Is real estate a good investment?
Investing in real estate can be a very effective way to generate wealth. And especially when mortgage rates are low, people become very interested to learn how to do it.
Buying investment property involves three phases, and the goal you choose determines what type of property you'll seek and how you'll pay for it:
- Goal-setting (rental income, buy and hold, fast flip, etc.)
- Choosing the right types of investments and finding a property
- Determining how you'll pay for your investment
[Note that this article covers only residential real estate, not commercial real estate, office buildings, vacant land or real estate mutual funds or trusts.]
Setting Your Investment Property Goal and Strategy
There are a number of ways to make money by investing in real estate:
- You can be a landlord and generate rental income
- You can buy property, hold it, and sell at a profit
- You can decide to fix a property and flip it quickly
Long-term real estate investors
Long-term real estate investors are usually willing to complete some repair work, but their goal is not a fast profit. They look for solid, desirable rentals to supply reliable monthly income, some tax advantages and property appreciation. Others buy properties they can use as their residences or vacation homes and ultimately sell at a profit. For novice investors, the long-term is generally a safer route to wealth.
One method popular with new landlords is to purchase a duplex, triplex or four-plex, live in one unit and rent out the other(s). This can give you access to better mortgage terms because you finance the home as a primary residence.
Short-term real estate investors
Flipping makes for great reality TV; but if you're not experienced in home-building or repair, a lot of the potential profit may end up in a contractor's pocket. Finding the right property (requiring cosmetic work but not a structural overhaul) can be tricky. Even highly experienced investors get stuck sometimes, so approach flipping with caution unless you can afford to pay for your mistakes.
Finding a Flip
If you plan to try house-flipping, live by this rule:
You make your profit when you buy a home, not when you sell it.
Avoid house-flipping mistakes
In order to make your profit, you need to be patient and expect to look at a lot of properties for every one that you purchase.
Don't get emotional or caught up in competitive bidding and overpay. And do your due diligence - don't buy without a clear title and satisfactory inspections.
How do you evaluate investment property to flip?
There are three factors to consider when evaluating property:
- What the property costs to acquire
- The extent of rehabilitation needed
- The potential sales proceeds.
Many professionals don't bother with property that has less than a 20% upside. If a 20% profit is your goal, don't bother with investments that don't offer that potential.
Try to stick with properties that don't require extensive renovation. Every project becomes an opportunity for costs to expand and problems to come out of the woodwork (sometimes literally).
Motivated sellers / short sales / foreclosures
Homeowners who need to sell fast or mortgage lenders with foreclosure property on their books might be willing to sell cheaply.
However, "short sale," "foreclosure," "motivated" or "distress sale" does not automatically mean "screaming deal."
There are plenty of online home valuation sites and apps. To get a better idea of a home's true value, order a broker price opinion (BPO) from a real estate broker or a home appraisal.
Local government sources
Redevelopment or revitalization areas are neighborhoods that local governments are trying to improve. There may be issues like bad schools, but a neighborhood on its way up can be a great investment. If the schools get better, so does your home's value.
In addition, redevelopment agencies often offer grants or low-interest loans to cover your down payment and/or closing costs.
HUD Homes are foreclosure properties that were financed with FHA-backed mortgages. You can find them on HUD's Home Store website. They may be deeply discounted but are normally sold "as is." As with any other distress sale, don't assume a HUD home is a great deal without comparing it to recent sales nearby.
How do you check distressed home values?
- Look up public records from your local assessor (available online in most counties).
- Search for the property address and check out its sales history.
- Then pull up neighboring properties and check their sales prices. This can tell you if the neighborhood is trending higher or slumping. Online real estate or home valuation sites can also give you an estimated property value.
Investment property real estate agents
The right partnership with an investment property specialist can be a beautiful and profitable thing. Experienced agents and brokers can evaluate property faster and more accurately than a newbie investor. Expert advice and knowledge of local market conditions is an invaluable resource.
Finding Rental Properties
Long-term investors generally look for two streams of income - potential profit when selling and monthly rental income.
You should consider the real estate market, especially the property location. (Renters usually care more about location than floor plans.) For rentals, the best real estate investments are solid, desirable properties that don't require much renovation.
When looking into a property's potential, you need to know how much rent income to expect. An appraiser can provide a rental schedule showing expected rent based on comparable rentals, or you can ask a good real estate agent. If the property's already rented, the seller should be able to supply leases and property expenses.
Evaluating Rental Income
You calculate your cash flow from the property this way:
- Start with the rental income and subtract expenses. Those might include home maintenance, any utilities that you pay, property taxes, HOA dues and property manager fees.
