PT’s note: This comprehensive article was contributed by Eric Bowlin from IdealREI.com.
I first heard Eric on this Bigger Pockets episode.
He lives here in Texas with me now and we regularly get together for lunch and talk real estate and business. Here’s Eric….
It’s remarkable to see how real estate investing can create so much wealth.
You see it everywhere – TV, the web, or your friend who randomly decided to flip a house, it seems like everyone is making money in real estate.
Allow me to quickly go over the power of real estate investing. There are plenty of misconceptions.
First, you cannot simply compare house prices to stocks since appreciation is only 1 of 5 ways real estate generates wealth.
Most investors use a shallow analysis of real estate.
Most investing sites will do some quick analysis and show you a graph like I made above. I’ve normalized real house prices and stocks to 100 in the year 1970 and also adjusted for inflation.
When you compare the two with this sort of shallow analysis clearly stocks outperform real estate by a lot. Stocks nearly triple in value. Homes went up only 40%.
The real power of real estate is not in appreciation. It’s in rental income.
Just as a silly example, let’s say you purchase a terrible rental property and it earns only 4% return on the value each year (after all expenses, vacancy etc). I personally would never invest in this deal, but it’s a good working example with easily attainable numbers.
Now, we need to adjust the charts to account for rental income. The best way to compare is to add the total rental profit back into the price. It’s just like adjusting a stock price for collected dividends.
The strength of real estate is rent, not appreciation.
Now, look at the following chart of cumulative rents + house values vs stocks.
Starting at the same point, once you add even a measly 4% return from rents each year, real estate outperforms stocks over the period.
To be clear, changing the time frame can easily change the results. I chose 1970 simply because that is the data I have available. But, the evidence is still strong that real estate can perform very well, and the returns are very stable and smooth.
Of course, not everyone wants to be a full-time real estate investor, nor should everyone become one, but I believe that everyone could benefit by allocating some of their wealth into a real estate investment.
The problem is – real estate is very expensive. Most people simply can’t drop a few hundred thousand and buy some rental property.
Luckily, there are a ton of ways to invest in real estate without becoming a real estate investor and without needing a ton of money.
- Rent Out Your Home
- Do a Live-In Flip
- Buy a Turnkey Rental Property
- Partner with Other Investors
- Invest Through Crowdfunding
1. Rent Out Your Old Home. Use the “Stepping Stone” Approach
Cost to Start – Under $20,000
You may have heard of something called the “accidental landlord.” It’s when someone lives in one home, moves, then rents out the old home. The “accidental landlord” never planned to be a landlord. They become one when they buy a second home.
Unfortunately, most single family homes actually make terrible rental property because they can’t earn a profit. As the charts show, appreciation alone is a terrible reason to buy property.
To make the strategy work, you need to plan it in advance. You should focus on buying a home in a neighborhood with great rents that are higher than the cost of the mortgage and all expenses.
When it’s time to move into a better home you simply “step up” to the new home and rent out the old one. You’ve just become a real estate investor.
I started in real estate with the stepping stone approach. My first property was a 3-unit multifamily near my grad school. We rented two units and lived in one for free. After a couple years, we moved to a townhouse and rented out all three units.
The great part was the rent on two units paid for all of our expenses while we lived there. When we moved, the 3rd unit paid for almost all of our expenses in our new home. We owned two properties and never had to pay out of pocket each month for them.
We’ve since moved again and the rent from the townhouse covers most of our expenses where we live now.
To do this you simply need to qualify for a normal mortgage. If you go with an FHA loan, you can buy a reasonably priced home under $200,000 in most states which will cost around $10,000 for a down payment and closing costs.
2. Do a Live-In Flip
Cost to Start – $30,000
A slightly different but closely related strategy is the live-in flip.
The goal of this strategy is to buy a home that is livable (and therefore can be financed) but one that requires a lot of work. Work could include upgrading the kitchen/bathrooms, adding hardwood floors, finishing a basement/attic, or building an addition.
This isn’t for the faint of heart because you’ll essentially live in a construction zone for a while. However, the potential for tax-free profit is huge. Approach a live-in flip exactly the same way as a standard flip.
First, you’ll need to find a livable property and also estimate the “after repair value” or ARV. You can do this by asking your real estate agent or reviewing comparable sales.
The next thing is to estimate your rehab budget. Do the work yourself to earn some sweat equity, if you have the skills. If not, get a good contractor in there to give you a price.
The offer you make should account for some profit. Take the ARV and subtract your profit goal and also subtract the repair costs. The total is your best offer.
I estimate costs of $30,000 or more because you’ll need to fund the initial purchase ($10,000 or so if you go FHA) and you’ll need to fund the repairs. It’s impossible for me to give a blanket cost for repairs, but $20,000 will get a lot of work done if you do most of it yourself.
