Many people today feel like they’re between a rock and a hard place, at least as far as their investments are concerned.
On the one hand, the stock market has performed exceptionally well over the last several years, generating a nice balance in bank accounts and retirement plans. However, many investors today are beginning to have a sneaky suspicion that traditional investments like stocks and bonds have been doing a little bit too well recently.
If this situation sounds familiar, and you’d like to learn more about investing in something you can feel and touch, keep reading to learn how to diversify your investment portfolio and make money in real estate.
Five Biggest Advantages to Investing in Real Estate
Let’s begin by looking at the five biggest advantages to investing in income-producing real estate:
- Cash flow: rental real estate generates a consistent monthly income stream (similar to stock dividends but much, much larger) from turnkey single-family houses, small multi-family property, joint ventures and partnerships, and crowdfunding
- Appreciation: real estate market values historically increase over time, providing an excellent hedge against the wealth-destroying effect of inflation
- Depreciation: the IRS allows you to make non-cash deductions for depreciation from real estate net income to reduce your amount of personal taxable net income while potentially moving into a lower tax bracket
- Leverage: using OPM (other people’s money) by conservatively financing your real estate purchases boosts your cash on cash returns, total yields, and is a great way to maximize the amount of rental property in your portfolio
- Tax benefits: in addition to depreciation, your costs to own and manage investment real estate are fully deductible, and when you’re ready to Section 1031 of the Internal Revenue Code lets you legally defer the payment of capital gains tax when you relinquish one investment property and replace it with another like-kind property
Three Ways Real Estate Can Make You Money
Now, let’s dig deeper into the different ways that investing in real estate can help you make money.
In each example, we’ll use a property with an initial market value of $100,000 and a net cash flow after all of the expenses have been paid, including the mortgage – of $3,000 per year:
1. Monthly passive income
As the saying goes, “Cash is king.” Looking at the income that rental property can generate, it’s easy to see just how true that statement can be.
Cash-on-cash return is one of the best ways to measure monthly passive income. The cash-on-cash formula is expressed as a percentage that compares the amount of cash actually invested to the net cash flow returned:
- Cash returned / Cash invested = Cash-on-cash return
For example, if you purchase a $100,000 turnkey rental property using a conservative down payment of $25,000 (providing an LTV of 75%) and your net annual cash flow $3,000, the cash-on-cash return is 12%:
- $3,000 cash returned / $25,000 cash invested = 12%
So, if nothing changes, the return each year from the cash you invested in the property is 12%. That’s quite a bit more than the S&P 500 which has generated a negative return of -3.67% this year (through June 4th).
2. Increasing value with value adds
Now let’s take a quick look at how to increase cash returns by doing simple rehab work that can attract better tenants and let you increase the monthly rent.
As the name implies, “value add” is anything that adds value to the property and generates more gross cash flow. Value add projects can be capital-intensive, such as doing significant remodeling or adding rentable square footage by converting an attic into a studio apartment.
Or, value adds can be tasks that increase gross revenue incrementally, such as installing new energy-efficient appliances or repainting the inside of the house in today’s trendy designer colors. Neither project costs a lot of money but can have a positive psychological impact on the tenant, allowing you to collect more rent.
For example, let’s say by spending $2,000 to repaint the interior of the house you’re able to increase the monthly rent by $60. You haven’t incurred any recurring expenses, so that extra $50 per month drops straight to the bottom line.
Your new cash-in-cash return from this relatively minor value add project is:
- Cash returned / Cash invested = Cash-on-cash return
- $3,720 cash returned ($3,000 original cash + $720 additional rent) / $27,000 cash invested ($25,000 down payment + $2,000 painting) = 13.8% cash-on-cash return vs. 12% before adding value
3. Cash gain from appreciation
Appreciation is another way that you can make money investing in real estate.
It’s important to note that appreciation isn’t always a sure thing, because prices can go up as well as down from one year to the next. However, history shows that the longer you hold real estate the greater your odds are that market values will rise. That’s why so many successful real estate investors use the buy-and-hold strategy.
