This guide covers everything you need to to get started as an active investor in rental properties or flipping houses, or a passive investor in REITS or other funds.
In the past century, 90% of the world's millionaires have built their wealth through real estate.
Of course, most real estate investors don't get rich overnight. I've come to call real estate the “ultimate get rich slow scheme,” as it takes years for property investments to compound and generate significant wealth.
However, once your portfolio starts generating significant cash flow, it gets easier and easier to buy more — and your wealth will start to snowball.
I experienced this first hand with my own investments. I purchased my first rental property in 2017 and less than three years later, I've built a portfolio of 22 doors. Now I'm able to use the cash flow to buy four more doors every year without any additional investment.
I built my portfolio with a focus on value-add rental property, but there are many different approaches that can lead to success. That being said, the two primary real estate investing strategies are:
- Active investments where you take a hands-on approach to real estate
- Passive investing where you do nothing but provide capital
This article provides an in-depth analysis of different ways you can invest in real estate actively or passively, and the associated pros and cons.
JUMP TO SECTION
- Pros and Cons of Investing In Real Estate
- 4 Ways To Generate Wealth Through Real Estate
- Active Investing - An Overview
- Passive Investing - An Overview
- How Do I Get Started Investing In Real Estate?
- Which Strategy Is the Best For You?
Pros and Cons of Investing In Real Estate
Investing in real estate has a ton of positives, but there are some serious drawbacks that are often overlooked. The chart below highlights some of the major pros and cons and provides a baseline for discussing passive and active investments later in the article.
|Real estate appreciates in value over time||Investing in real estate can be expensive, and your capital isn't liquid|
|Real estate offers stable monthly cash flow||Investing in real estate often requires personally guaranteeing large quantities of debt|
|Real estate investing offers the the ability to get creative to improve your returns||Being a landlord is hard work, and you might have to get your hands dirty|
|Investing in real estate has incredible tax advantages||Real estate returns take a long time to materialize|
|Real estate lets you use leverage (debt) to control more real estate than you could otherwise afford||Real estate investing takes hundreds more hours than stock market investing|
|Real estate is a great hedge against inflation||You may have to invest out of state to get the returns you want|
4 Ways To Generate Wealth Through Real Estate
When most people think about real estate investors making money, they picture a landlord going door to door to collect rent. While rent is one way an investor generates wealth, there are actually four key drivers of wealth you should be aware of.
Over time, real estate appreciates in value — and usually outpaces inflation. This means the longer you own real estate, the more equity you build. Most investors earn the bulk of their wealth through the value of their real estate, not from rent.
2. Rental Income
Cash flow is king, and rental income is the engine that lets real estate investors grow their portfolios. The fastest way to build a large portfolio is to buy properties with positive cash flow. This lets investors use the cash flow from one property to buy another. I recommend using our rental property calculator to model your investment properties and forecast your cash flow.
This one is controversial — and not every investor uses leverage — but personally, I'm a big fan of what leverage can help you do.
For most investments, the bank only requires a 20% down payment and will lend you the rest of the capital needed to purchase a property. Right now, I can borrow money for 4% from the bank then turn around and purchase deals with an 8% cap rate.
This means I can get a positive return from the money I borrow in terms of cash flow. This doesn't account for the appreciation of the property I purchase as well. This further compounds the returns on the money you borrow, and makes leverage a very appealing way to rapidly grow your portfolio.
If you ever hear an investor joke that “real estate is rigged” — taxes are a big reason why. Real estate investors can deduct the following:
- Mortgage interest
- Deferral of capital gains with 1031 exchange
- Cost of repairs, maintenance, and upkeep
- Property management and legal fees
- Travel costs
- Property tax deductions
Active Investing - An Overview
Active investing is any type of real estate investing that requires continuous work from the investor to keep generating returns. Even if you have a property manager, you still have to manage your property manager to generate the best returns.
House hacking is first on the list as it's a great way for new investors to get started in real estate. House hacking is a term for investors that buy a duplex, triplex, or fourplex, and then live in one unit while renting out the others.
When you house hack, you can use a Federal Housing Authority (FHA) loan and purchase an investment property for just 3.5% down. This type of loan makes buying an investment property much more affordable for first time buyers.
Another benefit is that a good house hack eliminates your rent or mortgage payment, as your tenants are now paying for your housing. You can then use the savings from on your rent or mortgage to build a down payment on your next property.
I got my start as an investor with a house hack, and you can learn more about house hacking and how to do it here.
