How to invest in real estate

In nutshell

Real estate is a tangible asset whose value keeps pace with inflation and can provide a stream of rental income.

• Real estate is one of the first options investors look to when diversifying their portfolios away from stocks and bonds.
• Investors may own a property outright, or they may own shares of a fund that invest in real estate.
• The popularity of investing in vacation homes has waxed and waned in recent years.

In this article, you'll learn how to invest in real estate, including a variety of real estate investment options for hands-on to completely passive investing.

How to invest in real estate

While many people think about owning rental properties when investing in real estate, that's not the only option. Investors have a variety of real estate investment choices based on how involved they want to be, how much money they have to invest, and what tax benefits they're looking for.

Buying a rental property

One of the most popular ways to invest in real estate is to buy a rental property. Rental properties range from single-family residences to commercial buildings to storage facilities and more. Many investors get their first taste of rental property investing when they upgrade from their starter home to something larger. Instead of selling their first property, they convert it into a rental property and rent it out themselves.

You can manage your rental properties yourself or turn over those duties to a property manager. A property manager finds tenants, collects monthly rents and handles the day-to-day activities so you don't have to. They generally charge 10% to 20% of monthly rental income, but that could be well worth it when you consider the time savings and hassles that you avoid.

Rental property investing offers some of the best tax benefits in the real estate niche. Investors depreciate their rental property's value to offset profits and generate cash flow without an immediate tax burden. This depreciation lowers the property's cost basis, which increases the taxable income when the property sells.

However, investors can 1031 Exchange the sale proceeds to reinvest into other rental properties and avoid taxes until the new property sells. Investors can perform a 1031 Exchange an unlimited number of times to avoid paying taxes on the appreciation of the properties.

Crowdfunding real estate platforms

Many investors either don't have enough money to buy their own property or want to diversify their money into multiple properties. With the advent of crowdfunding real estate platforms, private real estate developers receive money from investors to complete their projects.

Depending on the platform and the deal, investor money either takes an ownership interest in the property or is lent to the developer in place of a bank. Some platforms require accredited investor status to participate, while others "democratize" the process so that any investor can join. Investors can start with $5,000 or more through platforms like Fundrise, Groundfloor and Diversyfund.

Keep in mind that these investments are generally illiquid and have a long-term investment horizon. This means that you are unable to sell your investment at any time. You may have to wait for specific trading windows or until a "liquidation event," like the sale of a property or the maturation of the fund.

Real estate investment groups (REIGs)

A real estate investment group (REIG) is a business that pools investor money to buy and sell properties that it renovates to increase their value or rental income potential. Some REIGs also finance properties for other investors to generate interest income for their investors.

For example, a REIG buys a multi-unit apartment complex and sells shares or individual units to investors. The REIG manages the apartments on behalf of the investors and distributes profits according to their pro-rata share of the complex or the performance of their specific unit. REIGs are similar to real estate investment trusts (REITs); however, they do not qualify as a REIT and therefore are subject to specific limitations or disclosures on their investments.

Often, the initial investment to join a REIG is higher than other fractional-interest real estate investments. The minimum investment amount depends on the structure of the REIG and the type of investments that it focuses on, but it’s usually more than what small investors are willing to part with. Being invited to participate in a REIG is also more difficult than opening a brokerage account.

Real estate investment trusts (REITs)

A real estate investment trust (REIT) is a fund that invests in real estate properties, originates mortgages, or buys mortgage-backed securities (MBS) to create recurring income for investors. REITs are highly-regulated investments that must distribute at least 90% of their taxable income to avoid taxes at the fund level.

REITs offer instant diversification for investors into multiple properties and/or mortgages within a single investment. Some REITs focus on rental properties, some specialize in mortgages, and others do both. Equity REITs that purchase rental properties often specialize in certain types of real estate, like apartments, commercial buildings, hotels, healthcare, or storage facilities. This allows investors to niche down into specific industries to customize their portfolios.

There are numerous ways to invest in REITs, such as publicly-traded companies, index funds and private REITs like RealtyMogul. REIT distributions to investors are ordinary income, which has the highest tax rates. Because of that, many investors hold REITs in their tax-advantaged accounts, like a 401(k) or IRA. This reduces their annual tax burden on their investment income.

