What investment diversifies portfolios, pays off its own debt and builds equity, produces predictable and stable cash returns, appreciates in value, and reduces taxes through deductions?
Investing in real estate is the ultimate money maker.
A successful investment property can make you money in your sleep, and once your investment returns are high enough, your property can literally buy you more, exponentially increasing your profits.
Real estate as an investment creates a money-making snowball effect every investor dreams about. If you’re just getting started, there are quite a few things you should know heading into your first deal.
Purchasing an investment property
Despite all the lucrative benefits of investing in real estate, bad real estate investments exist, and if you’re not careful, you could end up buying one.
A general piece of advice for new real estate investors is to stay away from the fixer-uppers. These can cause you more trouble and cost you more money than they’re worth, so start small.
Where you buy largely determines how profitable your real estate investment will be. Try to invest in upscale, growing communities where your property will appreciate faster and you can charge higher rents.
Know the investment properties
Investors categorize their properties into three property types: residential, commercial, and mixed use.
- Residential real estate investments are homes, individual condos and apartments, and other residential structures.
- Commercial real estate investments are retail stores, apartment buildings, and other commercial structures.
- Mixed-use real estate investments are hybrids of the two — typically, commercial structures with residential units within.
If you’re keen to know more about investment property basics, check out our guide to investment properties.
What makes a good investment property?
Most real estate investors agree that a good investment property is one that generates enough cash flow to reach your return targets by desired time frames.
Investors pick their properties by evaluating several factors: location, market trends, property value, cash flow and growth potential, and property condition and management. We dive into each of these factors here.
Ultimately, an investment yield or ROI assessment will help you see how much money you can make on any property you look at.
Property investment yield
This is a measure by which real estate investors evaluate the earnings their properties generate over a specific period of time, usually annually. Investment yield is expressed as a percentage rate of the purchase price of your investment.
There are three types: gross yield, net yield, and cash-on-cash rental yield.
When you’re buying an investment property, it’s important to consider net yield over gross yield. The former evaluates profitability after expenses while the latter does not. You can find a detailed breakdown of these terms here.
Calculating net yield can help you determine whether a property will be an asset or a liability. The formula is as follows:
Yield = [Annual Cash Flow / Purchase Price] × 100
Real estate investment return calculator
You may have heard other investors use the terms yield and ROI interchangeably, but there’s a subtle difference between the two.
Like yield, ROI is a measure by which property investors evaluate profitability. While yield shows your annual return on the total purchase price of an investment, expressed as a percentage rate, ROI shows your annual cash flow after associated cost deductions as a percentage of your total invested capital.
The ROI formula is as follows:
ROI = [Annual Cash Flow / Invested Capital] × 100
To learn more about ROI and how to calculate it, head over to this post.
Real estate investment mortgage rates
Interest is the price you pay to take out a mortgage, and it’s one of the most important aspects of buying a property you should understand.
Mortgage interest is expressed as an annual rate, and it shows you how much of the loan principal the lender expects you to pay in a year.
Mortgage interest has either a fixed rate (where the interest won’t change throughout the loan term) or an adjustable rate (where the interest will adjust after a fixed-rate period).
Financing your real estate investment
You don’t have to buy your investment property with all cash.
By far the most popular financing method for real estate investments is the conventional mortgage. The typical down payment for getting an investment property conventional mortgage is 20 percent. And interest rates are typically higher for investment properties since lenders consider them higher risk.
There are other ways to finance investment properties, such as with Federal Housing Administration (FHA) loans and more. Click here to learn more about financing your real estate investment.
Minimum down payment
Down payments on investment properties are typically 20 percent. You can negotiate a lesser down payment, but you’ll end up paying more.
Generally, the more you can put down on an investment property, the less money you’ll have to pay in interest and insurance. And starting a new real estate investment with more equity gives you more buying power for future purchases.
If you don’t want to pay the full 20 percent down payment, you can get a loan with a much lower initial investment requirement. Find out how to fund a real estate investment with a low down payment here.
Investment property mortgage refinance
If you feel you have unfavorable mortgage terms, or if you need access to the equity in your investment property to cover expensive surprises, you can get a mortgage refinance — a loan you take out to pay off your current mortgage.
When you take out a new mortgage to pay off your original one, you effectively swap the bigger loan for a smaller one, putting you in a position in pay less insurance, pay smaller premiums, and cancel mortgage insurance. Our post on investment property mortgage refinances explains more.
IRA real estate investments
You can buy real estate with your tax-advantaged IRA, but there are strict rules to follow. Here are several of them:
- You cannot get a conventional mortgage for your investment property, nor can you use non-IRA money to help finance it. You can get a non-recourse IRA loan.
- You must pay unrelated-business income tax if you finance your investment property.
- The property must be an investment. Thus, you can’t use it for anything else, and you and your family can’t live in it.
- Your IRA must assume all property expenses, including taxes, repairs, and other fees.
If you don’t follow these rules, you risk invalidating the tax-advantaged status of funds in your IRA. Head to this post to learn more about buying real estate with an IRA.
Real estate investing in 2020
A recent Zillow report suggests we’re headed for an economic recession in 2020, but the housing market won’t be the cause, as it was in 2008. In the report, a senior economist states that “meaningfully higher interest rates should eventually slow the frenetic pace of home value appreciation.”
In other words, housing prices may increase at a much slower rate — only 2.8 percent, as Zillow predicts — than what has been observed over the past couple of years, to the delight of many new real estate investors looking to buy for the first time.
Check out real estate investing in 2020 to learn more about what’s expected, as well as which real estate markets are expected to flourish next year.
The bottom line
If you’re investing in real estate for the first time, approach it from the perspective of a business owner, not a new homebuyer. As you get the proverbial ball rolling, it’ll take on the life of a business, which will need smart management and even smarter decision-making.