Real estate investment is considered to be one of the most enjoyable and lucrative asset classes. It’s essentially the land, along with any permanent improvements or structures attached to the land. These can be natural or manmade, including water, minerals, trees, buildings and bridges. ‘Real property’ is often referred to in place of ‘land’ and ‘real estate’, but there are some subtle distinctions which investors should be aware of.
- Real estate: the land in addition to any permanent manmade structures, such as houses and other buildings.
- Real property: the interests, benefits and rights inherent in the ownership of real estate.
- Land: the earth’s surface down to the centre of the earth and upward to the airspace above – including trees, minerals and water.
As such, real estate includes the physical surface of the land, everything below and above it, and the rights of ownership. Such rights include the right to possess, sell, lease and use the land. Investing in real estate, therefore can offer a number of promising returns.
What influences the value of Real Estate Investments?
The economic characteristics of real estate can hugely affect the value of the investment. As with all investments, initial cost, supply and demand, and market conditions can all impact the return on investment. Real estate has a few unique characteristics that affect ROI.
- Scarcity – Although the land isn’t considered rare, the total supply is fixed. Meaning, the basic economic principles of supply and demand are not as prominent in real estate investment since a substantial change in the supply of land on the market is unlikely.
- Structural improvements – Additions or changes to land or a building that affects the value of the investment is called an improvement. There’s a difference between private improvements (homes, fences and decor) and public improvements (sidewalks, and sewer systems).
- The permanence of investment – Once the land has been improved, all the capital and labour allocated to the building improvement represents a sizable fixed investment. Despite the fact the building can be razed, improvements like drainage, electricity, water and sewer systems tend to be permanent since they cannot be removed.
- Location – A preferred area refers to the choices and preferences of people regarding a given area. Value is determined by factors like convenience, reputation, and history. It’s arguably one of the most important economic factors of real estate investment.
(Take up of commercial real estate in central London by area 2018 – 2020. Image: Statista)
The graph above shows the precise effects of location on the value of real estate. In this instance, commercial real estate in central London has shown stark disparities between the city’s core to that of the Docklands. There’s reason to believe that the same principle of location impacting the value of real estate can be applied to residential and industrial real estate too.
Types of Real Estate
Real estate refers to the production, maintenance, buying and selling of property and land; i.e. real estate. It’s a critical driver of economic growth and development across both the private and public sectors. As such, real estate can be divided into four types:
- Residential real estate – includes the construction and maintenance of new homes as well as the resale and purchasing of homes. Commercial real estate refers to family homes, condominiums, co-ops, duplexes, multi-generational and vacation homes. In effect, they are residential buildings where you can expect to live.
- Commercial real estate – all buildings and land that are owned to produce income. These include shopping centres, medical and educational buildings, hotels and offices. Apartment buildings are considered commercial, despite being used for residents.
- Industrial real estate – includes the premises where manufacturing and production take place, including warehouses. Such buildings can be used for research, storage and distribution of goods. Zoning, construction, manufacturing and production is handled differently to commercial buildings.
- Land – includes vacant land and working farms. It can be bought, improved and sold, or retained to use as commercial property.
Ways to Invest in Real Estate
The most common real estate investment strategy is to buy a house. Those who own a mortgage have effectively made an investment that gives them ownership of the property, as well as prospects for high returns as property prices continue to climb.
If buying a property is too expensive of an investment, it’s not the only way to add real estate to your investment portfolio. In fact, there are many ways to gain a stake in the real estate game and earn money on such an investment. As with all investments, real estate comes with high risk and reward, and different strategies carry different appetites for risk.
Buying property for rental
Owning rental properties is an ideal opportunity for investors willing to renovate the property, maintain it and have the patience to manage tenants. This strategy still requires substantial capital to finance up-front maintenance and to cover those inevitable vacant months.
But property remains a relatively safe long term investment that’s still likely to increase over the long term. So, if you find the right property and can secure the mortgage; it remains a viable money-making proposition. Do keep in mind that investing in buy-to-let properties used to be a much stronger game.