Investing in rental property is what most people think of when they think of a real estate investor, and for good reason — it works.
Most rental property investors only own a few properties, which they manage themselves. This means they are responsible for finding properties, managing renovations (or doing the work themselves), marketing the properties, screening tenants, and being on call when things undoubtedly go wrong.
Being a landlord can be a lot of work, but the returns often justify the time spent. On the other hand, if you're willing to give up a percentage of your rent, you can hire a professional property manager. What you lose in income you make up for in time saved — and stress avoided.
However, it's worth nothing that even if you hire a management company, you still need to manage them to generate the best returns.
To learn more about rental property you can read our complete guide on how to purchase a rental property
Over the past few years I’ve modeled hundreds of properties to find the best deals. I’ve used this tool to quickly screen out bad deals, and let me know which properties deserve my attention.
Enter your email address for free access to the same spreadsheet I use, and a video explaining a step by step walk-though of how to model rental property.
Turnkey rentals are often considered passive investments, but I put them in the active investments category because I think the claim that they're truly passive is false, and they carry significant risk.
A turnkey rental is a property that another company purchases, renovates, and leases, and then sells to an investor as a “turnkey” investment. Theoretically, all they have to do is purchase the property — the rest is taken care of. While this sounds great, in theory, there is a lot more risk than these companies would like to admit.
Sometimes turnkey rental companies will do a shoddy renovation and sell their property for far more than it's worth to out-of-state investors. You're also banking on their ability to stay in business and manage tenants well. If things end up going south and you need to fire the management company, you've suddenly become an active investor with an out-of-state rental that isn't performing well.
While turnkey rentals can be a great investment, you need to carefully vet each company and property to ensure you're not getting duped by someone looking to turn a quick profit.
AirBnB (Short Term Rentals)
Short-term rentals (listing your properties on sites like Airbnb and VRBO) have the potential to generate the highest returns of any of the rental options on this list, but they also come with the most work — and the most risk.
As I write this, the country is currently on lockdown due to Covid-19, and owners of short-term rentals are experiencing nearly 100% vacancy on all of their properties, resulting in a huge strain to continue to make their mortgage payments.
This is an unprecedented situation, but does highlight a key risk of short-term rentals: you're at the mercy of the market for every customer, unlike a more long-term approach where you have tenants signed to year-long leases.
In addition to the extra risk, managing a short-term rental is much harder than managing a traditional rental property, as you have to furnish the residence and clean it after each stay.
However, just like with rental property, you can hire a manager to take care of the day-to -day work, which can make building a portfolio of short-term rentals a lot less work.
When short-term rentals go well, I've seen investors make 4x the monthly profit on each of their properties compared to what they'd make as long-term rentals. If you have a knack for furnishing apartments and marketing on Airbnb, short-term rentals can be one of the best ways to generate massive returns as a real estate investor.
Personally, I take a more conservative appraisal approach and plan to stick with long-term rentals for the majority of our portfolio.
That said, I might experiment with one or two of our 22 units as short-term rentals. This would allow my partner and I to potentially get the benefits of increased profit with short-term rentals, while still maintaining a diverse stream of income.
Flipping houses is the ultimate high-risk-high-reward real estate investment. You can make (or lose) hundreds of thousands of dollars on a single flip — but if you can master the strategy, you can create a consistent source of income to purchase more stable investments like rental property.
I won't go into too much detail on flipping houses in this post, but the high level strategy is simple: you want to purchase houses where the purchase price + needed renovations = less than 70% of what you can sell the property for once it's done. This “70%” rule gives you a good baseline to follow when you're evaluating potential flips.
Flipping houses comes with some large risks, but the two that you need to worry about the most are:
- Renovations that go way over budget
- Financing risk.
It's common for inexperienced flippers to go over budget by 50% or more on their first flips, as they aren't able to accurately estimate what repairs a property needs or how much they'll cost.
The other big risk is financing. Many flippers use “hard money” — aggressive private lenders — to finance their flips.
The longer they hold the property before reselling, the more they'll have to pay. If your flip goes over budget and takes a couple months longer than expected, you could be tens of thousands of dollars in the hole once you finally sell the property.
Flipping houses can be an incredibly lucrative strategy, but you need to really do your homework before giving it a try. If you're interested in learning more you can read our in-depth guide that will give you the confidence you need to consider trying your first flip.
Passive Investing - An Overview
If you're interested in real estate investing but aren't too thrilled about all the work involved in active investing — or you want to diversify some of your investments outside your local market you currently invest in — passive investing might be for you.
