Many investors today are looking at real estate as a way to generate long-term returns and diversify away from an increasingly volatile stock market.
While there are plenty of potential opportunities in real estate, it can be difficult to know where to start. That’s why we’ve put together this list of 10 fundamentals of real estate investing, to make your investment decisions a little bit easier.
Key takeaways
- Real estate investments can generate recurring income, appreciate in property value over the long term, and provide unique tax benefits.
- Real estate markets historically go through cycles, which is one reason why many investors buy and hold rental property for the long term.
- Leverage is a strategy investors use to increase cash-on-cash returns to quickly scale and grow a real estate portfolio.
- Automating as much as possible, from tenant screening and rent collection to tracking income and expenses can lead to more consistent cash flows and tax benefits.
10 fundamentals of real estate investing
Understanding how real estate investing works, along with education, time, and effort, can lead to long-term success. Here are 10 fundamentals of real estate investing to help you scale and grow a rental property portfolio.
1. Study real estate market cycles
Real estate markets historically move through 4 distinct cycles over a total period of 18 years on average. As this report from Harvard explains, the 4 real estate market cycles are:
- Expansion as occupancy exceeds long-term averages, properties become scarce, and rents rise.
- Hypersupply occurs when consistent increases in rents and prices lead to higher vacancies and unsold properties because of unaffordability.
- Recession occurs when occupancy falls below long-term averages, leading to lower rents, while new supply simultaneously comes to market.
- Recovery begins when buyers purchase property at below market values and tenants benefit from more affordable rents, even with little or no new inventory under construction.
Note that each phase of the real estate market cycle affects cash flow, appreciation, and owner’s equity differently. For example, as the market moves from expansion to hypersupply, property that is overleveraged may begin to have negative cash flow if rent prices need to be reduced.
2. Choose the right real estate investing strategy
Real estate investing strategies are often categorized as active or passive, although the word “passive” is misleading because there is always work required on the part of an investor.
Examples of active real estate investing strategies include wholesaling, fix and flip, house hacking, bird-dogging for another investor, and self-managing a single-family rental (SFR) property.
On the other hand, real estate investing strategies that are customarily thought of as passive (or less active) include investing as a silent partner in a real estate limited partnership (LP), purchasing shares of a real estate investment trust (REIT), providing capital for private lending, or investing in a long-term or short-term rental (STR) property handled by a professional local property manager.
3. Buy and hold has big benefits
Buy-and-hold real estate investing is a strategy used to generate recurring rental income and cash flow and long-term gains from appreciation, while helping to protect an investor from cyclical fluctuations in the real estate market.
As the Federal Reserve reports, the median sales price of houses sold in the U.S. increased from $171,100 in Q4 2001 to $408,100 in Q4 2021, a gain of nearly 239% over 20 years. However, during that 20-year period, there were many times when home prices declined. Investors buying and holding for the long term rode the ups and downs, while short-term investors may have panicked and sold at a loss.
4. Select the best possible location
We’ve all heard that real estate is all about location, location, location. That concept applies at both the market and the neighborhood level.
As a rule of thumb, many smaller Sun Belt cities with strong local economies and good weather have seen above-average population and job growth in recent years that has increased the demand for rental property. According to RealWealth.com, the 21 best places to buy rental property for cash flow and appreciation in 2022 include Albuquerque, Birmingham, Charlotte, Houston, Orlando, and Tampa.
After selecting a city in which to invest, the Roofstock Neighborhood Rating tool is a good, free resource to help you better understand neighborhood-specific risks and benefits based on attributes such as school district quality and home values.
5. Leverage can boost returns
The conservative use of leverage (also known as using "other people’s money") can be used to boost real estate returns.
To illustrate, assume an investor has $250K in capital to invest and those funds were used to purchase one rental property. If the pretax cash flow after expenses is $15,000 per year, the cash-on-cash return would be 6%:
- Cash on cash return = Annual pretax cash flow / Total cash invested
- $15,000 / $250,000 = 0.06 or 6%
Now assume an investor used only $30,000 of that $250K in capital for a down payment on an SFR property. If the rental property was purchased for $120,000 and the property has a pretax annual cash flow of $2,400 (after paying operating expenses and the mortgage payment), the cash-on-cash return would be 8% per year—and the investor would still retain another $220,000 for other investment opportunities.
6. Obstacles are normal
In real estate investing, and in life in general, things don’t always go according to plan. The most successful investors understand that obstacles are inevitable, and strive to stay cool, calm, and collected.
Allowing emotions to get out of control, such as spending more for a property during a bidding war, can cost an investor both time and money. There are always good deals to be had when an investor is prepared to persevere and keep looking for a deal that best matches an investment strategy and long-term goals.
7. Always run the numbers
It’s important to run the numbers by using different calculations to forecast potential returns from a rental property. Some common metrics real estate investors use include:
- Cash flow
- Cash-on-cash percentage
- Cap rate
- Gross yield
- Annualized return
- Total return
You can use the free rental property analyzer in this article to forecast the potential return of a property. Simply enter some information to view projected key return on investment (ROI) metrics, including cash flow, cash-on-cash return, net operating income, and cap rate.
8. Real estate investing is a team sport
There are only so many hours in a day, and the fact is that a real estate investor can’t be everywhere at once. That’s why building a real estate team is one of the most important things an investor can do.
Key members of a real estate investing team include:
- Real estate agent
- Mortgage broker
- Escrow officer
- Appraiser
- Insurance agent
- Real estate attorney
- Contractors and laborers
- Property manager
Having a real estate team is especially important for remote real estate investing.
9. Maintain a capital reserve account
While routine expenses can be easy to budget for, it’s the unexpected costs that catch some real estate investors off guard. To help getting hit with a major repair bill, it’s a good idea to contribute a percentage of the rent collected each month to a capital reserve account. That way, the money will be there when needed, instead of having to tap into personal savings or use a high-interest credit card.
10. Automate as much as possible
Nearly everything is done online nowadays, and today’s property technologies can lead to lower tenant turnover, more consistent cash flow, and tax benefits.
Online tenant screening services such as Avail and Cozy automate the process of marketing a vacant property and screening potential tenants, although it’s still a good idea to pick up the phone and speak with an applicant’s references.
Collecting the monthly rent online can lead to increased on-time rent payments and more satisfied tenants. According to the tenant screening and online rent payment service SmartMove, 6 out of 10 landlords prefer to collect rent online. The company also notes that 61% of millennials—a key tenant demographic for rental property owners—are used to paying their bills online.
Free rental property management software from Stessa is an easy way to automate income and expense tracking instead of using an old-fashioned spreadsheet. Stessa is intuitive to use and helps investors to maximize revenues, run a real estate business with confidence, and claim every possible tax deduction.
