When building wealth, there is no shortage of investment opportunities. Stocks, bonds, mutual funds, ETFs, precious metals, and more all play a role. However, many of the world’s great fortunes are based on real estate investing. Let’s examine why real estate is a good investment and how you might build significant wealth.
Reasons Why Real Estate is a Good Investment
Cash flow, passive income, tax breaks–the list goes on. Here are just a few of the reasons why real estate is a good investment:
There is a steady cash flow
As a real estate investor, you can generate a steady cash flow if your investment properties have tenants. Calculate your cash flow by deducting your mortgage payments, property taxes, insurance, and maintenance expenses from the gross rent.
Could have great returns
A long-term investment in real estate can bring great returns. Solid appreciation over time means you can sell the property for a substantial profit. Of course, there is no guarantee that an individual property will generate big returns but remember the real estate mantra: Location, location, location.
Long-term security is an asset
The long-term security of real estate can make it a great investment. You are not just waiting for your real estate investment to appreciate. Instead, you are renting out the property and earning money every month.
There are great tax advantages
One of the top reasons that real estate is a good investment involves its tax advantages. As per the IRS, various real estate expenses are deductible, including:
- Mortgage interest
- Property taxes
- Operating expenses
Diversification means security
Real estate is an essential part of a diversified investment portfolio. Your real estate portfolio might remain relatively robust when the stock market tumbles during an economic downturn. When investing in real estate, consider portfolio diversification into different real estate types for further security during tough times. Besides single-family residential real estate, there are opportunities in commercial properties, apartment buildings, and other income-producing properties.
A reliable source of passive income
Investment real estate can create a reliable source of passive income. If you engage the services of a property manager, there is little you have to do daily. Instead, you can enjoy passive income from your tenant’s monthly rent checks.
You have the ability to leverage funds
Rental property investors do not usually pay cash for properties. Instead, they use real estate leverage and borrow most of the money from banks or mortgage lenders.
Many investors bought their first investment property by taking out a Home Equity Line of Credit (HELOC) on their primary residence. Most lenders allow homeowners to borrow up to 80 percent of their dwelling’s worth.
There is protection against inflation
Real estate investing offers some protection against inflation. Inflation raises the price of goods, but it also raises wages. Since wage growth is tied to rental prices, you can increase the rent on your rental properties once current leases expire.
You have a chance to build capital
Owning real estate is a great investment for building capital. When you sell properties that have increased in value, the cash is the capital you’ve built. The key to building capital in real estate is choosing properties likely to increase in value and biding your time until they appreciate sufficiently. It’s key to building long-term wealth.
Fulfillment and control are yours
Do you want to be your own boss and have more control over your destiny? That’s an attractive component of investing in real estate, although this fulfillment comes with greater responsibilities. As a landlord, you also play a vital role in your community.
The Risks of Real Estate Investing
In general, real estate is a good investment over time. However, risks are involved, and it is possible to lose money. By knowing these risks, you can take steps to avoid them.
Some market risks exist
You expect to receive rental income from your investment properties. That income also goes toward paying your mortgage and other property expenses. What happens if you experience a long-term vacancy? Tenants break contracts and can leave you hanging. Are you prepared to not receive rental income from a dwelling unit for a few months or more?
Remember that investment properties are illiquid except for real estate investment trusts. If you need to obtain cash quickly, that’s a problem.
Investment properties require upkeep and maintenance, and these are considerable expenses. You must budget for ordinary and major repairs, such as roof replacement, HVAC repair, or plumbing issues. Properties are also subject to fire, flooding, and natural disasters. Make sure you have adequate insurance in case of such a calamity.
As a landlord, the last thing you want are tenants who don’t pay their rent or cause problems. Mitigate some management risks by carefully screening potential tenants for your rental property. That includes running a background check, obtaining their credit report, and rental history.
Issues with interest rates
Investing in real estate investing is inextricably tied to interest rates. These rates affect home value, with lower rates bringing higher demand and rising interest rates dampening buyer enthusiasm. Higher rates are inevitably an issue for the real estate investor, but that doesn’t necessarily mean you should avoid buying property in a high-interest-rate environment.
For example, look into adjustable-rate mortgages when rates are rising so that you can make lower monthly payments during the period the rate is in place. Another option is choosing a longer-term, interest-only mortgage. The latter only works if you can refinance at a lower rate should rates fall. Even though interest rates are high now compared to recent years, they are still historically low. Be prepared for them to remain relatively high for the near future.
If possible, take advantage of buying down the interest rate with cash.
Potential recession risks
The economic cycle consists of ups and downs, and recessions are part of the latter. The Great Recession of 2008 certainly had a huge negative impact on real estate. Still, the real estate market and home values eventually came roaring back. With real estate investing, you need to take the long-term perspective.
Home prices are still high
Property prices for single-family homes are historically high. The risk here is that you could buy an income property at the top of the market and wait a long time for significant appreciation. Of course, when house prices are historically high, fewer potential homeowners can purchase them. That makes the demand for rentals even higher.
How to Reduce Real Estate Risks and Overcome Challenges
Seasoned real estate investors know how to reduce their risks. Here are some tips on preventing some of the issues arising with real estate investing:
Conduct thorough research
When it comes to real estate investments, conducting your due diligence is imperative. You must know your costs and crunch the numbers to ensure the investment makes sense.
If the property already has tenants, familiarize yourself with the terms of the lease, its length, and the rent roll. Verify that all lease information is accurate. For example, you could discover that tenants receive discounts for certain items, meaning the rent paid is less than expected.
Get the expense history of the building from the owner or property manager so that you can make comparisons with similar properties and determine your cash flow.
Before you buy a property, have it professionally inspected. Pay a visit to the municipality’s building department and check out any permits for work on the property. Does the description of the property match the reality of the property? If a house has two bathrooms but only one is listed, that’s a red flag. The owner may have added that second bathroom without permits. The town may require illegal work to be ripped out.
Diversify your real estate portfolio
When investing, it’s always wise to avoid putting all your eggs in one basket. That’s where diversification comes in. Putting money in different asset categories can protect you from some of the risks of real estate investing.
For instance, if your real estate portfolio consists only of residential properties, consider investing in commercial property or industrial sites for diversification. One of the easiest ways to diversify your real estate portfolio is via a real estate investment trust or REIT.
Hire a qualified property manager
It is impossible to overestimate the importance of hiring a qualified property manager to oversee your real estate investments. You can likely handle most property management tasks if you’re a handy person with a rental property or two in your local area. Expand your investment properties outside your geographic area or buy numerous multi-family units; the DIY approach is seldom viable.
Stay informed about your local markets
The real estate market is not static. Change is a constant. You want to know towns’ good and not-so-good areas for investment purposes but also look for opportunities in less-than-stellar areas ripe for upscaling.
Follow local media to stay abreast of current conditions affecting the housing market. That may involve regional job market health, zoning changes, property taxes, and environmental problems. Keep track of local crime rates and other issues affecting property values.
The National Association of Realtors produces Local Market Reports to help you understand the data. The latest information on foreclosures, housing inventory, prices, and sales is necessary for investment property and management.
How can real estate hedge inflation?
As an asset class, real estate often rises with inflation. Historically, real estate has proved a good inflation hedge. Along with the ability to increase rents, investors can benefit from a long-term fixed-rate mortgage. Your rental income is rising, and your property’s value should increase over time, yet you are not making a higher monthly mortgage payment.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.