(Increase of UK rental prices 2015 – 2019. Image: SevenCapital)
UK rental prices have soared by 8% since 2015. As the growing demand for rentals continues, there is scope in the buy to let investment market to produce stable returns.
In fact, regulations and tax changes in the UK reduced investment in this area by 80% between 2015 – 2017. There are still some golden gems of opportunity in the rental market with low prices and strong demand for rentals, but don’t be fooled into thinking that this is an easy game – despite the growing cost of rent.
- Generates regular income
- Properties can appreciate in value
- Maximises capital through leverage
- Some tax-deductible associated expenses
- Can be difficult to manage tenants
- Damage likely to occur from non-permanent tenants
- Reduced income from gaps in tenancy
- Stamp Duty on buy to let properties can be high
Buy to let investment tip: the ideal buy to let investment will have a rental yield of around 8-10% (Property Investments UK), with decent capital growth and strong tenant demand.
Real Estate Investment Trusts (REITs)
A real estate investment trust is created when a trust – usually a corporation – manages investors money to purchase and operate income properties. REITs are bought and sold on major exchanges, just like any other stock. REITs are ideal for investors who want portfolio exposure to real estate, without the responsibilities of managing traditional real estate transactions.
The corporation managing the trust must payout 90% of its taxable profits in the form of dividends in order to retain REIT status. In doing so, REITs avoid paying corporate income tax – as opposed to regular companies that are taxed on profits and then decide whether to distribute after-tax profits as dividends. The idea is to research thriving REITs and purchase shares in them as a potentially profitable investment.
As a dividend-paying stock, REITs are good investments for stock market investors since they generate regular and reliable income. They act as a gateway to real estate investment into non-residential properties such as commercial real estate, which is typically not feasible for individual investors.
(Total return for REITs by segment in 2019. Image: Investopedia)
REITs have historically performed well. Considering the average return on investment on the S&P 500 is 10%, REITs in retail real estate, as the worst-performing REIT, still outperforms the average returns on the major stock market.
One of the main advantages of REITs is that they are highly liquid since they are exchange-traded. There is no need for a realtor to cash out an investment. Ultimately, REITs are formal versions of a real estate investment group.
Investors should make a choice between equity REITs, that own buildings, and mortgage REITs that dabble in mortgage-backed securities (MBS). Both welcome investors into real estate, but in practice, an equity REIT is more traditional in that it provides ownership in real estate. Mortgage REITs centre around the income from mortgage financing of real estate.
- Regular income from dividend-paying stock
- Holdings tend to be long term and cash producing leases
- The leverage that comes with traditional rental real estate does not apply
Real Estate Investment Groups (REIGs)
Real Estate Investment Groups are essentially small mutual funds that invest in rental properties. The typical framework of a REIG works as follows: a company buys or builds a set of apartment blocks, then enables investors to purchase them through the company, meaning, they join the group.
REIGs are perfect for those who want to own rental real estate without the responsibility of running it. A single individual investor can own one or more units of self-contained living space, but the company operating the REIG collectively manages all units by maintaining the building, handling vacancies and advertising apartments. The group then takes a percentage of the monthly rent.
All of the units pool a portion of the rent to guard against occasional vacancies. As such, investors will always receive some income even if their unit is empty. Provided the vacancy rate for the pool does not climb too high, vacancy costs should be covered with cash to spare.
- Less responsibility than owning a rental property
- Provides reliable income
- Units may appreciate in value
- Fees associated with investing in REIGs
- Susceptible to unscrupulous managers
Property loan notes
A property loan note is a financial instrument that is used to raise capital for property developers. They’re an attractive way to invest in the property market without getting your hands dirty. Property loan notes allow investors to sit alongside institutional investors in major development projects that would otherwise be unavailable to individuals.
The process is simple and as follows; once a property site development is identified, planning permission is applied for to the local council. Once approved, developers seek funding to fund the project by issuing property development specific loan notes to investors. Interest payments start when outlined in the loan note agreement. A gross development valuation is conducted by an authorised valuation agent and the project is then sold to an investment institution like Morgan Stanley. The investor capital is then paid back.
