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Investing in Real Estate – What You Need to Know to Get Started

When done right, real estate investing can generate shockingly high returns.

I once earned a 400% cash-on-cash return on a rental property within a few months of buying it. After I scored a good deal on the property, a neighbor approached me about buying it and offered me full market value — around twice what I had paid. Because I had financed most of the purchase, my cash investment was low, and I earned an absurdly high return on a small down payment.

Sure, we can chalk some of that experience up to luck. But when you buy assets for less than their market value, you position yourself for plenty of similar luck.

Even without scoring great deals, real estate investments tend to perform well over time. A joint study by several U.S. and German universities, along with the German central bank, found that residential rental properties outperformed every other asset class in the 145 years from 1870 to 2015.

Bear in mind that investing in real estate takes more effort on your part than investing in paper assets. I’ve completely automated my stock investments using a free robo-advisor; I can’t do the same with my real estate investments. But for that extra effort, there are many benefits, ranging from immediate passive income to enormous tax breaks.

Interested in trying your hand at real estate investing? Start with the following fundamentals as you set about learning the ropes.

Why Invest in Real Estate?

Before you invest the time — not to mention the money — in learning how to invest in real estate, you should set clear goals for your investments.

Different types of real estate investments come with different perks, but consider the following as you create an investing plan.

High Potential Returns

As outlined above, real estate offers the potential for high returns.

A house flipper, for example, can realistically invest $100,000 in acquisition and renovation costs, then sell that property for $150,000. That’s a 50% return on investment in a few months, and doesn’t even account for leverage (more on that momentarily).

Rental investors routinely earn annual yields in the 8% to 12% range, which says nothing of appreciation.

Real estate investing comes with several barriers to entry, limiting the competition among investors. While anyone with $100 can invest in stocks instantaneously through their brokerage account, it takes far more money, time, and skill to invest in real estate.

This makes it easier to earn high returns.

Leverage: Other People’s Money, Your Investments

Real estate investors can use other people’s money to build their own portfolio or finance their flips.

Consider the flipping example above, but imagine you borrow 80% of the purchase price and renovation costs. All told, say you invest $20,000 in cash out of $100,000 in total costs.

Instead of earning $50,000 on a $100,000 investment — a 50% return — you earn $50,000 on a $20,000 investment. That’s a 250% return on your cash investment.

That’s the power of leverage.

Ongoing Passive Income

When you buy a rental property, you start earning passive income immediately in the form of rents. And that property can keep on generating income forever.

If you own enough rental properties, you can eventually cover your living expenses without your day job. You reach financial independence and you can retire if you want, no matter your age.

Few investments offer the same income yield as rental properties at the same manageable risk level.

Predictable Returns

When you invest in stock index funds, all you can do is look at historical stock market returns and hope the future brings the same long-term returns. With real estate, you can accurately predict your returns.

A house flipper, for example, can forecast their costs: the purchase price, initial closing costs, renovation costs, carrying costs, and marketing costs. They can also forecast revenue in the form of the house’s after-repair value (ARV). The difference between the two is their profit margin.

Likewise, rental investors can forecast all expenses, and they know the market rent. That leaves them with an average annual cash flow figure.

Tax Advantages

Real estate investors can deduct every conceivable expense from their tax bill, without having to itemize their deductions.

From repairs to property management, travel to bookkeeping costs, real estate investors deduct it all. They can even deduct some paper expenses they don’t actually have to shell out money for, such as depreciation.

If you own the property for at least a year, you pay the lower capital gains tax rate. Through tactics like 1031 exchanges (more on them later), you can even avoid paying capital gains taxes.

Inflation Protection

People need housing. Real estate has intrinsic value, so when inflation strikes, people simply pay more dollars for the same property.

The same can’t be said for debt investments like bonds, aside from special cases like Treasury Inflation-Protected Securities. If you buy a one-year bond paying 3% interest, and inflation surges at 5% that year, you effectively lose 2% on your investment.

Given its strong comparative performance, real estate remains a perennial favorite investment to protect against inflation.

Inflation Graph Increasing Dollar Sign Time


Ways to Invest in Real Estate

Investors have many options at their disposal to invest in real estate.

But for direct investors, those options come down to two ownership styles: buy and hold, or short-term flipping.

Flipping

Although people have been doing it since they moved out of caves, flipping houses skyrocketed in popularity in the housing bubble of the mid-2000s. Television shows glamorized it, and everyone loves a good “get rich quick” plan.

Investors who know what they’re doing can earn spectacular returns quickly flipping real estate. The problems start arising when investors fail to get the education they need and dive right in under the false assumption that real estate is intuitive. (“I know about houses; I’ve been living in them my whole life, after all!”)

Flippers must score a great deal, oversee the renovation on time and on budget, and sell quickly for the full ARV. It sounds easy on paper, but it’s easier to run into trouble than you might think.

