Real estate investment provides a diverse range of investment opportunities, each with its own set of compelling benefits.
Let’s look into what makes real estate investment so effective, the different ways you can get involved, and the best way you can get started.
What Makes Real Estate So Special?
Real estate assets are unique from different investment methods due to intrinsic benefits to their asset class.
Property, land, and all the assets that constitute real estate investment have distinct economic characteristics that influence their financial performance and investment potential.
No matter the type of real estate investment you make, these characteristics undergird the viability of your investment and affect the value of your real estate returns.
Scarcity
A definitive characteristic that makes real estate investment so special is the scarcity baked into the assets. The land is a finite resource.
The limited land supply in a given area, especially in an area that is highly developed, necessarily makes the value of the land more competitive. The land is impossible to increase, and the property itself is extremely difficult to reproduce.
The amount of time, effort, and money it takes to develop more buildings in an area put a reliable limit on the supply of real estate assets available on the market.
This scarcity translates to a consistent supply that lends a high degree of stability to the property price.
Improvements
Real estate can potentially increase in value due to the direct involvement of the property owner due to improvements.
Compared to other asset classes, real estate asset holders have the opportunity to make improvements to the land, property, or building. Alterations ranging from transformational development of raw land to refinishing kitchen cabinets add value to the asset, giving property owners a degree of control over the value of their investment.
Even improvements in the surrounding area can affect the value of the real estate. The more effort put into real estate, the more valuable it can become.
Permanence
The high permanence inherent to real estate assets adds to their stability and value as an investment.
Some improvements made to real estate can be so foundational they are virtually permanent. From constructing water lines or connections to the power grid to transformational development of land, the capital that goes into these permanent improvements becomes fixed investments into the property’s value.
It is extremely difficult, if not impossible, to reverse these types of adjustments to the assets so that investors can count on the stability of their permanence.
Location
Location is a seminal economic characteristic that can make or break the value of a real estate asset.
Real estate decisions are all about location. Whether it’s residential buyers looking for their forever home or businesses looking for the most lucrative commercial spot, location is the guiding factor that determines an asset’s value.
A virtually identical property can have widely fluctuating value depending on its location—a single-family home in Los Angeles will be far more valuable than the same house in rural Kansas, for example.
The role location has in the value of real estate means that investors can make more informed decisions about an asset return potential. Identifying market trends in a given location can give investors crucial information that makes for smarter, more consistent investments.
Types of Real Estate Investment
There’s more than one way to get into real estate. Real estate offers investors a range of options defined by the level of involvement they are willing to make in the asset.
Here are a few of the most common types of real estate investment.
Private Ownership
Private ownership opportunities are the real estate investment types people are most familiar with.
This type of real estate investment involves the most equity held in the real estate asset by an individual investor. Even within private ownership, there are more than a few options available for investment.
Due to the higher level of equity held by investors who privately own their properties are entitled to stronger returns. However, they also incur much higher degrees of risk.
Here are two most common ways investors use private ownership to get a return.
Rental Properties
Property rental is an extremely common way real estate investors can get a return on their investment.
You’re likely familiar with rental properties on some level. Most rental properties tend to be residential: single-family homes, condos, and multi-family homes that the property owner leases to residents.
While commercial and even industrial properties can be leased, individual investors rarely have the capital to take ownership of these assets for rental purposes. Residential properties have a high enough financial threshold as is—the average sales price for a single-family home in Q1 of 2022 was over 500,000 dollars.
Rental properties earn their income from the rental payments accrued on the property. Landlords draw up a contract that outlines the rent paid on the property. Often included are additional fees that offset maintenance costs: water payments, electrical payments, or trash collection fees, for instance.
Average Return on Rental Properties
The average ROI on rental properties can vary.
Depending on the ownership fees paid, the level of equity, and the tax breaks available; the ROI on a rental property can range from 8% to 15%.
