With real estate prices skyrocketing in big cities, everyone wants a piece of the pie! Investors are flocking to buy properties in hot areas to turn them into rentals or flip and sell them. But what are the benefits of investing in real estate? And how can you invest in real estate with just $1,000? Let’s find out.
Benefits of buying a home
The benefits of buying a home are both rational and emotional in nature. A home provides a roof above your heads. It provides comfort. It’s a place where you can relax and create fond memories with your family and friends.
When we bought our first (and current) home, we were as happy as ever! The feeling you get once you receive the keys of your own home is priceless!
If you want to get started in real estate, I really advise anyone to save up and buy your own home. Your own home doesn’t give you any cash-flow, but it will provide a roof above your head in good times and bad.
On top of that, you will build equity in your house by paying off your mortgage and possibly enjoy some increase in value over the years.
Should you spend an excessive amount of money on your own home? I would say not. But you should never underestimate the the tangible utility of your own home.
The beauty and risk of leverage
One thing that makes investing in real estate so lucrative is leverage. You can invest in real estate with borrowed money. Money with which you intend to generate a higher return than the interest you need to pay to the bank.
Leverage multiplies your returns positively, but also negatively. Let me illustrate this with an example:
Buy a $150,000 apartment fully in cash. You find a tenant that pays you $12,000 per year in rent. After $4,000 in expenses you have a nice net return of $8,000, or a 5.3% return on equity ($8,000/$150.000*100%).
Buy a $150,000 apartment with a down payment of $30,000 and a loan of $120,000 at 2.2%. You find a tenant that pays you $12,000 per year in rent. After interest expenses ($2,640) and other expenses ($4,000) you have a net return of $5,360. Although this is much lower than the $8,000 in situation 1, the return on equity is 17.85% ($5,360/$30,000).
Obviously, you need to pay back the $120,000, but it gives a simplified example what leverage can do to your return. But the same is true the other way around. If the rent stops coming in you still need to pay the bank the interest on your loan.
Actively investing in real estate
If you want to invest in real estate beyond your own home, there are a few options. One of these options is to invest in real estate directly, by for example, buying another house, apartment (building) or office building.
A benefit is that you know what you are buying and in which area. As many realtors say, there are three things important when buying real estate: location, location, location. This remains true as ever.
Another benefit is that you can build so-called ‘sweat equity’ in a property. By buying an apartment or house directly you can renovate it yourself. After renovating the property yourself, the increase in value -/- costs of renovating = sweat equity. This can be a big plus if you’re very handy with construction work.
Obviously there are many downsides as well. An element I think is very important is diversification. Let’s say you have $100,000 in investable assets. You invest $50,000 in stocks, $10,000 in bonds and you want to invest $40,000 in real estate.
Depending on your location, with $40,000 you can make a down payment for an apartment or house. Even if you know what you are doing and have experience in real estate, you invest 40% of your portfolio in 1 house or apartment, in 1 country, in 1 city, in 1 neighborhood, in 1 street.
I think such an investment from a risk perspective is rather tricky. Especially when you consider the difficulty to sell any property in distressed times. And probably that’s exactly the time you need to sell it.
If you still want to invest in real estate directly, see it as a business, not as a hobby. You need to screen your tenants carefully, be firm and strict if they do not pay their rent on time, have a plumber on speed-dial if needed and don’t forget to manage the legal side of things. Prepare for the worst, streamline the whole process and it’s possible to generate a very nice return.
Investing in real estate indirectly through REITs
Another approach to investing in real estate is by investing in real estate investment trusts (REITs). An REIT is a company that invests in real estate. There are REITs that invest in specific sectors such as energy, healthcare, office buildings and residential.
There are specific requirements a company needs to meet to become an REIT and be exempt from corporate taxes. For example, 75% of revenues need to come from activities related to real estate. But a REIT also needs to pay out 90% of its income as a dividend to its shareholders.
As an investor of an REIT you indirectly invest in real estate. Large international REITs often cover several sectors in many countries and cities. Providing a lot of diversification.
REITs also make it possible to invest indirectly in real estate in Asia or Africa. It’s much harder to do this directly because of language barriers, no local knowledge of the real estate market, different laws and regulations, etc.
Another benefit of REITs are that you can invest with just $1,000 or even less. Even if you have a relatively small portfolio of $10,000, you can gain exposure to real estate without betting everything on one property.
A REITs is like a stock and you can buy and sell them easily. REITs provide a steady income because it requires them to pay out 90% of their income as a dividend. The downside of this is that an REIT can only reinvest 10% of their income, which will lower growth. Because of this steady flow of income, REITs are a great addition to investors approaching (early) retirement.
Although I’m enthusiastic about REITs and they seem like a safe investment, don’t be fooled. Except for diversification and managing the rental process yourself, the same risks apply to both directly and indirectly investing in real estate.
- If you want to invest in real estate, start by buying your own home
- By investing in real estate directly or indirectly, you can generate decent returns
- Borrowing money to buy real estate (leverage) is a beautiful instrument to increase returns, but do not overlook the risks
- REITs are much better at providing diversification, liquidity and ease to invest in international real estate