For those willing to learn the ropes, however, flipping real estate offers a fun, fast way to earn extra money.

Long-Term Rental Properties

Rather than buying, fixing, and selling, some real estate investors buy and hold for the long haul. They sign long-term leases with tenants and step back to allow the properties to appreciate in value as the years go by.

But home values aren’t all that go up over time — rents also tend to rise each year, usually matching or surpassing inflation.

That bodes especially well for investors who take out a fixed-interest mortgage. Your monthly mortgage payment stays the same, even as the dollar loses value and rents increase.

Short-Term Vacation Rentals

A variation on the buy-and-hold theme, some investors hold their properties long-term but rent them out short-term to vacationers.

This model blurs the line between investing and running a business, as Airbnb hosts must put in a great deal of work in their day-to-day operations. But for that extra work, many vacation rental landlords gain higher returns plus the flexibility of using the property themselves at their leisure.

Indirect Real Estate Investing

Anyone looking to diversify their portfolio to include real estate — but who doesn’t want the headaches that come with direct investment — can opt to invest indirectly.

Options for indirect real estate investments include:

When my friends ask me about investing in real estate, I respond with a simple question: “Do you have a burning personal interest in learning how to invest in real estate as a side gig, or do you just want to diversify your portfolio?”

Investing directly in real estate takes discipline, knowledge, and skill. If you have a passion for it, then I encourage you to pursue it. But if you just want to diversify your investments, look to one of the indirect investing options above instead.

Reit Real Estate Investment Fund Concept


How to Invest in Real Estate: Fundamental Skills

There are dozens of skills you may need, depending on the type of real estate investing you want to do. For example, if you want to invest in short-term rentals and manage them yourself, you need to learn how to operate a hospitality business.

No matter the type of investing you want to undertake, a few core skills apply. As you learn how to invest in real estate, focus on these fundamentals before all else.

1. Forecasting Returns

When I teach real estate investing, I harp on this ad nauseum — largely because novice investors are so cavalier about it.

I can’t tell you how many knuckleheads I’ve heard say lines like “Well the rent is $1,500, and the mortgage is only $1,300, so I’ll earn $200 a month!” That person should start preparing their bankruptcy paperwork now.

Would-be landlords often fail to understand the mechanics of rental cash flow. As a general rule of thumb in the industry, investors refer to the “50% rule:” landlords can expect to lose around 50% of the rent to non-mortgage expenses.

Those expenses include:

  • Repairs and maintenance
  • Property management fees
  • Vacancy rate
  • Property taxes
  • Property insurance
  • Rent default insurance, if the landlord is wise enough to buy it
  • Homeowners association or condo association fees, if applicable
  • Bookkeeping and accounting costs
  • Travel, legal, and other miscellaneous expenses

The same goes for flippers. They take on plenty of hidden expenses, from contractor delays to carrying costs to permit fees and even unscrupulous city housing inspectors who require bribes before they’ll pass your property (no exaggeration; I’ve encountered them).

Learn how to accurately forecast both your expenses and your revenue before buying your first investment property, regardless of the real estate niche you want to enter.

2. Finding Deals

There are dozens of ways to find deals on investment properties. Some require a great deal of work and can yield excellent deals. Others, such as turnkey property platforms like Roofstock, require very little work but don’t offer the same spectacular deals.

Therein lies the tradeoff. You can either outsource the work of finding deals and streamline your investing or take on the headaches required to find hidden gems.

Consider “driving for dollars,” a classic strategy for finding off-market deals. It literally involves driving around your target market and looking for vacant or run-down homes. You then look up the owners of those homes on the public record and contact them however you can to make them a lowball offer. The majority of these property owners ignore you, but a small minority inevitably respond. It’s a numbers game, plain and simple, and it’s labor-intensive.

On the other side of the spectrum lies turnkey investing. Some other investor has already done all the work for you, putting the property in rent-ready shape and perhaps even leasing it to a tenant. You just step in and start collecting rent.

Of course, you pay market pricing for those deals, because you compete with other strangers on the open market for them.

Settle on one or two strategies for finding deals, and learn everything you possibly can about them before making your first offer.

3. Funding Deals

Whether you plan to pay cash or finance the property to the hilt, you need a plan for how to come up with the money at the settlement table long before making an offer.

Novice investors tend to jump straight to conventional mortgages, at least for financing rental properties. Yet conventional mortgages aren’t really designed for investors; they’re designed for homeowners. Although you can borrow a couple of them, you quickly hit a ceiling because most lenders cap the number of mortgages you can have reporting on your credit — which conventional mortgages do.

Instead, real estate investors should think in terms of building a “financing toolbox.” They should work with many types of lenders, including some creative options.

On the more vanilla side, you have hard money lenders and portfolio lenders, who specialize in working with investors. They issue loans and keep them on their own books, rather than immediately turning around and selling them on the open market the way conventional lenders do.

