Real estate is no-doubt a profitable investment to add to your overall portfolio. If you agree with Frito’s statement from Idiocracy, you’ll find it a great first-step toward financial independence and generating residual income. Whether trying to generate positive cash flow from rentals or pocket larger sums from flipping, many investors have had success with real estate. If you’re interested in how to start real estate investing, read on.
The real estate market differs from stocks and bonds in that you can use leverage to purchase an asset, only making a downpayment up front and paying down the principal and interest over a term period. This allows you to obtain properties with low or no money down in some cases.
The real estate market, like many others can be turbulent, but overall has climbed steadily over the long term.
In our home of Washington State, the market is also up over recent years; see the below NWMLS data from 2006 – 2019. Check out our Seattle housing market blog posts for more recent and comprehensive data on the local market here in the Pacific Northwest.
What are the most common real estate investments?
There are many different avenues to traverse when considering how to start real estate investing; what works for you will depend on your financial situation, short and long-term goals, knowledge, personal interests, and other factors. Below you’ll find some of the different real estate investment types and strategies you can use as you progress on your real estate endeavors.
Buy & Hold (landlord or live-in)
A longer-term investment, the buy and hold method is the most common among new investors. If you already own a home, great! Consider yourself a real estate investor. After purchasing a property with the intent of being a landlord, it is expected to produce rental income as well as appreciate over time. These investments are almost always five years or more. An investment property in a growing area will appreciate between 3% – 5% annually.
To calculate the return on investment (ROI) for a rental property, take the gain on the investment and subtract the cost of the investment. Then divide by the total cost of the investment.
Cash Example: For simplicity let’s say you paid cash for a property at $100,000. If your closing costs were $1000 and some improvement costs were $5000, your total investment would be $106,000. Let’s say after you rented it out that you collect $1000 a month. After twelve months, you’ve collected $12,000. Expenses like water, sewer, garbage, taxes and insurance totalled $2400 for the year ($200 a month).
Financed Example: When financing is involved, it’s a bit more complicated but not difficult. Let’s use the same example $100,000 property above but with financing this time. If your down payment requirement was 20%, you’d need to come up with $20,000 down (.20 x 100000 = 20,000). Closing costs are higher (since this is a loan) coming in at $2500. Again you paid $5000 for remodeling. Total expenses for the above would be $27,500 (20,000 + 2500 + 5000).
Since this is a mortgage loan, let’s say you took out a 30 year conventional fixed loan at 4% interest on the borrowed $80,000; the monthly principal and interest payment would be $381.93. We’ll add the same annual utility/tax expenses at $2400(monthly $200) totalling to $581.93 per month. Rental income at $1000 will total again to $12000. $1,000 rent – $581.93 in payments gives you a cash flow of $418.07 per month. After collecting $418.07 for 12 months, your annual return was $5016.84. Divide this by the total cost of the initial investment ($27,500) to get your ROI.
When searching for a property, a good predictor of expenses is the 50% rule. It’s fairly safe to assume that 50% of your income will be spent on your expenses, not including your mortgage payment. For example, if your property brings in $2000 in rent, you can expect to pay $1000 in expenses and have $1000 left for your mortgage payment and left net income.
If you’re wondering what the best method is for how to start real estate investing, buy & hold is the #1 choice in our book.
Not for the faint of heart, another method when learning how to start real estate investing is trading or flipping. This more short-term investment takes a lot more capital, market expertise, the ability to oversee or perform handiwork as well as a bit of luck. There is a lot more risk in flipping but depending on market conditions there can be large returns in a relatively short time period. You’ll need to keep your finger on the pulse for market data or have an expert help you with this. If we all of the sudden slide into a bear housing market, short term investors could quickly find themselves upside down.
The flipping process involves buying a property under market value and then either performing improvements or just holding for a short duration (typically 3 months or so) and selling for a profit. If you plan on going down this rabbit hole, have a great team of folks ready to help you with tasks along the way; think tax advisor, real estate broker (contact us), lenders, contractors, fellow investors, real estate attorneys etc.
A good rule-of-thumb for determining the profitability of a flip is the 70% rule. An experienced real estate trader will attempt to purchase a property at 70% of the market value that he thinks he can sell it at subtracting any rehabilitation costs. For example if a home in good condition were worth $250,000 and and it’s rehab costs were $30,000, he’d target to pay $145,000.
(70% * $250000) – $30000 = $145,000
Flipping can be a very lucrative option; you can also consider living in the house to offset some risk.
Real Estate Investment Trusts
Real estate investment trusts (REITs) are companies that own (and usually operate) income producing properties; these can include single & multi-family residential as well as commercial real estate. REITs are a great starting point for those curious on how to start real estate investing; the initial capital needed could be as low as a few hundred dollars. REITs are a great addition to diversify your stock portfolio as well.
Companies that orchestrate REITs must pay out 90% of their taxable profits as dividends in order to maintain their REIT status. This way they don’t have to pay corporate income taxes.