- Next subtract the mortgage payment to get your net cash flow. Cash flow is not the same as income. You can have positive income but negative cash flow. Plan for this if it's the case.
Negative cash-flow example:
If you expect to charge your tenant $1,500 per month, and your operating expenses come to $500 a month, you have monthly operating income of $1,000 a month. And if your mortgage payment is $1,200 a month, so your net cash flow is minus $200 a month (-$2,400 per year). Make sure you're comfortable with this figure.
Keep in mind that your after-tax income is different from cash flow. For one thing, your mortgage is not entirely an expense. As you pay it off, you acquire home equity, an asset.
Another consideration is the favorable tax treatment of real estate.
Even if you don't itemize deductions, you can deduct expenses related to property that you actively manage. You can even use investment property deductions to offset up to $25,000 of ordinary income like your salary.
If your tax bracket is 25%, your annual depreciation is $20,000 and your mortgage interest comes to $10,000, your after-tax income looks very different:
- Rents: $18,000
- Operating cost deduction: -$6,000
- Mortgage interest deduction: -$10,000
- Depreciation deduction: - $20,000
- Taxable income: -$18,000
The deduction for depreciation is key because it doesn't come out of pocket, just on paper. Depreciation represents the future cost of wear and tear on the property. In a 25% bracket, $18,000 of rental income equals a $4,500 savings in taxes. That's $375 per month.
Capital Gains When You Sell
The other form of income for long-term investors is profit when they resell the property. In the entire U.S. over the long-term, average real estate prices increase by about 4% per year.
Imagine that the property in the example above is purchased for $300,000 and kept for ten years. If it appreciates in an average way, it will be worth about $445,000 when it's time to sell - a gain of $145,000.
If you hold the property long enough, you'll pay the lower long-term capital gains tax rate. If you roll your profits into a new property (called a 1031 exchange), you can defer the tax on your gain.
Investment Property Mortgages
You have several mortgage options when buying a home as an investment property - the right one depends on the type of real estate investment you buy. The right one for you depends on whether you're going to live in a multi-unit property, how much you plan to spend, your down payment, landlord experience, current mortgage rates and your time frame.
In most cases, investment property mortgage rates are higher than those for primary residences or second homes.
FHA and VA home loans
These government-backed mortgages only let you purchase two- to four-unit properties, and you must live in one of the units. You can put zero down for VA loans, or 3.5 percent down for FHA home loans. Unlike most conventional (non-government) mortgages, there is no requirement that you have previous landlord experience.
Conforming mortgages (Fannie Mae and Freddie Mac)
These are popular. You can finance a multi-unit building as a primary residence or as an investment. For home loans when the borrower will not be occupying the property, most conforming lenders require the following:
- A down payment of at least 20%, with a maximum debt-to-income ratio of 36% plus a FICO score of at least 680, or a maximum debt-to-income ratio of 45% plus a FICO of at least 720. Otherwise, you need 25% down or more.
- Six months of "reserves," which means enough cash to cover six months of payments in case your place becomes vacant.
- Documented previous experience as a landlord or in property management. This is a tough one for many first-timers.
Once you have four financed properties, you'll have a harder time getting conforming loans. But Fannie Mae does offer a program for those with 5-10 financed properties for highly qualified borrowers.
Portfolio mortgage options
Portfolio lenders, like your neighborhood bank, may have more creative programs (called non-QM, non-prime, portfolio, Alt-A or non-conforming loans) and finance local investments more easily. You may also need to go that route if your property requires an especially large mortgage or if you lack landlord experience.
If you have enough home equity, you could also finance an investment property with a loan against your primary residence. This strategy could get you better mortgage terms, but your home is on the line if your investment fails.
If you buy a foreclosure property at auction (risky) or need a quick close to beat out the competition, you'll have to bring cash.
Property flippers often use "hard money," or private lenders to get that cash. They pay several points up front, a high interest rate and make a substantial down payment. However, they only borrow the money for a short period of time, just enough to rehabilitate the property and sell it.
This can be a good strategy. If you get the chance to make 30% on a flip, paying out 10% for financing won't kill you. But if it takes too long to sell the house, this kind of financing can drain your resources very quickly.
How to Invest in Real Estate: Don't be Intimidated
Harvard University's Joint Center for Housing Studies has concluded again and again that real estate investing is one of the most effective ways to build wealth in the U.S.
It's more than just making deposits into a mutual fund. That's because of three things…
- ... having a mortgage builds equity as you pay it (called "forced savings")...
- ... real estate gets such favorable tax treatment…
- ... the potential for both rental income and property appreciation.
Successful real estate investment takes hard work, diligence, and a good team (including you, your real estate agent and your mortgage lender).