Ask ten financial advisors about the best way to build wealth, and it’s likely at least nine will say, “real estate.” Real estate has obvious utility, is in constant demand, and, as the saying goes, “they aren’t making any more land.” But just because investing in real estate is the closest thing you’re going to get to a sure thing doesn’t mean it’s easy. Contrary to what the infomercials and ads for weekend investing seminars tell you, it takes careful research and planning to do more than break even.
More often than not, the best investment is going to come down to the best fit for you. The would-be investor has to be honest about how much time and money they’re looking to put into it. There are low-maintenance, hands-off investments (REITs), high-maintenance, hands-on investments (being a landlord), and everything in between. Let’s go over some of the most popular ones, and outline the basics you need to know before you put your money in.
Traditional Real Estate Investment
You know what this means: you buy a house, rent it out to generate cash flow, and eventually sell it at a profit.
But how do you figure out which properties are sound investments, and which are money pits? One proven guideline is “the 1% Rule.” To put it simply, an investment is high quality if the potential rent is at least 1% of the acquisition cost.
Let’s look at an example. Let’s say you’re looking at an investment property for $200,000, which is a little below the U.S. median home value. For that property to be a quality investment , it would need to generate at least $2,000 a month in rent. Notice, also, that we’re talking about 1% of the acquisition cost, not the price. If you have to put ten or fifteen thousand dollars in renovations into the property before you can get your target rent, you’ll need to tack that onto the price to get your total acquisition cost.
Sink below that 1%, and it’s going to be tough to generate a positive cash flow. Using the 1% Rule quickly reveals that a lot of the more lucrative U.S. markets aren’t great investment areas. A $1 million home is considered cheap in a hot market like Washington, D.C., or San Francisco, but in order to meet the 1% rule, it would have to generate $10,000 a month in rent. That’s a tough threshold to meet.
1% Rule And Calculating Cash Flow
Let’s say you’re looking at a three- or four-unit property, have determined that you can bring in high-quality tenants at your target rents, have a reputable property manager lined up, and you’re ready to pull the trigger. How do you know if you’re going to have positive cash flow, month in and month out?
There’s a rule for that, too. The 50% Rule states that 50% of your rent will go to expenses like insurance, repairs, property management, and taxes. Note that the list of expenses doesn’t include your mortgage payment.
Returning to our example from above, let’s say you closed on a $200,000 property and, in accordance with the 1% Rule, have rents of $2,000 coming in. You should anticipate that $1,000 of that is going to be allocated toward expenses, so if your mortgage payment is going to be more than the remaining $1,000, you should be prepared to dip into your cash reserves each month.
Combining the 1% Rule and the 50% Rule creates a high standard for potential investments, but if your property meets both thresholds, you’re probably going to be in pretty good shape. Of course, there’s another method that can lighten your financial obligations in those early phases of investment.
What Is House Hacking?
House hacking is the practice of buying a multi-unit investment property, living in one of the units, and renting out the other units.
If you play your cards right, you’ll essentially be living rent-free. Considering that rent is typically the largest single household expense, this will free up a significant amount of cash each month for your mortgage payment or, if your cash flow is really healthy, to put towards the down payment on your next property.
This strategy can dramatically shorten the timeline of your investment, although it comes with some obvious logistical drawbacks. Living next door to your tenants can make for some awkward interactions; you can tell them to call the property manager when they bang on your door about a clogged toilet at four in the morning, but you might not get back to sleep for a while. Still, combining house hacking with the 1% and 50% Rules can build wealth at a rate unrivalled by any other investment strategy. And once you’ve built up healthy equity in that first property, you can start looking for your second, and third, and even fourth investments.
Beware of “No Money Down”
A lot of “get rich quick” real estate schemes trumpet the use of “no money down” mortgages, but you should tread lightly here.
While there are some solid government mortgage programs that come with competitive rates and zero or very little money down, these can put an investor in a precarious position. Putting the standard 20% down gets you a healthy equity cushion in case of a downturn in the market, whereas the “no money down” investor will be underwater virtually overnight.
Another drawback is that putting less than 20% down often requires private mortgage insurance. This is another monthly expense to add to the list, and can really eat into your cash flow. And it’s entirely avoidable.
A Note on Flipping
House flipping is thoroughly in the zeitgeist, but it’s not as easy as reality TV makes it seem. Flipping houses can definitely be lucrative, but it takes deep pockets, savvy project management, an appetite for risk, and a lot of luck.
Once you buy that undervalued fixer-upper, you have to quickly get dependable contractors in there to do the renovations. Any delays or cost overruns are going to come directly out of your future profits. If there are permitting or inspection problems with the upgrades, that’s going to eat into your profits. And this is on top of the carrying costs you’re racking up every single day from the purchase to the sale.
If you’ve even slightly misjudged local buyers, and the property sits on the market for any length of time, that’s money coming out of your pockets. And if the market dips while you’re still renovating? That could sink the entire project.
Bottom line? Flipping houses can be profitable, and exciting, but it’s not easy, and it’s anything but risk-free.
Alternatives for the Hands-Off Investor
House hacking, investing in rental properties, and flipping houses are all expensive, time-consuming ways to make money in real estate. In most cases, looking after those investments is going to be a full time job. But there are other ways to put your money into real estate without having to clock long hours.
In 2019, everything has a shiny, hyper-efficient online version, and real estate investment is no exception. If you’ve ever donated to a Kickstarter project, you’ll understand real estate crowdfunding.
Through platforms like Fundrise, Realty Mogul, and RealtyShares, potential investors can invest small, moderate, or large sums of money in various pre-vetted real estate projects. When they turn a profit, you get a cut. If they don’t, well, every investment is a risk. While the platforms that deal in more sizable projects often require investors to meet SEC accreditation standards, there are smaller platforms with much lower bars to entry.
The drawbacks to this investment model are clear; if you only invest a small sum, your profits are going to be equally small, and it’s reasonable to assume that if these projects could get conventional financing, they wouldn’t have to solicit money on the internet, meaning that they might be riskier than other investments.
Still, this is an easy way to get your money into real estate, and all you have to do is check a phone app now and then for updates.
A REIT is a real estate investment trust; think of it as a mutual fund, only with a portfolio of real estate instead of stocks and bonds. REITs usually own commercial real estate like office buildings, shopping malls, hotels, and large apartment buildings, and they often give a great return on investment.
Some REITs are publicly traded just like stocks, and some require a private buy-in. Most have a minimum investment requirement, so you’ll need to significant capital to buy in. But if you have experience working the stock market, buying shares of a publicly-traded REIT is going to be a comfortable way to get into real estate.
Real Estate Vs. Stocks
Remember when we said that nine out of ten financial advisors would probably recommend real estate as the best investment? Those same advisors would no doubt rate stocks as a close second, and for good reason.
Stocks have been a solidly profitable investment over the past century; one respected metric found that stocks even exceeded housing over that term, averaging an annualized return of 9.5%, while housing averaged a 3.7% return.
Still, stocks fluctuated wildly over that term, while housing has been on a much smoother, more predictable upward trajectory. And buying property offers the obvious utility of a potential roof over your head, as well as a tangible, physical investment, which can offer huge psychological benefits.
In the end, real estate and stocks both offer a top-shelf investment opportunity, with real estate offering a slightly safer place to put your money. You can’t go wrong with either, but you can go a little more right with real estate.
Ben Mizes is the CEO of Clever Real Estate, an online platform that connects home buyers and sellers with a top-rated, full-service real estate agent for a fraction of the traditional commission fee. Ben is also an active real estate investor in St. Louis, MO with over 22 units.