Fringe Benefits of Flipping
The great benefit of this strategy is the tax advantages. A typical flip is subject to all kinds of taxes on the profits. After 3 years of residency at the home, you’ll get most or all of the taxes wiped out since profits on homes are not taxed up to a certain amount. I’m not a tax professional, so please consult one before buying or making offers.
This strategy is great because it’s pretty low-risk. If the numbers don’t work and you can’t sell for a profit, simply stay in the home! You need a place to live in anyhow.
If you can sell for a nice profit, sell it and buy your next live-in flip. You could put more money down and have a lower mortgage or you could invest the money into the stock market or other investment.
Combine this strategy with the “stepping-stone” approach and earn even more. By refinancing the property, you will capture the equity and then also have the benefit of long-term rent.
3. Buy a “Turnkey” Property
Cost to Start – $30,000 – $50,000
If you aren’t keen on the idea of moving a lot or living in a construction zone, you may want to consider turn-key investment property.
As the name suggests, a turnkey company takes care of almost everything for you. They help you find, analyze, buy, and manage the property. Every company is different and they don’t all offer the same services, but here are the basics:
Finding and analyzing the turnkey property
I’ve seen turnkey companies find property in a variety of ways. Some buy and fix the property directly while others use a network of rehab companies to find their completed properties. Others provide fixer-uppers and give you the repair estimates and have you pay for upgrades.
Regardless of what numbers they give you, make sure you do your own analysis!
Buying the turnkey property
Most turnkey companies have relationships with mortgage brokers or private lenders to help the deal happen. It’s still important that you are financially stable and qualified to purchase.
Managing the turnkey rental property
Turnkey companies will either manage the property directly or connect you with a reputable management company. Their reputation really relies on this piece, so they tend to take it very seriously.
Also, management companies can get a lot of referrals from turnkey companies. If there is a problem with your management company, you can sometimes go back to the turnkey company and ask for their assistance. The property manager may go out of their way to make you happy just to keep those referrals coming.
Cost of turnkey properties
Turnkey companies focus on cheaper properties that can range from $50,000 on up.
It requires approximately $30k to get started, though it can vary. Since you won’t be living in the property, you’ll need a conventional loan and 20% down. On a standard $100-150,000 house, that’s $20-30k plus closing costs. You’ll also need to have some cash available as reserves in case you have any major repairs in the first year.
The risks of turnkey properties
I won’t lie, I’m not a huge fan of turnkey properties. A lot of people swear by it. Which is why I included it in the list.
There are a lot of risks with turnkey investing. First off, there is a lot of incentive for turnkey providers to charge you top dollar for the properties. Since you aren’t familiar with the out of state market, you probably won’t even realize it.
Also, property management companies have a lot of incentive to cause more repairs and tenant turnover.
I generally distrust deals where the incentives don’t align and that’s why I shy away from turnkey rentals. But, I do know there are many very reputable turnkey companies out there and I know several people who swear by them.
4. Partner with Other Investors
Cost to Start – $25,000 – $100,000+
Consider working with other investors if you aren’t interested in the nitty-gritty of real estate investing but you still want to add real estate to your portfolio.
Good investors are always looking for partners on deals. Good investors are good at finding deals. Since deals cost money, good investors are always out of cash.
Investors complete more deals by partnering. The more partners, the more deals get done, the more money everyone makes.
Different ways to partner
There are two primary ways to partner on a deal – as an equity investor or as a lender. The key difference comes down to risk and return. Also, there are a number of different areas of real estate to partner in, and each has their own sets of risks and rewards.
House Flipping ($25,000+)
One of the most common ways to partner is on a house flip. The best house flippers are always looking for private lenders but rarely want to share equity. New investors can’t qualify for any kind of financing, so they will split profits.
On the low side, you may be able to use your money to help fund some repairs, but you can’t help much with the acquisition or other costs.
On the high side, you may be able to fund the entire purchase plus repairs.
The more money you provide, the better terms you can negotiate because you are more valuable to the borrower/partner.
SFR and 1-4 Unit Multifamily Rentals ($35,000-$50,000)
Another way people partner is on rental property. Many people are great at saving but may not qualify to purchase more property. This is where partnering comes in.
Every deal is different so no two are structured the same, but essentially one person provides the down payment (or a bulk of it) while the other finds and buys a property. There will be some split of equity and rents based on how your partnership is negotiated and who provides more money and services.
Commercial and Apartment Building Syndication ($25,000 – $100,000)
Syndications buy most of the large buildings you see around town. Groups of investors pool their money to provide the down payment on the property, and the sponsors of the deal finance the rest.
