Residential and Commercial Real Estate Investing 101
Real estate investment can seem intimidating to the uninitiated. The first and only foray into owning property that most Americans will ever make is in purchasing a home—and that’s challenging enough without adding complications to the mix! After all, who in their right mind would sign-up for more in the way of mortgage payments, insurance fees, and maintenance costs?
As an answer, you need only look at the historic rate of appreciation seen on real estate market investments (about 9% per year over the past thirty-five years).1 This makes sense because jobs are created as the economy grows. Consider that the U.S. population sat at right around five million souls two hundred years ago. A century ago, there were (approximately) seventy-five million people living in our country. Today, that number has more than quadrupled, and over three hundred million people now call the US of A home—and you may safely assume that most of those folks are going to need two things at some point: a place to work and a place to live!2,3 Incidentally, both of those things require real estate.
Generally speaking, the continued creation of new homes and jobs in our country will require us to draw from the finite supply of land that we have access to. As the amount (supply) of this land decreases, even as the need for it grows (demand), prices rise higher and higher. Remember when you were back in elementary school, learning about the Great Westward expansion of the 1800s? In those days, the Federal Government was literally giving away land to citizens who agreed to live on and work that land in exchange. They could afford to be so generous because the supply of land at the time greatly exceeded the demand for it.
Such is no longer the case—and as with any finite resource—prices will continue to rise as the human population grows, fueling the consumption of our fixed supply of buildable land. As such, the savvy individual will see real estate as a sound investment. However, this is not to say that the real estate market is immune to the ups and downs that the financial markets are subject to. Far from it! In fact, most people who do not find success in real estate investing are the ones who overreact to short-term fluctuations, and attempt to juggle their holdings accordingly.
In order to fully realize the appreciation potential of real estate investing, it is usually necessary to buy and hold property over many years—even to retirement, and beyond—in order to weather short-term losses and take advantage of long-term appreciation. Furthermore, while it is theoretically true that all land prices will continue to rise as the population expands, this could take a while in some cases.
Therefore, it is not enough to simply purchase any old piece of real estate, then sit back and watch your property appreciate in value. You need to apply tried and true methods for assessing a property’s worth before buying, in order to maximize your chances of seeing the value increase at a faster rate than other properties (relatively speaking). These include: analysis of local real estate markets and economies, thorough inspections and appraisals for every property you seriously consider, and realistic calculations for expected income streams versus outgoing expenditures.
All of those considerations and more will be covered in this multi-part tutorial: Residential and Commercial Real Estate Investing 101! In this installment, I’ll lay out the pros and cons of buying property to grow your wealth. Then, we’ll talk about some of the more indirect methods of real estate investing, for those folks who just want to get in on the returns enjoyed by the market over time, but who have no desire to deal with the hassle that goes hand-in-hand with being a landlord.
In the second installment, How to Invest in Real Estate Directly, I’ll give a detailed overview of what is involved with investing in the three main types of property: residential real estate, commercial real estate, and undeveloped land. In Part 3, Real Estate Valuation and Cash Flow Analysis, we’ll tackle the principles you need to understand in order to scout out desirable areas for your real estate investment
activities, how to perform a proper valuation, and a step-by-step method for determining cash flow (i.e., rental income minus expenses).
Part 4 of this series, Negotiating Deals and Avoiding Scams in Real Estate Investing, will give you insight into the finer points of closing a real estate deal (cost) efficiently, as well as a primer on some terrible real estate investments to avoid at all costs. After reading this installment, you will be prepared to identify some of the common “lemon-traps” of the real estate world, as well as popular tactics employed by unethical buyers and sellers.
So, without further ado, I give you Residential and Commercial Real Estate Investing 101!
Residential and Commercial Real Estate Investing 101
What do big cities like New York, Los Angeles and San Francisco have in common? For starters, real estate prices in all of those thriving metropolises are some of the highest around! This is because the supply of developable land is scarce when measured against the great demand for it. Therefore, both residential and commercial properties are more likely to sell at a premium.