According to the Federal Reserve, over the last five years the median sales price of houses in the U.S. have increased by about 13%. Let’s look at what the potential cash-on-cash return of our rental property would be if we hold it for five years.
We’ll begin by adding up the money received over the past five years:
- Initial down payment = $25,000
- Net cash flow over 5 years = $3,000 x 5 years = $15,000
- Gain from appreciation = $100,000 purchase price x 13% appreciation over 5 years = $113,000 less mortgage debt of $75,000 = $38,000 gain from appreciation
- Total return = $15,000 total net cash flow + $38,000 appreciation = $53,000 total return
Now, let’s calculate the total cash-on-cash return during our five year holding period:
- Total cash returned / Total cash invested = Cash-on-cash return
- $53,000 total cash returned / $25,000 total cash invested = 212%
In other words, in just five years, you’ve received more than two times the amount of cash back compared to your initial amount of cash invested.
To be fair, this is a simplified example and we’ve left out variables such as rental income lost between tenants, the possibility of market rent increases and appreciation being higher or lower than the national average, and the pay down of the mortgage balance over the first five years.
But with that in mind, it’s still easy to see how investing in real estate can generate very impressive cash returns over a relatively short period of time.
Active vs. Passive Real Estate Investing
Actively investing requires you to take an active role in the property. Self-managing rental properties, and participating in the construction, development, and rehabbing of real estate of some of the routine tasks required of an active real estate investor.
On the other hand, passive real estate investors have more money than time. They’re looking for ways to put their capital to work while letting someone else handle the busy work.
You’ve probably heard of passive real estate investing without even realizing it. Some examples of passive investing include:
- Turnkey single-family and small multi-family rental property
- Joint ventures and partnerships
- Group investing
- Portfolio investing
- Crowdfunding and real estate fund investing
- REITs (real estate investment trusts)
What all of these methods of passive real estate investing have in common is that you contribute your capital while professionals handle the day-to-day activity to generate the greatest returns and maximize property market value over the long-term.
Different Types of Investment Real Estate
Real estate is categorized by class and by asset type:
- Class A: newly built or completely updated property with the most modern fixtures in the best areas
- Class B: slightly older construction with an above-average grade of fixtures, although some deferred maintenance may be required
- Class C: older construction with average or below average fixtures and deferred maintenance, and can generate solid predictable cash flow although appreciation may be minimal
Real estate is divided into four main categories - residential, commercial, land, and special use:
- Residential: single-family homes, small multi-family property, medium and large apartment buildings, and mobile home parks
- Commercial: office buildings, shopping centers, and industrial properties
- Land: raw land, farmland, land held for the development of commercial and residential projects, and subdivided lots in a subdivision
- Special use: short-term vacation rental property, student housing, senior living facilities, build-to-suit property for single tenants, government buildings, and churches
Investment Real Estate Strategies
There are three main strategies you can use to invest in real estate, depending on the blend of risk-and-reward:
- Core is newer turnkey real estate with no deferred maintenance leased to the most qualified of tenants. Class A core property can be found in the best neighborhoods and school districts and offers a lower rate of return in exchange for a reduced level of risk.
- Value Add real estate offers opportunities to increase value by doing updating to generate more rent. Class B value add property is usually found in average and above-average neighborhoods and school districts and offers a balanced blend of risk and reward.
- Opportunistic real estate is used by investors willing to accept more risk in exchange for a potentially higher reward. Real estate wholesaling and fixing-and-flipping are two examples of how the opportunistic real estate investing strategy is used.
Other Options for Investing in Real Estate
There are also ways you can invest in real estate without actually buying a property directly:
- REITs: Real estate investment trusts, real estate mutual funds, and real estate ETFs – or exchange-traded funds – let you buy shares of stock in publicly-traded real estate funds
- Crowdfunding: Online real estate investment platforms for buying a percentage interest in large investments such as commercial buildings, apartment projects, or new developments
- Real estate partnerships: Partnerships or JVs (joint ventures) have a managing partner actively involved in the daily operation and management of the investment, while other passive investment partners contribute capital instead of their time.