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Investing in real estate can make it possible to earn passive income and build equity in the homes you own. Real estate investing also comes with risks, however, including those associated with a bad location, tenants who don't pay, vacancies and more.
Before you get into real estate investing, it's important to understand both the benefits and risks. Here's what you need to know.
Benefits of Real Estate Investing
There are many reasons to consider real estate as a viable way to invest. Here are some of the more prominent benefits:
- Passive income: Income earned from investment properties is mostly passive in nature, which means you don't need to work every day to earn the money you receive. The cash flow is also steady as you receive rent from tenants every month, so you can count on receiving that money.
- Long-term security: Real estate is usually a long-term investment, though some investors may use flipping to gain short-term returns. Over time, though, holding real estate can provide you with steady profits and appreciation.
- Appreciation: In addition to the monthly income you receive from rent payments, you'll also benefit from the property gaining in value over time.
- Equity: As you make your monthly mortgage payment and the value of the home increases, you'll gain more and more equity in the property. If you decide to sell the home at some point in the future, you'll be able to capture that profit on the sale. You'll also be able to borrow against it if need be.
- Tax benefits: Landlords can deduct many of the expenses they incur while managing their properties. That includes the cost of maintenance and repairs, mortgage interest, property taxes, property management fees and more. When you sell the home after owning it for at least a year, that income will be taxed at the capital gains tax rate, which is lower than the ordinary income tax rate.
- Protection against inflation: When the price of goods and services increases, home values tend to go up along with them. Additionally, landlords can increase their rents over time to keep up with inflation.
- Leverage: You don't need enough cash to buy an investment property outright. While you'll need to put some money down, you'll be able to borrow money to finance the rest of the purchase. Just be sure you have a plan for covering your mortgage payments in case your rental unit sits empty. Real estate investing isn't the only type of investment opportunity that allows you to leverage your funds—margin investing in stocks and ETFs is another option—but it's often a lower-cost form of borrowing to invest.
Drawbacks of Real Estate Investing
While there are clear advantages to using your money to invest in real estate, it's also important to understand the risks and how they can impact your investment:
- Bad location: It's crucial to ensure that you pick a good location for your investment property. If the area has a high crime rate, the tenant pool is small or there's a lower potential of appreciation, it could impact both your income and long-term returns.
- Negative cash flow: There's no guarantee that you'll receive enough cash on an annual or even monthly basis to cover all of your expenses. This is especially true if you experience a high vacancy rate, the interest rate on the loan is high or your maintenance and repair costs are high. While you can still benefit from the appreciation of the home, a negative cash flow could impact your ability to pay your bills.
- Problem tenants: It's critical to have a good screening process when tenants apply for a lease. But even if the tenant has a solid history, you may run into a variety of problems, including late rent payments, delayed communication of maintenance and repair needs, vandalism, and accelerated wear and tear.
- Unpredictability: The real estate market isn't always predictable, so it can be difficult to know what to expect. While real estate prices have a general upward trend, a downturn in the market could cut the value of your investment significantly, and it could take years to recover.
- Landlord responsibilities: In some cases, an investment property can take up more of your time than you want, especially if you need to find a new tenant. While you can hire a property manager to do most, if not all, of the work, that's an expense you'll need to budget for.
- Lack of liquidity: If you're investing in a brokerage account and need the money, you can easily sell off some of your portfolio. While you may end up paying a higher tax rate on short-term positions, where you sell less than a year after you bought, you still have that cash in hand. With real estate, you'd need to sell the home to access the equity you've built or take out a home equity loan, HELOC or cash-out refinance.
Should You Invest in Real Estate?
The decision to invest in real estate can be a difficult one, particularly because it can be costly to change your mind. Buying and selling a home involves loan closing costs and agent commissions that can cost you thousands of dollars, and if you don't stick with the property for very long, you may not get enough value to make up for those costs.
As a result, it's important to carefully consider all of your options and the pros and cons to determine whether real estate investing is right for you. If you don't want to make the commitment required to buy an investment property, investing in a real estate investment trust (REIT) can be a worthwhile alternative—more on that in a minute.
With all that said, investing in real estate may be a good option for you if you want more passive income in your investment portfolio, as well as more diversification across different asset classes. It may also be worth considering if you have enough cash on hand to put toward an investment property without putting your savings or investment portfolio at risk.
However, if you're worried about what it takes to be a landlord, don't want to put in the work required to be one or you don't like the idea of having an illiquid investment, you may want to think twice.
How to Invest in Real Estate
There are a few different ways to invest in real estate. Here are some of the more popular options you may consider:
- Rental property: Buying an investment property is similar to buying a home for your own personal use, albeit with a few differences. Once you've purchased the property, you can rent it out to tenants and take their rents as income. You can also purchase commercial properties and rent out the space to businesses instead of individuals.
- House flipping: Some real estate investors buy properties that need significant repairs, put in the time and money to make them attractive, then sell them for a significant profit.
- REITs: REITs are companies that use investors' money to invest in real estate properties. As a shareholder of a REIT, you don't own property yourself, but you do get to enjoy the benefits of regular income through dividends and appreciation when the company sells the properties in its portfolio.
- Crowdfunding: Some online companies use their platform to crowdfund the money necessary to buy properties from investors. However, you often need to have a significant amount of assets to use these programs.
Build Your Credit to Reduce Your Costs as an Investor
As you build your real estate portfolio, you'll be able to create a business to manage your properties. But when you're just starting out, you may need to rely on your personal credit to obtain investment property loans.
As a result, it's crucial that you take the time to monitor your credit history and build a good credit score. This can help improve your chances of getting approved for a loan and securing a low interest rate and homeowners insurance premium.