The Basics of Real Estate: The Beginner’s 2022 Guide
April 16, 2022
Real estate can be a great investment when done right. Before you invest in real estate, learn the basics of real estate so you can determine how you should invest, what the tax benefits are (or consequences), and how much money you can make.
Real Estate Basics
Investing in real estate can be a great way to diversify your portfolio and possibly earn cash flow. Understanding the basics of real estate can help you understand how it works, the risk it involves, and decide if it's right for you.
Who Can Invest in Real Estate
The good news is that the real estate market is open to anyone. Real estate investors don't need to be a specific person, have a certain amount of money, or have special knowledge to invest in real estate. As long as you have the necessary capital for a down payment, can afford the mortgage payment, and are up for the challenge of being a landlord or house flipper, real estate investing can be for you.
Accredited vs Non-Accredited
Some real estate investments differentiate between accredited and non-accredited investors. Suppose you're investing directly in real estate. In that case, residential property is typically open to investors, and institutional-sized investments, like apartment buildings, hotels, and office buildings, are reserved for accredited investors.
To be accredited, you need an annual income of at least $200,000 per year for the last two years and/or a net worth of $1 million. But, if you want to buy residential real estate or even smaller commercial real estate investments, you may not need to be accredited as long as you can fund the investment with your funds.
Why Start Investing in Real Estate
There are many reasons investors add real estate to their investment portfolio. First, it offers diversification. Why take a risk investing in only stocks that could crash at any time? If you diversify with real estate, you offset the risk of a total loss even when the stock market crashes. Real estate and the stock market often operate in opposites, giving you a better chance of offsetting a significant loss.
Other reasons investors add real estate to their portfolio include:
- Potential monthly cash flow
- Equity build-up
- Capital appreciation
- Hedge against inflation
- Potential tax benefits
Overall, real estate appreciates even if there is a downturn in the industry. Investors that treat real estate like a long-term investment, meaning they don't bail after a few months or even a few years, usually see the best return on their investment when investing in the real estate industry.
Real Estate Terminology to Know
Listing Agent vs Buying Agent
A listing agent is the agent representing the seller and trying to sell the property. The buying agent represents the buyer, helping you find the best property for the best price.
This is the 'bid' you give to the seller or listing agent that includes the amount of money you're willing to pay for the home along with other details such as the closing date, items you want left in the home, and any contingencies you need in the contract such as an appraisal or inspection contingency.
This is a legal agreement between you (the real estate investor) and the seller to buy the home according to the terms in the contract.
A contingency is a way out of the purchase contract after signing it. Sellers don't love contingencies because if everything doesn't go perfectly, you might be able to cancel the sale. An example of a contingency is an appraisal contingency. This clause gives you time to get the appraisal done on the property, and if it comes back at a value lower than you offered to pay, you can withdraw your offer and get your earnest money back.
Earnest funds, otherwise known as a good faith deposit, are funds you put down to show that you're serious about buying the home. The escrow funds are held by a neutral third party until the contract clears or you back out of the contract (with or without a contingency). If you satisfy the contract's terms, the earnest funds go toward your down payment, and you have to bring less money to the table.
If you don't satisfy the contract's terms, the seller can keep the escrow funds in exchange for the time the home was off the market.
Pre-Approval vs Pre-Qualify
Before you look at homes, you should determine what you qualify for with a mortgage lender. Your lender can provide either a pre-approval or a pre-qualification, but a pre-approval is better if you're serious about buying a home now.
When you're pre-approved, the lender evaluates your personal financial information and agrees that you can afford the loan. They write a pre-approval letter that tells sellers you qualify for financing based on the information provided.
A pre-qualification means the lender took information from you verbally and estimated how much you can afford. Most real estate investing transactions go much faster and smoother with a pre-approval versus a pre-qualification.
A professional appraiser conducts the appraisal. They inspect the property, measures it, and takes note of its features. The appraiser will take pictures of the interior and exterior of the property and compare the home to the current real estate market. The appraiser looks for similar homes that sold recently to determine the property's fair market value.