The smaller the deal, the lower the minimum investment, but rarely below $25,000. A small $2 million deal only needs to raise $500,000 for the purchase. That’s only 20 investors with $25,000 each, not hard to achieve.
Imagine trying to raise $30 million…suddenly $25,000 doesn’t seem like a lot. That’s why large deals may have minimums of $100k or more.
How to find investors to partner with
Since it’s technically illegal to advertise partnerships and projects, it can be difficult to find partners. It’s always best to start with your own network by asking everyone you know if they invest in real estate or if they know someone who does. Then you can begin to expand your network by attending local investor meetings and try to network with some people there.
A lot of cities (especially smaller ones) don’t have any good investor meetups. Sometimes the networking events are there, but they are focused on a different area of real estate than you want to invest in. In that case, you should start networking with investors online to grow your network.
5. Invest in Crowdfunded Real Estate
Cost to Start – $1,000 – $20,000
This is the newest game in town. Crowdfunding is where a group of investors can pool their money in a project and share the profits.
Wait, that sounds exactly like syndication…
…because it is. Crowdfunding is essentially web-based syndication.
It’s obviously not a new concept but it is a new way to do deals. The key difference between syndicating and crowdfunding is that crowdfunded deals can be advertised online but they are limited to only accredited investors.
The benefit is the best crowdfunding platforms do a lot of due diligence for you and that helps weed out the bad deals. The bad part is you end up paying some extra fees for that, and it’s limited to accredited investors. Unfortunately, that’s just the way the SECs rules are written.
A couple sites let you invest in some deals for as little as $1,000 which is awesome. Most sites require $5,000 – $10,000 which is still good. A few require $20,000 or more which is more in line with what a standard syndication requires.
The biggest drawback is the requirement for accreditation. Currently, only two crowdfunding sites have any products for non-accredited investors. The good part is it opens up some investments to the non-accredited, but the bad part is they are actually just private REITs and not a syndicated deal. I’ll get into the pros and cons of REITs in the next section
Non-accredited investors can buy into one of these REITs or partner with somebody instead.
6. Buy Into Real Estate Investment Trusts (REITs)
Minimum Investment – $10?
A REIT, or real estate investment trust encompasses a wide range of offerings that invest in a broad range of real estate. It is required to distribute 95% of its earnings to shareholders and also pass a number of other tests in order to maintain its status as a REIT.
There are some exchange traded REITs where you can theoretically buy just 1 share, but there are also private REITs with massive minimum payments which is why the minimum investment has a question mark next to it.
The great thing about a REIT is you can get some exposure to real estate in your portfolio by simply buying into a REIT with your brokerage account. Unfortunately, though, the returns aren’t quite as good as syndication or direct investments in real estate, but it does help increase diversity and decrease volatility in your portfolio.
There are 3 types of REITs – Private REITs, public exchange-traded REITs, and public non-traded REITs.
Public Exchange Traded REITs
These meet all the SEC requirements to be listed on a stock exchange, but they are still a REIT. The benefits of these are they are highly liquid (a rare feature in real estate). The drawback is they have higher fees and most likely have lower returns due to the SEC regulations.
These are the most popular and least risky form of REITs.
Privat REITs are not listed on an exchange. They also don’t need to meet the burdensome requirements of the SEC. In theory, the returns can be much higher due to the reduced regulatory burdens, but there are a lot of bad private REITs out there with massive fees.
The lack of liquidity can also make it very difficult for many investors to get their money out of a
Public Non-Traded REIT
These REITs meet the same regulatory requirements of their exchange traded brethren, but they are not traded on an exchange.
Investors are more confident in them because they have to meet a higher regulatory and disclosure burden, but they are also stuck with a non-liquid investment. The benefit is that they may be less volatile since the value is not in any way related to the broader stock market.
Disclaimer on REITs
FINRA has a pretty big disclaimer about private and non-traded REITs and I need to make sure all the readers are aware of it. Non-traded REITs come with significant risk because they are illiquid, often have a lot of fees buried in their 150+ page offering curricula, and are very complicated investments for normal investors.
The biggest drawback of non-traded REITs is they don’t have a specified selling period like most syndications do. Once the money is in, you don’t know when you will get it back.
Make sure you understand what you’re getting into before buying into a REIT.
Even More Ways to Invest in Real Estate
The wonderful thing about real estate is there are countless ways to invest in it. Unfortunately, I can’t talk about everything in one article.
Without opening a browser, I can think of a half-dozen awesome ways to invest without being a hands-on investor that I didn’t even mention – mortgage notes, tax liens, non-performing notes, wrap-around lending, and more…
The point is – don’t get trapped into 2D thinking in a 3D world. Regardless of your risk tolerance, investing style, or available cash, there is some type of real estate investment that can work for you. Find the kind of real estate that works for you and pursue it.
Your net worth will thank you.