How to Profit from Real Estate Investing
There are only a few options when it comes to making money in real estate investing. Though the concepts are simple to grasp, don't be fooled into thinking they'll be simple to put into practice. Understanding the fundamentals of real estate can assist investors in maximizing their profits. When approached correctly, real estate adds another asset class to an investor's portfolio, increases diversification, and reduces risk.
There are three primary ways in which real estate investors could profit:
- An increase in the value of your home
- Rental income derived from the property being rented out to tenants
- Profits derived from real estate-related business activities
Of course, there are other strategies for making money in real estate investing, such as becoming an expert in obscure fields like tax lien certificates. The three items listed above, on the other hand, account for the vast majority of the passive income—and ultimate fortunes—made in the real estate industry.
Property Value Increase in Real Estate
First and foremost, you must understand that property values do not always rise. This lack of asset growth was painfully evident in the late 1980s and early 1990s, as well as the years 2007-2009 when the real estate market crashed. In fact, property values rarely outperform inflation, which is the rise in the average price of goods and services in a given economy.
If you own a $500,000 home and inflation is 3%, your home may sell for $515,000 ($500,000 x 1.03 percent), but you aren't any wealthier than you were last year. That is, the same amount of milk, bread, cheese, oil, gasoline, and other goods can still be purchased (true, cheese may be down this year and gasoline up, but your standard of living would remain roughly the same). The reason for this is that the $15,000 profit was fictitious. Because the increase was due to overall inflation, it was only nominal and had no real impact.
Mortgage rates are an interest-related factor that affects the value of a home. You'll need a few details about the loan to calculate a mortgage, and you can use the mortgage calculator below to crunch the numbers.
Real Estate Investing and Inflation
When inflation occurs, a dollar loses its purchasing power. When the government's spending exceeds its revenue, it is forced to create (or print) money. All other things being equal, each existing dollar loses value and becomes worth less over time.
Taking advantage of a situation that appears every few decades is one of the ways that the savviest real estate investors can make money in real estate. They do this when long-term debt interest rates are expected to rise faster than inflation. During these times, people might be willing to take a chance by buying real estate, borrowing money to pay for it, and then waiting for inflation to increase.
As inflation rises, these investors will be able to pay off their mortgages with far less valuable dollars. This is a transfer of wealth from savers to debtors. In the 1970s and early 1980s, you could see a lot of real estate investors making money this way.
Inflation was out of control until Paul Volcker Jr., the president of the Federal Reserve from 1979 to 1987, took a 2x4 to it and brought it under control by raising interest rates dramatically.
Purchases with a Cyclically Adjusted Cap Rate
The key is to buy when cyclically adjusted cap rates—a measure of a real estate investment's rate of return—are attractive. You buy when you believe there is a good reason to believe a piece of real estate will be worth more in the future than the current cap rate suggests.
Real estate developers, for example, can look at a project or development, the economic situation surrounding it, or the property's price and estimate future rental income to justify the current valuation. Based on current conditions surrounding the development, the current value may appear to be too expensive. On the other hand, these investors can see future profitability because they understand economics, market factors, and consumers.
You may have witnessed the transformation of a run-down old hotel on a prime piece of property into a bustling shopping center with office buildings generating substantial rents for the owner. You are speculating to some degree or another in the absence of those cash flows and net present value, no matter what you tell yourself. If you're financing the purchase with debt, you'll need significant nominal currency inflation to bail you out. You could also count on a low-probability event to go your way.
Investing in a rental property as a real estate investment
Making money by collecting rent is so simple that any 6-year-old who has ever played Monopoly understands the basics on a visceral level. If you own a house, an apartment building, an office building, a hotel, or any other type of real estate investment, you can charge people rent to use it.
Of course, simple and simple are not synonymous. You might have to deal with everything from broken toilets to tenants running meth labs if you own apartment buildings or rental houses. You might have to deal with a business that leased from you going bankrupt if you own strip malls or office buildings. If you own industrial warehouses, you may face environmental investigations as a result of the actions of the tenants who occupied your space. Theft may be a concern if you own storage units. Rental real estate investments aren't the kind of thing you can call in and expect to succeed.
Comparing Investments Using Cap Rate
The good news is that there are tools available to help you compare different real estate investments. A special financial ratio known as the capitalization rate is one of these, and it will become invaluable to you in your quest to make money from real estate (cap rate). Cap rates represent the rate of return on a commercial real estate investment. Its foundation is the net income that the property will generate.
If a property earns $100,000 per year and sells for $1,000,000, the earnings ($100,000) are divided by the price ($1,000,000) to yield 0.1, or 10%. That means the property's cap rate is 10%, which means you could expect to earn 10% on your investment if you paid for it entirely with cash and no debt.
Just as a stock is only worth the net present value of its discounted cash flows at the end of the day, a piece of real estate is worth a combination of:
- The value that the property provides to its owner.
- In terms of the price paid, the net present cash flows it generates
- As a safety net, consider rental income.
Rental income can act as a safety net in the event of economic downturns or collapses. Certain types of real estate investments may be more appropriate for this. Leases and rents can provide a reliable source of income.
To return to our earlier discussion of the difficulties of making money from real estate, office buildings can serve as an example. Typically, these properties are leased for a long period of time. You could profit from a real estate collapse if you buy one at the right price, at the right time, with the right tenant and lease maturity.
Even though there are places where you can get lower rates, you would still collect above-average rental checks from the businesses renting from you (due to the lease agreement they signed). If you get it wrong, you could be stuck with poor returns long after the market has recovered.
Profits from the Real Estate Business
Special services and business activities are the final way to profit from real estate investments. You could sell on-demand movies to your hotel guests if you own one. Vending machines and parking garages can help you make money if you own an office building. If you own a car wash, you could make money from time-controlled vacuum cleaners.
Almost all of these investments necessitate sub-specialty knowledge. Some people, for example, devote their entire careers to designing, building, owning, and operating car washes. The opportunity to make money can be limitless for those who rise to the top of their field and master the intricacies of a particular market.
Other Investment Opportunities in Real Estate
Still, there are other real estate investment options. Real estate investment trusts (REITs) are a good way to invest in real estate (REITs). Privately held REITs or non-traded REITs do not issue shares and are not traded on an exchange, whereas publicly-traded REITs do. REITs of all kinds will concentrate on specific real estate sectors, such as nursing homes or shopping malls.
Several exchange-traded funds (ETFs) and mutual funds that invest in REITs and other real-estate investments are also available to real estate investors.