Investors should establish relationships with several of them. The more you work with these lenders, the more trust you build, and the more flexible they become on terms.

Additionally, look into rotating lines of credit, whether from HELOCs through Figure.com, business credit lines, or even unsecured business credit cards. These credit lines prove especially useful for funding renovations or emergency repairs.

Also consider more personal, negotiable sources of financing. It never hurts to ask sellers if they’re willing to offer seller financing. Alternatively, experienced investors have no trouble raising money from their friends and family if they’ve established a proven track record of success.

4. Hiring & Managing Contractors

It’s impossible to overstate how challenging contractors are to work with.

The professional, reliable contractors who show up on time every day for work and complete every project on time? Few exist, and those few charge outrageously high rates.

If you invest in real estate, you will almost certainly have nightmare experiences with contractors. You’ll have blown timetables, shoddy workmanship, and sudden price changes halfway through contracts.

You can’t avoid these experiences entirely, but you can minimize them.

Plan on investing dozens of hours in screening and hiring contractors. Start by collecting a massive number of referrals from other investors and from homeowners. Then screen the heck out of them, calling all their references, showing up at current job sites, and talking to their current clients — not just cherry-picked references. Also consider using websites like HomeAdvisor. They screen contractors in your area and each goes through an extensive background check.

Then negotiate aggressively with them. Make sure you pay as little money as possible initially, and as much of the total cost as possible only at the end of the job once the work is completed. Every real estate investor I know has had contractors ghost them halfway through jobs.

Do not give them a materials deposit. If materials are genuinely expensive for your job, go to the store with the contractor and buy the materials yourself. As a side bonus, you then get to charge the cost to a rewards card rather than paying cash.

Stay on top of contractors every step of the way. Visit the property and check progress daily, if at all possible.

Never, ever underestimate the time and stress required to manage contractors.

5. Form a Plan for Property Management

If you plan to buy and hold, you need a plan for managing your properties.

That plan could involve you managing them yourself. You’ll need to go out and learn everything you can about how to manage rental properties. It’s not intuitive. You need a written plan in place for raising rents each year, filing eviction against nonpaying tenants, tenant screening, and a dozen other management issues.

Don’t wing it. You’ll fall for the first renter with a sob story explaining why they shouldn’t be held to their obligations in the lease contract but you should be. I’ve been there myself — and spent the next 11 months trying to evict that tenant who knew every loophole in the law to prolong the process.

If you intend to hire a property manager, plan on an aggressive screening and interviewing process. Many property managers charge hidden fees, from property visit fees to repair fees beyond what contractors charge. Others fail to screen tenants thoroughly, or to inspect properties regularly, or to promptly enforce your lease when tenants violate it.

It takes hard work to find a good property manager. And even when you think you’ve found one, it takes ongoing work to manage them and ensure they do exactly what they promised.

Pro tip: If you plan to manage your properties yourself, you need to make sure you have a good process in place for screening potential tenants. RentPrep will pull full credit reports with scores, do background checks, look for prior bankruptcies or evictions, and more. Sign up for RentPrep.

6. Form (Several) Exit Strategies

Never buy any investment without an exit strategy. That goes doubly for real estate, which is notoriously difficult to convert into cash.

Exit strategies range from selling to holding with multiple use ideas. I bought a shell of a house to flip in early 2008, then by the time I finished the renovations, the local housing market had completely collapsed. I kept the property as a long-term rental instead.

A friend of mine bought a house to live in and planned to keep it as a long-term rental after he moved out. When he moved, he ran the numbers again and discovered it didn’t yield enough revenue. So he converted it to a short-term Airbnb rental and was able to cover his expenses and then some.

Some real estate investors use a 1031 exchange to roll their profits into progressively larger, higher-yield properties, never having to pay taxes on the proceeds. This tax rule allows property owners to take all capital gains after selling a property and invest it into a “like kind” investment (another property) and defer paying capital gains tax until they sell the new property. They may never sell the property, or they may repeat the process with another 1031 exchange when they do.

Other investors simply borrow money against their rental properties once again, when they pay off their mortgage, as a tax-free way to pull out equity.

They may keep the rental as a source of retirement income and sell only when they grow sick of managing the property manager. Others die holding properties and pass them along to their children as part of their estate.

Whatever your exit strategy, make sure it’s concrete, and make sure you have at least one contingency plan in case Plan A falls apart. Murphy’s Law applies to real estate like everything else: What can go wrong, will go wrong. The stakes are high when you’re working with assets worth hundreds of thousands of dollars.


Final Word

If you want a completely passive form of investing, buy paper assets. Or at least paper assets backed by real estate, rather than buying real estate directly.

Investing in real estate the right way requires hard work. It takes work to learn how to do it properly by buying, managing, and overseeing your teams of support personnel.

But those willing to put in that work can find outstanding returns, tax advantages, and ongoing income for lifelong wealth.

Are you interested in investing in real estate? What types of real estate investment appeal to you most?

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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