine the new rental income and expenses:
Second Year Cash Flow = 30,075 - (14,166 + 2,005 + 2,406 + 1,203 + 2,776) = 7,519
In this example we assume an 80% loan that’s possible to get through a bank. Because of this the increase in net worth is magnified relative to the actual cash that was invested. Therefore, the yearly net worth increase is not just 3% (inflation rate) of 70,000, but is much higher. One way to think about net worth increase is:
Net Worth Increase = Cash Flow + Principal Paid + Property Value Increase
Let’s calculate this value for the second year since the first year is skewed due to the closing costs:
Second Year Net Worth Increase = 7,519 + 5,939 + (371,315 - 360,500) = 24,273
As you can see the net worth increase in just one “regular” year (i.e. not first year) is substantial relative to the cash required for this investment. Again, this is because of the leverage you get due to a bank loan. Over the long term this leverage has an even more apparent effect. For instance, in the first 4 years your net worth will increase more than the initial equity investment including the initial closing costs.
Is real estate a good investment?
So, is real estate a good investment? You can answer this question yourself by comparing the property example above with other investment options out there. Some of the best real estate investments are those where the rental yield is high, while the property appreciation and principal payoff continues at a steady pace. Should you invest in stocks instead if they too provide a stable 6% yield? Investing in real estate vs. stocks should be seen less as competitors and more as compliments to one-another. The right answer is to invest in both for optimal portfolio diversification.
What are the associated fees of real estate investments
We mentioned most of the fees and costs of real estate investing in our example. But let’s dive a little deeper into these fees. When you buy a property the first fees you’ll encounter are closing costs, which includes legal fees, land transfer taxes, realtor commissions, title insurance, etc. The sum of this cost usually ranges from 2% to 10% of the property value. Sometimes you may also encounter appraisal and inspection costs before you initialize the purchase.
Once you own the property, other fees need to be considered. These include your operating costs, such as property management, maintenance, insurance, property taxes, among other expenses. Depending on how you look at your real estate investment, your mortgage may also be considered a cost.
Though it is arguable that the principal portion of the mortgage payment may just be part of your equity increase. Whereas the interest on your mortgage is definitely an expense. Keep all these fees in mind when you invest in real estate, as they are important when determining if the investment is worthwhile.
Pros and cons of investing in real estate
Below we’ll take a look at some of the benefits of investing in real estate, as well as the drawbacks.
PROS
Monthly income
Real estate investing can provide you with monthly income that can help you with your day to day expenses. This is especially beneficial during retirement, when you are unable or not willing to work anymore.
Physical investment
Most investments these days are digitally done. Even commodities like gold and silver, which used to be bought physically, now have digital options. Real estate, on the other hand, still remains a physical investment that you can see, touch and feel. This tangible investment option is important for many investors. The exception to this rule is, of course, investing in real estate through investment funds, REITs and ETFs.
Inflation hedge
Like many financial assets, real estate grows in value as inflation grows. This provides an effective hedge against inflation. As the cost of living rises, your rental income and property price appreciation will also rise.
CONS
Interest rates
As the economy heats up, central banks usually start raising interest rates. With the rise of interest rates, getting a mortgage to finance your real estate investment becomes harder. This also results in higher interest expenses as part of your mortgage payment.
Vacancy rate and seasonality
If you are using websites like AirBnB to make rental income from your property, then you need to factor in the vacancy rate of your rental properties. Seasonality is also going to play a big role in your ability to rent the property out.
Tenant friendly laws
Many states have laws that favor the landlord, while others favor the tenant. Some examples where they favor the tenant include non-eviction from the landlord in the event of failure to pay a rent, or the tenant can withhold the rent he pays if he believes that the landlord isn’t providing him essential basic amenities.
Conclusion: Strengthen your portfolio with real estate investments
Real estate investments allow individuals to invest their money into something meaningful. Real estate is a tangible asset and offers a natural hedge against the continually fluctuating economy, inflation and unstable condition of dozens of other asset classes. There is no doubt that choosing between real estate, or any other asset class doesn’t involve making a twofold decision. However, a diverse portfolio backed by different assets can go a long way on the path to financial freedom. What are your thoughts on real estate investing? Please let us know in the comments.
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