A professional inspector performs a real estate inspection that determines the home's condition (not value). The inspector looks deeper into the home's structure, features, and inner workings to ensure it's a good real estate investment.
Mortgage lenders require you to secure lender's title insurance. This protects the lender from anyone that might come forward later claiming ownership of the property. The title company conducts a title search to ensure there aren't any liens on the property, and the title insurance protects those interests.
As a real estate investor, you can also buy owner's title insurance which protects your interests in the property from any future claims as well.
Real Estate Physical Characteristics
The physical characteristics of real estate are important to understand. When you invest in real estate, you invest in property that cannot move, is indestructible, and unique.
When you look at the land, you see that you can't move it. You invest in land that is permanently placed there. While you can change its surface slightly, you cannot move it.
Land and real estate are permanent. You aren't going to pick them up and move them, and they are rarely destructible.
Each parcel of land you come across will have different features and characteristics, even if you're looking at two lots next to one another.
Types of Real Estate
Before you invest in real estate, you should understand the different types, including residential housing, commercial real estate, industrial, and land investments.
Residential real estate is real estate you invest in that is meant for families to live. Single-family homes, condos, and townhomes are good examples. You can buy the properties as a rental property, find tenants and rent them out, giving other families a place to live. It's important to find a particular market in your area with a high demand for rental properties before investing.
Commercial real estate is real estate used for businesses. This could mean retail business, such as a freestanding store or a shopping mall. It could also mean residential buildings, such as an apartment building, office buildings, hospitals, or medical buildings. Commercial properties tend to be much harder to invest in alone, but real estate crowdfunding or real estate investment trusts are a great way to get into commercial real estate investing.
Industrial real estate is investments in buildings used for manufacturing or production. You'll typically find factories and warehouses in industrial buildings.
Investing in land could mean investing in vacant undeveloped land or land that's ready to be built on. It also includes farm land.
Special purpose properties are those used for things like cemeteries, parks, schools, or any other community purpose.
Ways to Invest in Real Estate
Today, real estate investing comes in many forms. Understanding your options and how they work can help you choose the right real estate investment type.
Rental properties can be single-family homes, condos, or townhomes that you own and rent out to tenants. You are the landlord in this situation and in charge of all property management, including collecting rent, maintaining the property, screening tenants, and filling vacancies.
If you'd rather not be a landlord, you can buy and sell property. This works best when you find undervalued properties in the housing market. You fix them up and sell them for a higher price once you increase the property's value. Most fix and flip investors do this within six months to turn a quick profit.
A real estate investment trust is a company that owns and manages commercial real estate. Investors like yourself, can buy shares of the company, therefore investing in real estate. You don't directly own the properties in a REIT, and you don't own the entire property either. Instead, you earn a prorated amount of the monthly rental income, equity buildup, and capital appreciation when they sell the property.
Real estate investment groups are properties owned by a company that sells them to investors like you. When you buy from an REIG, you become part of the group, owning the real estate, but you don't have to manage it. The company that runs the group handles the property management, but takes a small portion of the proceeds monthly to cover their costs.
Real Estate Limited Partnerships
A real estate limited partnership is like an REIG, but smaller and with a predetermined term. Typically a property manager starts the partnership and joins hands with everyday investors that want to become real estate investors. The investors aren't responsible for the day-to-day maintenance of the property or the administrative work. The property manager runs it all and shares the proceeds with investors.
Real Estate Mutual Funds
Real estate mutual funds invest in real estate companies, such as REITs, giving you the returns of a real estate investor without a large amount of capital or responsibility required to own real estate outright.
Fractional Real Estate
Fractional real estate investments are investments in a portion of a property along with other investors. You don't need a lot of capital to invest in fractional real estate, and you aren't responsible for the upkeep of the property or even finding the tenants. With fractional real estate, you earn a prorated amount of the property's proceeds according to the agreement.