Contrarily, real estate prices in much of the American Midwest or South are much lower because there is a greater supply of buildable land (i.e., think “wide open spaces”). That’s not to suggest that you couldn’t see a nice rate of appreciation on any real estate investments made in such rural areas—just that you should scale your expectations accordingly. For example, if you determine that the state of the
local economy in Mid-Sized Town A—a cozy little hamlet snuggled somewhere in the American Heartland—is healthy and poised to expand, then you have every right to expect an (well-researched and financially sound) investment property in the area to appreciate nicely over time. It may not command the sort of premiums you would expect from a Manhattan townhouse in your lifetime, but this is less important than the total appreciation on your original investment.
Progress, industry, and productivity all have a positive influence on real estate prices, and opportunities abound (in many areas) for intelligent investors who wish to see their money grow. As long as you have an understanding of how to analyze and select investment properties, chances are you will be able to find some worthwhile real estate in your general area. And even if not—for example, if you happen to live in an economically depressed region—you can still invest in real estate indirectly by way of REITs, and REIT mutual funds (discussed later).
Pros of Investing in Real Estate:
1. Property Appreciation & Rental Income
There are two ways in which real estate investors make money from their properties: appreciation over time and/or rental income from tenants. Moreover, unlike other (non-retirement) financial securities such as stocks and bonds, property appreciation compounds tax-deferred until such time as investors elect to sell. Paying taxes may still be avoided even then, if profits from the sale of any rental properties are used to purchase other rental properties. These are known as Starker exchanges, or IRS Section 1031 exchanges.
Fortunately, even if investors decide to not roll over profits from rental property sales, taxation on those profits are restricted to fifteen percent at most—if the properties in question were held for at least one year. Such profits are classified as long-term capital gains, and are taxed at a drastically lower rate than short-term capital gains, which can be taxed at a rate as high as forty percent. (Yikes!)
However, there is a catch, and it lies in the way the IRS classifies the profit realized from a (non-rollover) rental property sale. That is, the government doesn’t calculate the profits from the sale of a rental property as simply the sale price minus the purchase price. Instead, the depreciation (i.e., the reduction in the value of the property with the passage of time, due in particular to wear and tear) that investors
claim on their tax returns—for each year that a property is owned—is deducted from the original purchase price, and this number is then used to determine the total profits from a sale.
For example, say you are planning to sell a rental property that you purchased five years ago for $100,000. For each year of ownership, you claimed $3,000 in depreciation on your tax return, for a total of $15,000. Now, imagine that your property has appreciated at a rate of ten percent per year over those same five years, so that the total worth of your investment has grown to $110,000.
At first glance, it would appear that your taxable profit is a straight $10,000 ($110,000 – $100,000 = $10,000)—but the IRS doesn’t see it that way! In their eyes, your total profit would include the $15,000 depreciation that you claimed on your tax returns. Therefore, you would owe them their cut of a $25,000 profit, even though you really only made $10,000 on the sale ($100,000 – $15,000 = $85,000,
and $110,000 – $85,000 = $25,000). Just to drive the point home: fifteen percent of $10,000 is $1,500; whereas, fifteen percent of $25,000 is $3,750—more than twice the original amount!
Of course, this illustration doesn’t take into account the profit earned from rental income minus expenditures over that five year period. This is known as “cash flow,” and is a major determinant in whether or not a rental property will be a worthwhile investment. Typically, cash flow is small in the early years of property ownership— unless a large down payment is made (on the mortgage) in the beginning—as monthly operating profits are gobbled up by mortgage costs, property taxes, insurance and maintenance fees.
(Note: Cash flow—rental income exceeding expenses (e.g., mortgage, property taxes, insurance, maintenance) for a property—is treated more fully in Part 3 of this tutorial.)
In a best-case scenario, investors will increase the rental rates on their properties faster than their expenses increase, thus netting a steady profit. However, this may not be possible during times of slow economic growth—or worse, a recession. In such cases, rental rates may even fall!
Starker Exchanges are not DIY friendly. A third-party is usually required to oversee the process, and profits from your rental property sale go into an escrow account. Furthermore, you must identify a replacement property within forty-five days, and finalize the new purchase within six months. Most folks elect to hire a tax advisor/attorney to assist them with these rollover purchases, to make sure all of their “i’s” are dotted, and “t’s” are crossed!