REITs enable you to be a part of large scale and commercial real estate projects without needing the capital of a commercial investor. There are also mortgage REITs that focus more on the mortgage financing side of real estate.
Below are some popular REIT publicly traded ETF funds:
- Vanguard Real Estate ETF (VNQ)
- Schwab U.S. REIT ETF (SCHH)
- iShares U.S. Real Estate ETF (IYR)
- SPDR Dow Jones REIT ETF (RWR)
- Fidelity MSCI Real Estate Index ETF (FREL)
Real estate investment groups are organizations that purchase or construct apartments, complexes or groups of properties, opening up options to purchase to individual investors. The group remains responsible for the administration and maintenance of the property. A portion of all the rents collected by individual investors go to the managing group to cover management, administration, maintenance, vacancies and other costs. This is similar to the buy and hold strategy with less involvement and less risk of default from vacancies. Fees and administration costs are higher with this investment. This can be another great passive stream for your investment portfolio. Contact the local investment groups in your area for more information.
There are dozens of other ways that you could research on how to start real estate investing but the above is a great starting point. Check out the list below for more ideas:
- Notes – Buying real estate debt at below market prices
- Vacation Rentals – Rent out furnished property temporarily
- Airbnb – Host home or rental for travelers
- Wholesaling – Contracting sale of property and finding buyer; keeping the difference.
Importance of working with a real estate broker
When learning how to start real estate investing, it would behoove you to have a real estate broker who understands the local housing market and can automatically provide you with immediate listing data from the MLS that meets your criteria as soon as it becomes available. Most brokers have auto-mailer tools available. The NWMLS here in the Seattle metropolitan area for example can provide you with this.
A good broker will also understand your needs, keep you honest and play devil’s advocate if required. They should walk you through all the procedures of writing offers, addendums and contingencies; they’ll also work with you during the negotiation process keeping the most money in your pocket.
There are lots of details to consider when evaluating an investment property. In the area you’re searching, the location, job market, population, rent, median prices, school districts and many other factors affect home prices. If you’re in Washington State, our blog has a lot of this information for you. Your broker should be able to help you navigate your local market.
If you’re investing in Washington State in Snohomish or King Counties, contact us. Team Sno-King is here to help with your real estate investing opportunities and can also represent you when you decide to buy or sell property here in the Pacific Northwest.
How much money do you need to start real estate investing?
Determining how much cash on hand you need to invest in property depends on the type of investment you’re going for. With buy and hold properties, you can either pay cash or utilize one of many financing options you have available to you for leverage. Check out some of the most common loan types below that can be used to purchase investment property.
Loan Types –
Conventional – This is the most common type of real estate investment loan offered by banks and mortgage brokers. These loans typically require a 20% downpayment. For a decent interest rate, make sure your credit is above 740 if possible. You can still invest with lower credit but it will be harder to qualify. Most loan officers will require 6 months worth of mortgage payments on hand in case of default as well.
Hard Money Loans – These loans can be obtained by companies or private individuals for the sole purpose of real estate investing. They are short term (typically 3 years) and faster to qualify for with leaner underwriting standards. Interest rates are typically 10% higher than conventional mortgages. These loans are built for investors that have the intent of rehabbing and selling a property at a higher value very rapidly.
Rehab-Investment Loans – These are another type of hard money loan. These short term loans (sometimes less than 1 year!) provide funds for the renovation of the property in addition to the purchase price. Interest rates on these can be sky-high (18%+) so be sure you’ve selected a profitable investment before applying for this loan type. Closing costs are typically higher on these notes as well.
Owner Financing/Private Money Loans – Private money lenders are individuals (not banks or brokers) who have extra funds to loan, and are looking for a good ROI. These could be your friends, family, coworkers or acquaintances. Be sure to look over the terms of these loans with an attorney before signing the contract. These loans do have the advantage of offering flexible terms (like longer terms and lower rates) that you can negotiate.
REITs have a much lower cash on hand requirements; Check out some of the funds in the REIT section above,
What are the tax implications for real estate investing?
Any profits made from your real estate investments are subject to tax code and are considered capital gains taxes. These can be broken down into short-term and long-term capital gains.
- Property that is owned for less than a year is considered a short-term investment and will be taxed on the profit for whatever bracket you reside in. Report these short-term cap-gains profits using the form 1040E.
- Property investments that are owned over one year are considered long-term investments and are taxed at 0%, 10%, 15% and 20% depending on your tax bracket.
- Investment property cap-gains are taxed at 25% if you deducted depreciation on your tax return.
- If you buy and hold as your primary residence for a minimum of two years, there is a tax exemption at the time of this writing; you don’t have to pay cap-gains on up to $250,000 for single persons or $500,00 filing jointly.
- There are other tax implications to take into consideration like deducting losses, rental property taxes, and excise taxes (for sellers in WA) after the sale of the property. Talk to a tax advisor to determine what tax laws affect your investment strategy.
We hope you found this post on how to start real estate investing helpful. What investment resources have you found helpful? We’d love to hear in the comments. Thanks for reading!