rental property investing

7 Things to Know Before Investing in Real Estate

This will seem like a lop sided article because we’ve only listed 2 benefits of real estate investing below while listing 5 disadvantages. I want to reassure you that real estate is an excellent investment and there are actually many other benefits and reasons to invest including these 20 reasons in this article here that you can read.

In this article we are covering two additional major reasons why investing in real estate is a smart long term decision as well as showing you the negatives so that you are aware of what to watch out for also. Let’s get started!

2 Important Benefits of Investing in Real Estate

Reason #1: Portfolio Diversification

Real estate adds diversification to an investor’s portfolio so that they are not only invested in stocks, mutual funds, and bonds. Diversification spreads out risk and allows investors the chance to maximize returns when the different assets go through growth stages. When real estate is hot, the investors’ real estate investments will give a higher return to the investor than the other investment holdings, bringing up the value of the entire portfolio.

You can diversify to own real estate in two ways, but I’ll explain which is the best in a second. The first way and most simple way is buying the stock of Real Estate Investment Trust companies also known as REIT’s. If you visit your financial adviser and tell them you’d like to stick a portion of your investment funds into real estate, then this will likely be what he suggests.

However, I as well as many other real estate investors would say the best way to invest in real estate is to actually buy physical property you own. This is the true way to be invested in real estate since you actually own the property and not just a stock of a company who owns the property. Plus the downside of owning a REIT is it is just another stock meaning it’s price can tank any second and the company can go bankrupt any day.

Owning physical real estate allows you to be in control and real estate values move much slower than the stock market. By owning physical real estate, you’ll always own something of value, while owning a stock can become worthless in an instant because it’s not real like physical property and land.

So when you think about investing in real estate, think about the true and real way of investing which is buying physical land to own.

Reason #2: Financial Leverage

Real estate investors are attracted to real estate because it allows them to use financial leverage to their property. Financial leverage, in simple terms, is the use of other people’s money and not using your own. You are “leveraging” someone else’s capital.

The finance industry makes debt capital readily available to most investors if you have a good credit score and prove you don’t need the money by showing them a healthy net worth and steady income. Lenders will typically be willing to provide up to 70% of the value of the home.

Leverage allows an investor to control more real estate using other people’s money than they could otherwise with just their own money. Leverage magnifies returns but can also magnify losses if things don’t go well for the investor.

In the event the property doesn’t produce sufficient revenue to cover the debt payments and operating expenses, the investor will have negative cash flow. If you run analysis and see that the property doesn’t has a negative cash flow after paying off debt, avoid that investment. Duh 🙂

It’s not worth it to buy an investment that will have you coming out of pocket to cover expenses every month because the rent wasn’t enough to cover them for you.

Example of Leverage

To understand the impact of leverage on an investor’s rate of return, consider the following example: Jim has $50,000 to invest. He can do one of the following:

  • Purchase a $50,000 home without use of any borrowed funds
  • Purchase a $100,000 home with 50% borrowed funds, 50% his own money
  • Purchase a $200,000 home with 75% borrowed funds, 25% his own money
  • Purchase a $500,000 home with 90% borrowed funds, 10% his own money

The more he decides to borrow, the more his loan payments will be, which are part principal and part interest. But by purchasing a more expensive investment property, he can collect more rental income as well. It only scales up so much though with single family properties in terms of rent you can charge based on value of the property, which we’ll discuss later but to not leave you confused:

If you have a $50,000 property you’ll try and charge 2% of purchase value in rent, which is $1,000 per month ($1,000 / $50,000 = 2%). With a $500,000 home, it’s not likely you can charge a $10,000 per month rent. Your $500,000 will be better spent buying multiple less expensive units like an apartment complex or several single family homes rather than one expensive house.

Now let’s talk leverage’s effect on rate of return:

Assume he purchases the $150,000 property and takes out a $100,000 loan to cover the purchase. His loan payments will be $6,000 per year, and he expects to rent the property for $1,500 per month which means he will collect $18,000 per year in rental income: This leaves him $12,000 to cover operating expenses which total $4,000 for property taxes and insurance, and $1,000 for maintenance. His net cash flow is $7,000.

  • If he put in $50,000 of his own money and got a $7,000 cash flow in return his investment return is 14%
  • If he used $150,000 of his own money, his return would have been $13,000 / $150,000 = 8.6%.

By using leverage he increased his return on investment from 8.6% to 14%. So you can see why investors like to use other people’s money to control assets, and spread their personal capital out among multiple investments to generate more cash flow.

Instead of spending $150,000, the investor can break it into chunks of $50,000 and acquire 3 different properties or use the $150,000 as a down payment on a larger investment such as an apartment that costs $1,000,000.

With leverage you have to analyze your personal financial situation and see if the rental income stops, can you afford to keep making payments until you get it rented and cash flowing again. Ideally, investors leverage 90% maximum, and put in 10% minimum of the purchase price. To be safer, an investor might consider a down payment of 20% to 30% and leverage of 70% to 80%.

Run the numbers and see what works for you.

Disadvantages of Real Estate

Before you jump into a real estate deal, you need to keep in mind that their are risks and disadvantages of real estate just as there are positives. Looking at both sides will make you a smarter investor and keep you from making the newbie mistake of being overly optimistic.

In fact, do you know why asset bubbles occur?

Because people get overly optimistic. They think the stock market or real estate market will go up forever so they pay absurd prices for stocks and for houses and then get burned like in 2008 when the bubbles burst.

Great investors look to control risk, emotion, and base decisions on full analysis of different economic scenarios and how they’ll effect the investment. More on that later, but for now let’s look at some disadvantages.

how to get started as a real estate investor

#1: Illiquidity

Real estate is not as liquid of an investment as stocks and bonds. In the stock market you can purchase and sell stocks within a few seconds, but with real estate it takes days, weeks, months, and sometimes years to get in and out of deals. If you’re going to be a real estate investor you need to use capital that can be locked up for long periods of time and won’t be needed in emergency liquidity situations.

#2: Real estate can require large sums of capital

Unlike the stock market where you can buy shares of stock for $50, real estate requires thousands of dollars as most lower class homes still cost about $25,000 to $40,000 to purchase. This means it could take years for you to save enough extra income to afford investment real estate. There are ways around this such as borrowing capital or using capital partners to help you acquire property and grow your business.

#3: Real estate cycles make real estate risky

real-estate-cycle

Home prices go up for a while until the market is flooded with supply as every home owner wants to sell at these high prices and then demand falls because buyers don’t want to pay such high prices anymore and BOOM!… home prices start falling for a while until demand comes back. This cycle occurs in both the rental market and home value market, going up and down based on economic factors. An example in the rental market would be when unemployment is high. People don’t have the money to afford high rental prices and vacancies start to occur which is the next point.

#4: Risk of vacancy

If the income producing property sits vacant, you have no income coming in and have to pay out of pocket to cover the monthly expenses. You should have reserves established to cover you for so many months if needed.

#5: The markets will change

Real estate is driven by demand for housing by the people. Business districts and employment opportunities attract people to cities, but things can change as companies can go out of business, weakening the population available to rent to. People may move and migrate to other locations. This affects rent prices. High demand periods allow for increasing rents, but in low demand periods, rents will have to be reduced and if reduced too much, your expenses may be greater than the income potential of the property, putting you at negative cash flow.

Therefore, be aware of the changes in your city and local market area. What is your city doing to attract workers and increase the population?

What to Do Next?

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