An exciting and lucrative real estate investment strategy, house flipping has been dubbed the proverbial ‘wild side’ of real estate investing. Real estate flippers are very distinct from buy to let landlords. One of the main distinctions is that they often look to sell the properties they buy at undervalued prices within six months of purchase.
It’s a strategy for people with experience in real estate valuation, marketing and renovation; as well as sufficient capital to buy and oversee repairs as needed. These prerequisites make house flipping semi-exclusive. However, there are plenty of undervalued properties across the country with the potential to perform well.
For many house flippers, the ideal property will already have the intrinsic value needed to turn a profit without any major alterations. If not, they’ll typically be eliminated from contention. Others will make money by purchasing reasonably priced properties and adding value by renovating them. It’s for sure a longer-term investment but can yield high returns.
(Home flipping gross profits and ROI 2009 – 2018. Image: AttomData)
Recent trends suggest that the average ROI on flipping a house does not pay off. 2017 seems to mark the point at which the average home flipper managed to offload a property for less than what they had initially invested.
If an investor is unable to quickly unload a property, they might find themselves in financial trouble since they typically do not hold enough uncommitted cash to pay the mortgage on a property over the long-term. House flipping is a fast-paced game and is best suited for those who know how to budget.
- Capital is only tied up for the short-term
- Can generate quick and high returns
- Required deep real estate market knowledge
- Hot markets can always cool unexpectedly
Online Crowdfunding platforms
Real estate crowdfunding platforms provide a way for investors to access real estate investments. The scope for returns are high, but so too are the risks. These platforms are great for those who want to join others in investing in commercial and residential real estate, which is difficult for individual investors to fund alone.
The investment is done via online crowdfunding platforms and the amount of capital an individual chooses to invest is far lower than what is required to purchase properties outright. The online crowdfunding platform essentially connects investors who are looking to finance property projects with real estate developers. It is a good way to diversify your investments without spending too much money.
Whilst some crowdfunding platforms are only open to accredited investors, defined as net-worth individuals of more than $1 million (excluding the value of their home), others are open to all investors with an appetite for risk.
Fundraise and RealtyMogul are examples of crowdfunding platforms that welcome non accredited investors. They’re usually in the investment form of nontraded REITs or REITs that are not traded on the stock exchange. As such, they’re less liquid, meaning funds will be invested for at least several years before an investor can retrieve their cash.
Real estate crowdfunding investment tip: Many crowdfunding platforms have a short track record, and are yet to face an economic downturn. If this strategy is for you, turn to renowned real estate crowdfunding platforms for security.
- Options to invest in single projects or a portfolio of projects
- Geographic diversification
- Illiquid lockup periods
- Management fees
How to Make Money Investing in Real Estate
The most common way to make money investing in real estate is from increasing property value. Property appreciation is achieved in different ways – many of which we have explored above. You can also increase your ROI on a property by refinancing the loan you used to buy the property at lower interest. This will help to lower your cost abscess for the property and increase the amount you clear from it.
It’s easy to increase the appreciation of underdeveloped land by simply developing it. Immediate value is added and the market price increases. The land outside of expanding cities already experience an appreciation of value by virtue of their proximity to the city. Once developers build on it, the value is raised even further.
Appreciation in land can also come from the discovery of valuable commodities or minerals, provided the buyer of the land holds rights to them. This is true of gravel deposits, trees, water and other natural resources. Therefore, upon considering whether to invest in land, pay attention to the value of the land and whether you can enhance it.
As for residential properties, location is key to both appreciation and depreciation. As neighbourhoods evolve and local amenities improve, value is added. This is not only true of the well-known case of big cities like London, but smaller towns and villages can appreciate in value as the local area becomes more desirable.
Should you rely on Inflation for appreciation?
Whilst it’s true that properties are hundreds of thousands of pounds more expensive than they were in the 1970s, relying on inflation alone is somewhat a pyrrhic victory. Your property might be worth 5 times as much in 20 years time, but many other goods will cost 5 times as much to buy too. Purchasing power is always a factor in valuing properties.