Real estate crowdfunding is the pooling of funds from multiple investors to invest either in a property's equity or debt. With crowdfunding, If you invest in equity, you own a portion of the real estate and receive rental income, equity buildup, and capital appreciation. If you invest in the debt side, you are the lender and receive interest income for the duration of the term.
Making Money From Real Estate
There are several ways to make money from real estate, no matter how you invest. You can invest directly or with real estate investment companies to help you make the most of your assets.
Real estate naturally appreciates. While there is always the risk that a property's value can fall, it typically increases annually. As a property owner, whether direct or in a property portfolio, you can earn some or all of the property's appreciation or the difference in the current value to the original value paid for the property.
You might earn cash flow from an investment property if you bought it intending to rent it out to tenants. This works with residential and commercial real estate properties. The tenants live in or use the property and pay you or the investment group rent, which gets distributed to the owners or shareholders.
Real Estate Related Income
You can also make money from real estate by working in real estate, such as a real estate agent, broker, appraiser, or inspector. When you work in real estate, you can earn commissions for properties you help buy or sell, or you can earn fees for services such as home appraisals or inspections.
Ancillary income is income earned from items placed in real estate properties, such as vending machines or washers/dryers in an apartment building. You earn income from the use of the items within the real estate property.
Real Estate Tips and Tricks
Real estate investments can be overwhelming, especially if you think you need a lot of capital to have any real estate exposure. Here are some simple ways to make the most out of your chance to invest in real estate.
- Decide how you want to invest in real estate before starting. For example, do you want direct ownership and to be a landlord, or would you prefer a more passive approach and invest indirectly while earning profits from larger scale rental properties?
- Know how much you have to invest. You can leverage your investment by borrowing money to buy a property worth more than you have to invest, but make sure you can pay back what you borrow and that the property you're buying is in an area that's popular with renters.
- Consider working with a partner. If you have little real estate exposure thus far, consider working with a mentor or partner with a lot of real estate experience. You can learn from your mentor while making money together.
- Tell everyone about your quest to invest in real estate. You never know when you'll come across a great real estate deal or even a small rental property that can start you on your journey in real estate investing.
Risks vs Rewards
Real estate investing can be very rewarding, but it also has risks. No investment is foolproof, so always make sure you know the risks before investing. Do your research and make sure the area has a high demand for renters, has increased market rent, and is an overall good investment, so you don't lose considerable money on your investment.
Real Estate Investment Pros
- Real estate appreciates
- You may earn tax benefits
- Real estate often hedges against inflation
- You may earn cash flow (passive income)
- You may build equity
- You can leverage your investment
Real Estate Investment Cons
- Real estate can be labor and time-intensive
- You may need a lot of capital
- It's illiquid
- You could make a bad investment decision and lose money
What Are the Tax Consequences of Real Estate Investing?
Real estate investing has unique tax consequences. If you earn monthly cash flow from rental property, your income is taxed at your ordinary-income tax rate. However, when you sell a rental property, you also pay taxes on the capital gains. In addition, you cannot exclude the capital gains like you can with a primary residence, which means you'll increase your tax liabilities when you sell the home.
What Is the 5 Rule in Real Estate Investing?
The 5% rule means a rental property shouldn't cost you more than 5% of its value per year. This includes property taxes, maintenance costs, and capital costs (debt and equity).
How Does Inflation Affect Real Estate Investments?
Real estate is often a hedge against inflation. As inflation increases, so do the value of most properties. If you own investment properties, you can increase the rent along with inflation, which helps you either keep pace with inflation or possibly even beat it.
What Type of Real Estate Investment Is the Most Profitable?
Every real estate market is different. In some areas, single-family homes are a great investment, and in others, office buildings or short-term rental properties are the most profitable. Do your research in your area or work with a licensed real estate agent to determine which type of real estate is the most profitable in your area.
Real estate can be a lucrative investment or at least a great way to diversify your portfolio. If you're trying to hedge against inflation, switch up your portfolio, or try your hand at real estate investing, you have many options today. Determine what you're most comfortable with and how much capital you have to invest and enjoy the returns real estate has to offer. Learn more by signing up and visiting our blog.
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