Passive investing offers other ways to get into real estate without the hands-on work of active investing; however, it almost always offers lower returns than what you can achieve through active investments — although passive investments often offer more liquidity.
Real Estate Investment Trusts (REITs) are companies that own or finance the acquisition of real estate. Many of them are public and trade on the New York Stock Exchange.
The biggest benefit of investing in one of these REITs is their liquidity. You can buy and sell shares in these REITS instantly through your stock broker.
There are REITs that focus on almost every type of real estate investment, from single family rental properties to huge apartment complexes or warehouses. These funds usually offer target dividends and appreciation.
While the returns often won't match those of an active investor, these funds are truly passive, and the liquidity of publicly traded REITs is the highest of any real estate investment strategy I've ever seen.
Real Estate Funds
Real estate funds are similar to REITs, except they aren't publicly traded and often have a different fee structure.
Funds are most commonly structured where a General Partner or Managing Partner raises capital from investors, or Limited Partners, and invests it in an active real estate strategy we discussed above.
The fee structure varies wildly, but it's most common for fund managers to collect 1-2% of the total funds raised as a management fee, then 20% of the profit generated beyond a target return that they offer to their investors.
Many funds require that their investors are accredited, which means they must meet strict criteria from the SEC in order to invest. Here are the basic guidelines of an accredited investor:
- Having an individual or joint net worth over $1 million (not counting your primary residence)
- $200k in individual income or $300k with your spouse for each of the last two years, and a reasonable expectation that this will continue
- Any trust with total assets greater than $5 million that wasn't formed for the explicit purpose of acquiring the securities offered and is run by a sophisticated partner
- Any entity in which all the owners are accredited investors
- Any company not formed for the specific purpose of acquiring the securities offered, with total assets greater than $5 million.
Investing in real estate funds generally yields higher returns than a REIT — but comes with significantly more risk.
Unlike a publicly traded REIT, it's harder to research the background of a fund and much easier for someone to start one. If you're interested in investing in a fund, it's important to ask the fund manager to speak with their past investors and do your due diligence to get comfortable with the management team's background, experience, and strategy.
Good fund managers are worth their weight in gold, and a poorly managed fund might lose all your invested capital.
Real Estate Investment Platforms
If you're interested in real estate funds but don't meet the requirements of an accredited investor, you can still invest in some online real estate investment platforms.
These platforms, made popular by companies like CrowdStreet and Fundrise, let investors own a small piece of larger commercial real estate projects that offer substantially higher returns.
Some of these investments offer targeted internal rates of return of over 20%. Many of these offerings require investors to be accredited on CrowdStreet, but the majority of offerings on Fundrise are open to anyone.
While these numbers sound appealing, it's important to remember that increased returns come with increased risk, and it's still up to you to do your own due diligence
How Do I Get Started Investing In Real Estate?
If you're reading this guide and you're looking for the best way to get started, I'd recommend:
- House hacking for active investing
- Real Estate investment platforms for passive investing
House hacking will let you get started for just 3.5% down. I was able to purchase a $220,000 house for less than $8,000 all in with this strategy, and the wealth I generated from this purchase fueled the rapid growth of my portfolio.
Online real estate platforms like fundrise will get you started for as little as $500 and give you a taste for what it's like to be involved in real estate, so you can decide if you want to invest more, or get into active investing later on.
Which Strategy Is the Best For You?
When it comes to investing, there's generally two schools of thought:
- Modern portfolio theory
Modern portfolio theory teaches that a good investor diversifies their portfolio to mitigate risk. Following that theory, I would advise that you invest in several of the strategies in this post — both active and passive — as well as more traditional investments like stocks and bonds.
This strategy aims to minimize your exposure to asymmetric risk, where only one class of asset declines, and the rest increases. For most investors, this is the strategy I'd recommend.
The other strategy is specialization. This theory of investment states that if an investor has proven a process to generate outsized returns in a specific asset class, they should invest heavily in that class. It also offers the potential for higher returns, but also brings far more risk than modern portfolio theory.
Personally, my partner and I are following the specialization strategy, as the large majority of our net worth is invested in rental properties and startups — like the site you're reading this post on!
We believe that with our knowledge in real estate, we can generate outsized returns while we're in our 30's, then shift to a more conservative approach like the modern portfolio theory later in life.
This strategy is not without its risks, of course, but we have the benefit of time to recoup our losses if things don't go our way.