What’s the best way to invest in real estate?
This guide will show you all the top considerations for investing anywhere in the US. The first thing to consider is what kind of investor you are.
Are you looking to invest in real estate to own beautiful properties? Or are you looking to grow your money the fastest. This guide focuses on the latter: the professional numbers game.
The most important item you want to look at for any property you are considering investing in is the true yield of that property. The true yield is defined as true net income (e.g. rent) divided by the true price of the property.
The true price is defined as the price you pay for the property plus the value of all the time you spent on looking at all the properties in order to close on one, and also the price of immediate maintenance you need to put into the property. If you buy a property for $100,000 and spend 100 hours looking at properties (with the value of your time being say $50/hour) and then spend $5,000 on immediate repairs, your true price is $110,000.
Your true net income is the amount you get in rent, but subtracting out not just the explicit costs (like property taxes, property insurance, utilities, repairs) but also the implicit costs (like vacancies and the opportunity cost of your time spent dealing with this property). So, for example, if you rent the above house out to people for $1,000/month and your property taxes and insurance are $200/month, your explicit net income is $800/month.
But to calculate your *true* net income, you also need to subtract out vacancies and your time in dealing with the average tenant. Suppose the unit is vacant 10% of the time, and you spend 20 hours a year replacing the tenant. This reduces your true net income by $100/month and about $80/month ($50*20 hours a year) respectively, giving you a true net income of $620/month. This means that the true yield of the property is about $620/$110,000 = 0.56% a month or 6.7% a year. If you did the very naive calculation of yield, you might divided $1,000/$100,000 to get 1% a month or 12% a year. That a double factor of miscalculation here!
For all your properties, be sure to calculate the true yield. When you calculate the true yield of properties, you’ll find that you’ll get a (correct) bias towards properties that cost more but also pay more rent. This makes intuitive sense: a $100,000 property renting for $1,000 a month is a much worse deal than a $1,000,000 property renting for $10,000 a month. The overhead for both sets of properties are the same!
How to Finance Your Property
The next topic to discuss is how to finance (borrow money for) your real estate investment. Financing real estate lets you work with a lot more properties for the same amount of cash, yielding multiples more income. Financing methods include: partners lease option strategy; FHA 3.5% down-payment loans; USDA / VA no down-payment loans; home equity loans or HELOCs (from the house you live in); seller financing; and private or hard money.
The partners lease option strategy involves finding a partner (or the financial strength to do this yourself), and then having the partner buy the property with an option that you will buy it from them in a few years at a pre-determined price. This lets you get into the investment for little money down, and also lets you control the property from the start.
The FHA loan lets you get a loan for up to 96.5% of the appraised value of a property (as long as you put up the other 3.5%). This provides an incredible amount of leverage!
The USDA loan lets you get a loan for up to 100% of the appraised value of a property (so you don’t have to put any money down!). The VA loans are similar to the USDA loans.
Home equity loans let you borrow against the value of your house. The advantage of these is that you can do this with no money down. The disadvantage is that if your house doesn’t appreciate, you won’t have any more money to invest!
Seller financing lets you buy a property with no money down (and no monthly payments). The seller carries the note, and you pay them monthly. The advantage of this is that you don’t have to come up with any money to invest! The disadvantage is that you are now financially responsible for the property, and if anything goes wrong you could lose the property.
Hard money lets you borrow against a property for a large fee (e.g. 6-8%). This is useful when you need a lot of money quickly, but the high interest rate makes it expensive.
Private money is when you find an individual to lend you money. This is similar to hard money, except the interest rate is likely to be lower. You may also choose to self-finance by using the cash flow from your day job to invest in real estate. This lets you start out slowly with small deals and work your way up.
Type of Property
Once you have chosen your strategy, the next step is to decide on the property type: raw land, single-family houses, small (2-4 unit) multifamily houses, large multi-family houses, commercial properties (e.g. retail, office), mobile home or home parks, private notes, or REITs.
Raw land has no housing on it, and usually collects no explicit income, but it also has very few expenses. Raw land is a great way to speculate on an area or a city being more popular in the future.
Single Family Houses: The most popular investment for beginner investors is the single family home (SFR). The biggest advantage of single family homes is that the market is very liquid: it’s easy to buy the home, easy to rent (if it’s not a large home), and easy to finance as banks understand them and deal with them in high value).
Many tenants want to live in single-family houses, so they are easy to rent. For this reason, banks are very comfortable lending money on them. The disadvantage of single-family homes is that they can’t be scaled: it’s hard to buy 100 single-family homes at once! Also, they are expensive to acquire (since they are in high demand), and the management of them can be time-consuming.
Small (2-4 Unit) Multifamily Homes: Smaller multifamily homes (2-4 units) are a good way to get started: they’re less expensive than larger multifamily homes, so you don’t have to risk so much at the beginning. Because they still trade at some volume (although not as many units as SFRs), banks are quite comfortable lending money on them as well.