With real estate, you can typically borrow eighty percent or more of (the value of) your investment, thereby controlling a much larger asset at a fraction of the cost. For example, remember that $100,000 hypothetical property that you “purchased” in the previous section? Chances are that you didn’t imagine yourself walking
into the bank with a briefcase full of cash to buy the place. (I’ll bet you are now, though, right?) Rather, if you are like most people, you would have to get a mortgage to pay for your investment.
Traditionally, that means approaching a mortgage provider with (at least) a twenty percent down payment—or $20,000 for this example—and asking the lender to finance your outstanding balance. In this way, you are able to assume control of a $100,000 real asset at only one-fifth of the purchase price. If the value of your property appreciates over time, as you hope it will, then you have an opportunity to make money on your original investment in addition to the money that you borrowed.
To illustrate, let’s say that after holding the aforementioned real estate for a number of years, the property’s value increases to $120,000. If you elect to sell at this point, you will have made a one hundred percent return on your original investment of $20,000 (the down payment you made for your mortgage), after paying your lender the outstanding balance owed ($120,000 – $80,000 = $40,000). Of course, this simplified example assumes that your property existed in some bizarre limbo during your years of ownership, and you neither paid more into your mortgage, nor experienced any positive (or negative) cash flow from rental income. Also, it assumes that in bizarro world, the IRS gives people a free pass on taxes, and the transaction costs associated with buying and selling real estate don’t exist!
3. Long-Term Investing
One of the benefits of investing for the long haul is the reduced tax burden that is incurred by holding onto securities and assets over the years. As discussed in the previous sections, taxes on real estate sales can take a big chunk out of your earnings. Also, the transaction costs and miscellaneous fees associated with buying and selling property are cumbersome, and may cost you as much as fifteen
percent (or more) of the total value of a real estate asset.
In the financial sector, there is big business in reporting on every single move the Market makes, and network sponsored pseudo-analysts with harried expressions “advise” investors to juggle their holdings around in frantic attempts to buy low and sell high. But just as in real estate investing, frequent buying and selling eats into investor returns in the form of short-term capital gains taxation, not to mention broker commissions and various trading fees. Many people who put their money into financial securities and real estate fail to take these considerations under advisement, and end up missing out on the long-term appreciation the markets have enjoyed over time (averaging 7%–10% per year, historically), while simultaneously feeding the commission-driven machine made up of bad investment advice that pervades our society.
However, even though real estate market prices are in constant flux as much as stock market prices, there aren’t network channels, publications, emails, and text alerts dedicated to reporting on those changes. “Out of sight, out of mind,” as the saying goes, and real estate investors are afforded the relative peace-of-mind that comes with ignoring the subtle—and, frankly, insignificant—short-term machinations of market prices, in favor of long-term growth. Moreover, unlike stocks or bonds which may be traded at a moment’s notice, the hassle involved with preparing a property for sale is trying (not to mention time-consuming), and acts as an additional barrier to impulsive selling.
For instance, imagine a scenario like the one above, only now bizarro world includes a network television channel that reports on up-to-the-second real estate market fluctuations: Real Estate Watch! Moreover, a recent downturn has caused your property value to drop to $80,000, and you see that you have technically netted a one hundred percent loss on your original investment (your $20,000 down
payment). In a panic, you opt to sell before things get any “worse,” and end up sacrificing your real asset. This results in your having to actually pay into the sale to cover transaction costs and closing fees!
Several months later, after happening upon Real Estate Watch! while channel-surfing, you note that the market has rebounded. The value of your former property has gone back up to where it was before the downturn! In a blind rage, you fling the TV remote at your flat-screen, shattering it. Then, as an added insult, you remember that you don’t have any money to buy a replacement television—having already taken a bath on your real estate venture.
One advantage of real estate investing is that property values don’t move in sync with the stock market and/or other types of assets that you might hold. This is beneficial, because a diversified investment portfolio can help you hedge your losses if one or more market sectors fare poorly in an economic downturn.
(I talk more about the benefits of diversification in my tutorial: Mutual Fund Investing for Beginners. You may find the link for it in the "Related Work by Earl" section located at the end of this article!)