House flipping

House flipping has increased in popularity in the last 20 years. Many popular reality TV shows feature independent entrepreneurs who seek out undervalued homes that can be rehabbed to create additional value. Some homes need cosmetic updates while others require a complete gut and rebuild. In some cases, the investor will add an extra bathroom or bedroom to increase the home's value.

As a home flipper, you rehab the house to sell to a family that wants to live there or other investors who want to own it as a rental property. There are limits to how much you can increase the home's value based on recent "comps" (comparable sales) in the local area of similar homes.

House flipping requires significant cash upfront or a loan to fund the purchase and rehab of the property. Some investors become real estate agents or contractors to reduce their costs and increase their profits on every flipped property.

When you flip a property, you're subject to holding costs every month without any corresponding revenue. These costs include insurance, utilities, borrowing costs and the opportunity cost of your investment. Holding costs can eat into profit on rehabs that take longer than expected or when a home sits for sale for too long. Additionally, the housing market can turn during the rehab, and the home value at the end of rehab may not match your initial assumptions.

Short-term and vacation rentals

Short-term rentals have waxed and waned in popularity through the ups and downs of the pandemic. Instead of renting your home to a long-term tenant, you may be able to get a higher daily rental rate as a short-term rental. Although your home may not be rented for the entire month, it may generate enough income from short-term renters to be even more profitable.

To take advantage of this trend, some investors have been converting their rental properties from traditional rentals into short-term rentals. And other investors bought properties in specific neighborhoods based on their short-term rental potential. Tools like Beyond Pricing, Guesty and Hostaway make it easy for investors to make this switch in strategy.

There are drawbacks to this practice, however. Managing a short-term rental is much more labor-intensive than a traditional long-term lease. You must have the property cleaned between each guest and restocked before it is ready for the next guest. And you have to manage guest communications before, after and during their stays. Plus, guest reviews and your responses on vacation rental platforms, like Airbnb and VRBO, can make or break your reputation. These platforms help you find renters, but they also take a cut of your revenue from each stay.

Some popular tourist destinations like New Orleans and New York City have recently imposed restrictions on short-term rentals to discourage owners who do not live in the same building as their rental. Other places with high rents and a lot of tourist traffic may follow suit, so investors who take this path should be intimately acquainted with their local laws and pending legislation.

Some investors choose to manage their vacation rentals themselves, but it can be another full-time job. Handing over the property management of a short-term rental is more expensive than a traditional lease. On average, you can expect to pay 25% of your income to a short-term rental property management company.

Real estate limited partnerships (RELPs)

A real estate limited partnership (RELP) pools investors' money to invest in real estate properties. This structure is one of the many forms of a REIG. With a RELP, there is a general partner that assumes all liability and oversees the daily operations of the partnership. Other investors are limited partners and their risk is limited to the money they've contributed to the partnership. Limited partners generally have no say in the RELP.

Partnerships are not taxed and the profits pass through to the investors. Investors receive a K-1 form detailing their income for tax purposes.

Many RELPs are narrowly defined and may be project-specific, such as a shopping center or business plaza. RELPs may have the potential for higher returns, but they come with higher risks. Investments are expected to remain in the fund for longer periods of time and cannot be bought and sold regularly. RELPs are private investments, so they are not subject to the same disclosures and reporting as a publicly-traded investment.

Delaware statutory trusts (DSTs)

A Delaware Statutory Trust (DST) is a separate legal entity formed to hold one or more income-producing properties for investors. Similar to a mutual fund or REIT, investors own a fractional interest in the trust's properties and benefit from professional management of the portfolio. Investing in a DST also enables investors to own shares of large commercial properties that would otherwise be out of reach for the average investor.

One of the primary benefits of a DST is the ability to 1031 Exchange sale proceeds into the trust. This strategy enables real estate investors to reinvest their money into real estate to avoid taxes. Additionally, it eliminates the risk and hassle of owning individual properties. In some cases, investors can transfer ownership of their property into a DST if the property meets its investment criteria. Generally, DSTs require a minimum investment of $100,000 to participate.

The AP Buyline roundup: What’s your strategy?

Investors have numerous choices when investing in real estate. While many investors start out with individual rental properties, there are many options that don't require such a large investment of time or money. The best strategy depends on how much you want to invest, how involved you want to be and what tax benefits you're looking for.