You can also scale up from there, by buying larger multifamily homes (5+ units). The advantage of these is that they are less expensive to acquire per unit of housing since there are so many units. The disadvantage is that banks are a little less comfortable lending money on them since they are less liquid.
Commercial properties (retail, office space, etc.) could be a good area to get into once you are more advanced in real estate. They involve negotiating with retailers as well as companies. Retail has been suffering for the last decade, and investors are cautioned not to project past returns forward. Office space these days (with coronavirus) is also risky as the United States is rethinking the nature of office work. Mobile Home Parks
Mobile home parks are a specialized area: they require a lot of management and maintenance. The advantage is that they can be very profitable, but you have to live on site to make sure the place doesn’t fall into disrepair.
Private Notes: there are also private notes (IOUs) out there. These are loans that people have taken out, and the bank records the loan in their name. You can buy these notes at a steep discount, and then try to collect the full amount from the borrower. The problem is that some of these loans are not very good, and you may end up spending more time and money in legal battles than the amount you recover.
Real Estate Investment Trusts (REITs): REITs are an easy way for investors to get into real estate. They are like mutual funds, but focus on real estate. You can buy as little as one share, and the management of the fund takes care of renting out or selling the properties. The advantage is that you get diversification and don’t have to deal with renting out property or finding tenants. The disadvantage is that you don’t have control over what properties the fund invests in, and there is a management fee.
Acquiring the Property
After you decide what sort of property to invest in, the next step is to start acquiring the property! First, you’ll want to get a real estate agent to help you. They will have access to MLS, which has all the latest listings. They can also help you with the logistics of closing on real estate.
When picking an agent, there is a tradeoff between picking the agent that is a superstar but very busy, and picking the agent that has more time for you. Usually, you’ll want to pick the superstar because if they are busy, that means they are good at finding the best deals. Their lack of time is not usually a concern as they’ll have a great team. A great way to find a real estate broker is just using Zillow.com, and seeing which brokers have both the highest and most ratings. Quantity counts here! Another way to find a great real estate agent is to ask your friends and family for recommendations.
After you’ve found an agent, you’ll want to get pre-approved by a bank. This means the bank has looked at your finances and said that it is willing to lend you up to a certain amount. This is important because it tells the seller that you are able to complete a transaction.
The next step is to find a property. Usually you’ll do this with an agent, but you can consider just using the raw MLS. Using an agent is the safer route, since they have access to the entire database. They can also do things like schedule a showing when the property will be empty, and tell you about all the properties you are interested in.
Using the MLS is a little riskier, but can lead to better deals. The MLS database is open to the public on Realtor.com, so you can search it yourself. There is less filtering of properties, so you will end up visiting more duds.
Once you’ve found a property you are interested in, you’ll want to do some bench research from your computer on it. You can also look up information about the property on Zillow.com or other sites, which has tax records, recent sales, and other information about the property. You can call the selling agent and ask for more information as well, or work with your buyer’s agent.
After you’ve done some bench research, you’ll want to visit in person. The agent will be able to give you a showing. When visiting a property, you will want to notice both the feeling it gives off and details. Look for obvious problems like flooding or cracked foundations or unmaintained roofs.
Once you’ve found a property you like, you can make an offer on it. The offer is a legal contract where you agree to buy the property for a certain price. You can make an “all-cash” offer, which is the most appealing to sellers, but you can also make an offer contingent on a loan if you don’t have all the money right now. Once you’ve made an offer, the seller has to consider it. They can either accept, counter-offer, or reject it. If your offer is rejected, you can either increase the price or make a new offer with different terms. If the seller counters with a lower price, you can either accept or reject.
Once you agree on a price, your agent will help you finalize the sale. There will be lots of legal documents, but the most uncertain phase of the buying process is over! Once the documents are signed, you own the property — congratulations.
Renting Out the Property
If the property came with a good tenant, then your work is done. But if it doesn’t, your final step is to rent it out.
You can advertise the unit the traditional way and have a sign made and put it on the property. You should also post everywhere online you can: Craigslist, Facebook, Zillow, Apartments.com, and other sites.
You’ll need to screen your applicants. The best way to screen your applicants is by having them fill out an application that includes a FICO score check. Usually prospective tenants with a FICO score of below 600 often have problems making rent on time, while tenants with FICO scores of above 650 generally pay on time. You can also run a background check on your applicants, which will give you information on any felonies they’ve committed, or bankruptcies they were in, or any lawsuits they were in with other landlords. Once you’ve found the perfect tenant, you can sit back and relax.
If finding an dealing with tenants seem like too much for you, you can use a management company. This is a company that finds tenants, takes a cut of the rent, and then gives you the rest. You will still have to pay for things like repairs, but it will be easier since you won’t have to deal with finding and screening tenants yourself.