4. Adding Value to Your Property
When you invest in companies by purchasing stocks and bonds—either directly, or indirectly through mutual funds—there isn’t much more to do after that except sit back and watch your securities (hopefully) appreciate. An exception would be if you happened to own a great deal of stock in one particular company, which would entitle you to more of a say in that company’s operations. But you don’t necessarily have to be in a position to purchase a controlling stake at Microsoft in order to take a more active role in your investments.
Savvy real estate investors are often able to identify properties with superficial flaws, and then purchase them at a discount by employing astute negotiating skills. This is especially attractive to folks who like the idea of rolling up their sleeves and putting some work into their investments, in order to increase market value. Properties that need a new coat of paint, landscaping attention, or simply a good
cleaning abound on the real estate market, just waiting for an investor with the right frame of mind to apply a little TLC!
Some investors with a talent for home improvement take it even further than that, and purposefully seek out worn down or otherwise distressed properties to buy, for the sole purpose of fixing them up to be placed back on the market. This practice,
known as “flipping”, can be lucrative if approached correctly. However, don’t make the mistake of jumping into this niche without a proper understanding of economic indicators that influence pricing in the housing market (discussed in more detail
later), short-term capital gains taxes (discussed previously) and transaction costs associated with real estate sales, as well as a realistic estimate of how much the
repairs are going to cost you. Otherwise, you could end up pouring your blood, sweat, and tears into a money pit that has no chance of earning a decent return!
Real estate investors who purchase distressed properties in need of major renovations, for the sole purpose of performing those renovations in order to re-sell the property for a profit, are known as “flippers”.
5. Finite Supply of Land
You are probably familiar with Mark Twain’s iconic quote concerning real estate:
“Buy land, they’re not making it anymore.”
Chances are that you never gave it much thought, but consider that Mr. Twain lived during the second half of the nineteenth century, when the world population was approximately 1.6 billion. To put that in perspective, in 2014 the world’s total human population is more than 7 billion. So, it took more than two hundred thousand years for the population to reach one billion, and in a little over a century we have surpassed that number six times over!
Land is just one thing that people are always going to need, and barring the colonization of Mars or the Moon, we’re pretty much stuck with the amount that we’ve always had. Couple that fixed supply with a rapidly increasing demand, and it’s not hard to see real estate as an attractive investment. Furthermore, people tend to settle relatively close to each other, and in direct proximity to a robust transportation infrastructure including roads, railways, and airports.
Property located within thriving metropolitan areas—and the surrounding suburbs— that has a small supply of developable land tends to command the highest premiums (and usually appreciates the most). As mentioned at the beginning of this tutorial, real estate prices in places like New York City and San Francisco are sky high for these reasons. This also holds true for islands and island chains like Hawaii, Japan, and Taiwan.
Cons of Investing in Real Estate:
1. Enormous Time Commitment
Investing in real estate is no walk in the park. Determining the state of the local economy, researching trends in housing prices, and scouting out potential properties all take time. If you fail to do your diligence before buying, you may very well end up with a lemon.
Additionally, if you choose to rent your property out, you have to be ready to assume all of the responsibilities that come with being a landlord. Your job does not merely entail finding reliable tenants and then collecting a check from them every month. You must also deal with any problems they might have while renting from you, including all maintenance issues.
Are you prepared to answer the phone at 2 a.m. when the hot water tank at your rental property breaks down? Do you have the time to hire a sub-contractor and supervise the repairs? If not, then being a landlord isn’t for you.
While it is true that you can hire a property manager to handle many of these issues, this costs money. Moreover, delegating responsibility in this way doesn’t get you completely off the hook. The buck still stops with you—i.e., you will have to sign off on and oversee any major repairs.
2. NOT an Avenue to Easy Riches
Have you ever seen one of those late-night infomercials, where an unctuous spokesperson boasts about how he or she made millions of dollars investing in real estate, using a secret method that can only be learned by purchasing this or that book, how-to video, or other exclusive product? … Of course you have! This country just wouldn’t be the same without a standard assortment of hucksters who prey on that very American desire to get rich quick—with little to no effort—by employing some sort of gimmick. Like P.T. Barnum once (reputedly) said:
“A sucker is born every minute.”