Generating income through Real Estate
Whilst generally understood as rent, income from real estate can come in many forms. Let’s look at a reminder of all the ways real estate can produce steady returns:
Raw land income – companies will pay royalties for discoveries they find on your land, or for any structure they add. Raw land can also be rented for agricultural production.
Residential property income – commonly understood as rent. Tenants pay a fixed amount per month that goes up with inflation. Costs are deducted and the remaining amount is profit.
Commercial property income – basic rent for the commercial use of a building is most common. ‘Option income’ is generated when tenants pay additional rent for contractual options like the right to the office next door, for example.
Determining a good ROI for Real Estate Investments
The short answer is, it varies. What one investor considered a ‘good’ return on investment may be a disappointment to another. ROI on real estate varies by risk tolerance – that is, the more risk an investor is willing to take, the higher ROI they might expect. Whereas those investors with a low appetite for risk might happily settle for a lower ROI in exchange for certainty.
As a general benchmark, and to make real estate investing a worthwhile strategy compared to other asset classes, investors aim for returns that match or exceed the average returns on the major exchanges. The historical average S&P 500 return is 10% (NerdWallet). A 10% or above return on real estate is then a worthwhile investment for those who were considering putting money in traditional stocks.
As we know, investing in real estate isn’t exclusive to those buying, renting and selling physical real estate. Real Estate Investment Trusts trade on stock exchanges and can provide diversification to a portfolio without the need to manage a property.
Investors should remember that return on investment does not equal profit. Before ROI can be materialised in cash, the property must be sold. In many instances, the property will not sell at its market value. When a real estate deal closes below the initial asking price, the final ROI calculation for the property is thus reduced.
That’s not to mention the costs associated with selling a property, such as renovation, landscaping, appraisal costs, commission to the real estate agent and legal fees.
Risk and Reward: Is it worth it?
As with all instances of parting with your cash, investing in real estate comes with its risks. Will you be able to find tenants? Sell above market price? Flip the house in time? And after all, is the extra burden of owning and managing physical property worth the grind? These are all risks to consider, but the benefits of investing in real estate are numerous.
With strategically chosen assets, investors can benefit from predictable cash flows, high returns, tax advantages and portfolio diversification. It’s most certainly possible to leverage real estate to build wealth. Still not convinced? The following benefits might just sway you.
- Cash flow – the ability to generate a net income from a real estate investment after mortgage payments and operating expenses have been paid. Cash flow will strengthen over time as the mortgage is paid and equity is built up.
- Tax advantages – Investors can deduct the reasonable costs of owning, operating and managing a property. The cost of buying and improving an investment property can be depreciated over its lifespan. Meaning, investors can benefit from decades of deductions that help lower their taxed income.
- Appreciation – The value of real estate tends to appreciate naturally over time. Inflationary pressures combined with a growing population, increased demand, location improvements and business activity all boost the value of real estate over time. With a good investment, it’s possible to turn a profit when it’s time to sell. Rent also rises over time, increasing cash flow.
- Build equity and wealth – Buying and paying off properties helps to build your net worth. As investors come to build equity, they can leverage their status to buy more properties.
- Portfolio diversification – The diversification potential is vast. Real estate has a relatively low correlation with other major asset classes. So, real estate can lower portfolio volatility and provide a higher return per unit of risk.
- Inflation hedging – The positive relationship between GDP growth and the demand for real estate means that as economies expand, the demand for real estate increases payable rent – materialising into higher capital values. In other words, real estate has the capacity to offset some inflationary pressures by passing such pressure onto tenants and incorporating some of the inflation in capital appreciation.
Is it worth it?
Whilst the benefits of real estate investment are plentiful, there are of course some drawbacks. The main one, being the lack of liquidity and the relative difficulty in converting an asset (held in real estate) into cash. With stocks and bonds, this transaction can be completed in seconds. It can take months to close a real estate deal.
Nonetheless, real estate is a unique asset class in its ability to enhance the portfolio of an investor. It’s relatively simple to understand and on its own, can produce cash flows, tax advantages, equity building, and offset inflationary pressures. It also diversifies a portfolio – through physical property investment or REITs.