The total return amounts to cash flow from rental income earned subtracted from the ownership costs paid by the landlord.
But there are other factors to be considered that go into the total cost of a rental property and how much money an investor is gaining from it in the long run.
Renting a property can be extremely demanding.
It requires a great deal of attention to maintain, on top of high operating expenses. Pipes can break, tenants may fail to pay rent, property taxes can add up, or in the worst-case scenario, the landlord can be dragged to civil court for several reasons.
Property management is a lot of work. While it can give a lucrative return, the amount of work and risk required to get the best return must be factored into the investment.
House Flipping
Another common strategy for individual property owners is house flipping.
House flipping is an investment method in which property owners acquire a property, usually a fixer-upper home, make improvements to the house, and then sell the property to make a good return in a relatively short period.
House flipping is almost exclusive to the housing market, usually single-family homes or condos, due to the high financial thresholds required of other real estate asset types.
In a competitive seller’s market, home prices can go up over time. On top of the property value increase from improvements made, house flipping can earn a commendable return on investment in a relatively short period.
Average Return on House Flipping
When all goes well, house flipping can net real estate investors a substantial rate of return.
During the pandemic in the third quarter of 2021, the average return on house flipping was around 32%.
However, this is when all goes according to plan. House flipping can have highs, but it is a real estate investment strategy with high volatility.
For starters, it is a costly financial endeavor in both time and money. In addition to acquiring the property, the investor needs to make sufficient repairs to increase its value. These repairs take time and money.
And if the house requires more improvements than initially expected, the property can blow up in the investor’s face, leaving investors with a costly asset that burns through their capital.
REITs
Compared to private ownership opportunities, real estate investment trusts offer investors a more accessible opportunity to get into real estate.
Created in the 1960s, REITs are companies whose profits are earned through the financing and ownership of income-earning properties. Investors can be shares of REITs like any other publicly traded security on the exchange.
This makes rates an accessible, affordable option. Because investment functions similarly to stock trading, REIT investment has a high liquidity level compared to property ownership. While it can take months and months to liquidate a real estate asset, REIT shares can be traded within days.
Furthermore, REITs allow investors to buy into high-value real estate assets that are inaccessible to individual investors. There are REITs whose assets consist of commercial properties exclusively, down to niche commercial property types.
REITs may focus on something as specific as apartment buildings in San Francisco or frozen yogurt shops in strip malls.
Average Return on REITs
In the last 25 years, REITs have had an annual average return of 12%. That’s a commendable rate of return, often outperforming the S & P 500 Index.
REITs have a relatively high degree of safety and security. Investors aren’t on the hook to the same degree landlords and house-flippers are.
However, REITs have a glass ceiling on their growth opportunities. REITs must abide by a strict set of standards to operate. For example, REIT is legally required to pay out at least 90% of its taxable income to shareholders annually.
This makes it a fairly reliable return but drastically stymies the growth potential of the trust as it legally cannot access the liquid capital that fosters growth.
Best of Both Worlds: Private Equity Real Estate Funds
Private ownership options give real estate investors opportunities for explosive growth and high returns.
REITs offer investors accessible, relatively secure alternatives to private ownership.
A real estate investment opportunity that retains both of these benefits is private equity real estate funds.
Private equity funds are like REITs in that they are pooled funds that allow individual investors the opportunity to buy into high-value assets they wouldn’t be able to access on their own. However, private equity funds are not publicly traded, and only select accredited investors join the fund.
This allows professional managers to more actively pursue competitive, lucrative investment opportunities and get better returns for their investors.
Private equity funds have maintained an average return of 14.2% as of 2020. With real estate prices continuing to skyrocket, private equity funds returns from premium funds are also increasing.
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Sources:
Average Sales Price of Houses Sold for the United States | Economic Research
A Guide to Flipping Houses for Profit | SmartAsset
REITs vs. Stocks: What Does the Data Say? | Motley Fool