But in truth, there is no secret method to attaining piles of wealth through real estate investing, save good ol’ fashioned elbow grease. If you put the time into researching properties, identifying potential bargains, and running the numbers to determine estimated cash flow, then you will be better poised to enjoy the benefits of real estate investing than every guru school graduate on the face of the earth! (We’ll get into the specifics of evaluating a property later.)
Real estate investments are subject to the same risks associated with other kinds of investments, such as stocks, bonds, and mutual funds. As mentioned previously, the real estate market will experience short-term fluctuations from time to time, and some of these will adversely affect the value of your properties. Although real estate investors have historically enjoyed overall returns that are comparable to those enjoyed by stock market investors, past performance is no guarantee of future results.
Additionally, if your intention is to rent out your investment property, it is important to realize that even the most conscientious tenants do not care for a rental in the same way that an owner does. Accidents do happen, and as anyone who has children or pets knows, wear and tear is an inevitable consequence of habitation.
Moreover, tenants don’t simply fall from the sky and immediately occupy your rental properties. There is a (sometimes lengthy) process involved with finding reliable and trustworthy renters, as well as dealing with security deposits, lease agreements, and all of the other bureaucratic minutiae associated with our litigious modern existence. Especially if you have single-occupant properties (which can mean an entire family, not literally just one person), there may be times when you are stuck with no tenants at all, and must therefore cope with the cash drain of an empty unit without any rental income to offset expenses. (Ouch!)
Simple Real Estate Investments: Buying a Home & REITs
When you were first learning to swim, I’m willing to bet you didn’t immediately dive head first into the deep end and let the cards fall where they may. You probably
started off like most folks: in the kiddie pool, regaled in an assortment of colorful flotation devices, and carefully monitored under the watchful eye of a parent or
instructor. As you gained confidence and experience the flotation devices were disregarded, and eventually you were able to venture out into the deep water alone
without fear for your life.
Similarly, if you are new to real estate it is not strictly necessary for you to run out and purchase a multi-unit apartment building right away, in order to reap the rewards of investing in this sector. Why not “get your feet wet” (metaphorically speaking) with one or two comparatively simple real estate endeavors—buying a home and/or investing in Real Estate Investment Trusts (known as REITs)—instead? In fact, many personal investors never take their involvement in the real estate market further than this, and there is absolutely nothing wrong with that!
1. Buying a Home
Whether they know it or not, every homeowner in America is a real estate investor. Navigating the complex process of purchasing a domicile (e.g., scouting properties and crunching numbers, saving up for a down payment and approaching a mortgage lender) is similar in many ways to purchasing a residential or commercial investment property. Furthermore, as homeowners pay down their mortgages and build up equity in their homes—while hopefully enjoying a steady rate of appreciation—they are increasing their net worth in exactly the same way as a real estate mogul with dozens of investment properties, albeit on a smaller scale.
Moreover, if at some point down the line you decide to move, you have the option of converting your property into a rental. However, don’t even consider doing this
unless you are prepared to assume all of the responsibilities that come with being a landlord, as discussed earlier. Additionally, some homeowners mistakenly think to take this route during a depressed market, in order to wait for housing prices to recover before selling. This is also usually a bad idea because any profits from a rental property sale are taxed as capital gains in most cases (unless those profits are rolled over into another like-kind property).
(Note: I discuss the benefits of home ownership more fully in my article Buying Your First Home: an Investment in the Future, so check out the link in the "Related Work by Earl" section located at the end of this article, if you are considering making such a purchase!)
Real Estate Investment Trusts, or REITs, are organizations that take pools of investor money, and then purchase residential and commercial real estate with that money. Management of the properties is then handled by the REITs for a fee, with the profits earned from collected rents and sales getting passed on to the original investors. You can invest in individual REITs if you choose, but a more diversified approach is to invest in REIT mutual funds.
Don’t feel bad if you’ve never heard of REITs before—they don’t get a lot of press. There aren’t any reality shows dedicated to them, and real estate brokers (including the many, many books written by real estate brokers) usually won’t expound on REITs either, because it isn’t profitable for them to do so. This is because investing in a REIT “cuts out the middle-man”, and many real estate professionals are
essentially glorified middle-men and middle-women.
Real estate agents, brokers, and services all act as a go-between for property buyers and sellers, and they earn their livings by commission whenever two parties (whom they have brought together) conduct business. But REITs are traded on major stock exchanges like other financial securities, and therefore investors do not require the services of real estate professionals in order to purchase them. If anything, your stockbroker has more of a vested interest in trying to convince you to purchase REIT shares—but the tactics employed by securities brokers and brokerage firms is a whole other discussion!
Three highly-respected REIT mutual funds for your consideration (in alphabetical order), are the:
- Cohen & Steers Realty Shares Fund (ticker symbol: CSRSX)
- Fidelity Real Estate Investment Portfolio (ticker symbol: FRESX)
- Vanguard Real Estate Investment Trust (REIT) Index Fund (ticker symbol: VGSIX)
Each of these funds maintains holdings in a variety of individual REITs, so investors are not entirely dependent on the success of one single organization in order to see a return on their money. Additionally, all of the work involved with researching and purchasing shares in individual REITs is handled by fund managers, just as all of the work involved with researching and purchasing investment properties (not to mention managing those properties) is handled by the REITs—so you literally don’t have to do anything except invest and then get on with your life! Best of all, if you invest in REIT mutual funds through a retirement account such as a traditional IRA, you don’t have to pay any taxes on your earnings until you start taking distributions!
[NEXT]–> Part 2 of Residential and Commercial Real Estate Investing 101: How to Invest in Real Estate Directly (<--Forthcoming! Check back soon!! ~ENB)
Related Work by Earl:
1. Francis, J.C. and Ibbotson, R.G. Contrasting real estate with comparable investments, 1978 – 2004; pg.s 6-8 [Internet]. New York, NY and New Haven, CT (collaborative work): Available through Morningstar Inc.; circa 2007 Feb [cited 2014 Feb 7].
2. Hobbs, F. and Stoops, N. Demographic trends in the 20th century; pg. 75. Washington, DC: U.S. Census Bureau, Census 2000 Special Reports, Series CENSR-4; circa 2002 [cited 2014 Feb 7].
3. U.S. and world population clock [Internet]. Washington, DC: U.S. Department of Commerce / United States Census Bureau; constantly updating [cited 2014 Feb 7]. Available from: https://www.census.gov/popclock/
1. “Real Estate Panorama.” Source: philippaopao, CC-BY 3.0, via Deviantart. 2010 Sep 16 [cited 2014 Feb 7]. Available from: http://philippaopao.deviantart.com/art/Real-Estate-Panorama-179777478
2. “Neon Real Estate Sign.” Source: Chris Griffith, CC-BY 2.0, via Flickr. 2009 Jan 10 [cited 2014 Feb 7]. Available from: http://www.flickr.com/photos/chrisgriffith/3185860301/
3. “Archimedes lever.” Source: Mechanics Magazine, Public Domain (i.e., This picture was drawn in the U.S. before 1923, and so the copyright has expired:learn more), via Wikimedia Commons. Circa 1824 [cited 2014 Feb 7]. Available from:
4. “Median and Average Sales Prices of New Homes Sold in the US 1963-2010 (Monthly).” Source: Graphic created by ‘Smallman12q,’ based on US Census Median and Average Sales Price of New Houses Sold Data, Public Domain(the author has released this graphic into the public domain), via Wikimedia Commons. 2010 Jan 22 [cited 2014 Feb 7]. Available from: http://commons.wikimedia.org/wiki/File:Median_and_Average_Sales_Prices_of_New_Homes_Sold_in_the_US_1963-2010_Monthly.png
5. “East Midtown Skyline, NYC.” Source: Dimitry B., CC-BY 2.0, via Flickr. 2011 May 12 [cited 2014 Feb 7]. Available from:http://www.flickr.com/photos/ru_boff/9636312625/
6. “Real Estate for Sale Signs.” Source: Mr. TinDC, CC-BY-ND 2.0, via Flickr. 2009 Feb 7 [cited 2014 Feb 7]. Available from: http://www.flickr.com/photos/mr_t_in_dc/3265661290/
7. “Housing Market Street Sign.” Source: 401(k) 2013, CC-BY-SA 2.0, via Flickr. 2012 Feb 4 [cited 2014 Feb 7]. Available from: http://www.flickr.com/photos/68751915@N05/6877045981/
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
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