When it comes to making money in real estate investing, there are only a handful of ways to do it. Though the concepts are simple to understand, don’t be fooled into thinking they can be easily implemented and executed.
An understanding of the basics of real estate can help investors work to maximize their earnings. Real estate gives investors another portfolio asset class, increases diversification, and if approached correctly can limit risks.
There are three primary ways investors could potentially make money from real estate:
- An increase in property value
- Rental income collected by leasing out the property to tenants
- Profits generated from business activity that depends upon the real estate
Of course, there are always other ways to directly or indirectly make money by investing, such as learning to specialize in more esoteric areas like tax lien certificates. However, the three items listed above account for a vast majority of the passive income—and ultimate fortunes—that have been made in the real estate industry.
Real Estate Increase In Property Value
First, it’s important you understand that property values do not always increase. In fact, in many cases, property values rarely beat inflation—the increase in average prices in an economy.
Inflation and Real Estate Investing
When inflation happens a shilling has less buying power. It happens because the government has to create—print—money when it spends more than it takes in through taxes. All else equal, over time, this results in each existing dollar losing value and becoming worth less than it was in the past.
One of the ways that the savviest real estate investors can make money in real estate is to take advantage of a situation that seems to crop up every few decades. They do this when the rate of inflation is projected to exceed the current interest rate of long-term debt. During these times, you might find people willing to gamble by acquiring properties, borrowing money to finance the purchase, and then waiting for inflation to increase.
As inflation climbs, these investors can pay off the mortgages with dollars that are worth far less. This represents a transfer from savers to debtors.
Cyclically Adjusted Cap Rate Purchases
The trick is to buy when cyclically adjusted cap rates—the rate of return on a real estate investment—are attractive. You buy when you think there is a specific reason that a particular piece of real estate will someday be worth more than the present cap rate alone indicates it should be.
For example, real estate developers can look at a project or development, the economic situation around that project, the price of the property and determine a future rental income to support the current valuation. The current value might otherwise appear too expensive based on present conditions surrounding the development. However, because they understand economics, market factors, and consumers these investors can see future profitability.
You may have seen a terrible old hotel on a great piece of land get transformed into a bustling shopping center with office buildings pumping out considerable rents for the owner. Absent those cash flows, net present value, you are speculating to some degree or another, no matter what you tell yourself. You will require either substantial inflation in the nominal currency—if you’re using debt to finance the purchase—to bail you out or some sort of low probability event to work out in your favor.
Rental as a Real Estate Investment
Making money from collecting rents is so simple. If you own a house, apartment building, office building, hotel, or any other real estate investment, you can charge people rent in exchange for allowing them to use the property or facility.
Of course, simple and easy are not the same thing. If you own apartment buildings or rental houses, you might find yourself dealing with everything from broken toilets to tenants operating drug labs. If you own strip malls or office buildings, you might have to deal with a business that leased from you going bankrupt.
If you own industrial warehouses, you might find yourself facing environmental investigations for the actions of the tenants who used your property. If you own storage units, theft could be a concern. Rental real estate investments are not the type you can phone in and expect everything to go well.
Using Cap Rate to Compare Investments
The good news is that there are tools available that make comparisons between potential real estate investments easier. One of these, which will become invaluable to you on your quest to make money from real estate is a special financial ratio called the capitalization rate (cap rate). Cap rates show the rate of return on a commercial real estate investment. It takes its basis from the net income the property will produce.
Just as a stock is ultimately only worth the net present value of its discounted cash flows, a real estate is ultimately worth a combination of:
- The utility the property generates for its owner
- The net present cash flows it generates—relative to the price paid
Rental Income as a Margin of Safety
Rental income can be a margin of safety that protects you during economic downturns or collapses. Certain types of real estate investments may be better suited for this purpose. Leases and rents can be relatively safe income.
Typically these properties involve long, multi-year leases. Buy one at the right price, at the right time, and with the right tenant and lease maturity, and you could sail through a real estate collapse.
You would collect above-average rental checks that the companies leasing from you have to provide still—due to the lease agreement they signed—even when lower rates are available elsewhere. Get it wrong, though, and you could be locked in at sub-par returns long after the market has recovered.
Money From Real Estate Business Operations
The final way of making money from real estate investments involves special services and business activities. If you own a hotel, you might sell on-demand movies to your guests. If you own an office building, you might make money from vending machines and parking garages. If you own a car wash, you might make money from time-controlled vacuum cleaners.
These types of investments almost always require sub-specialty knowledge; e.g., there are men and women who spend their entire career specializing in designing, building, owning, and operating car washes. For those who rise to the top of their field and understand the intricacies of a particular market, the opportunity to make money can be endless.
Other Real Estate Investment Ideas
Still, other investment opportunities exist in real estate. You can invest in real estate investment trusts (REITs). Publicly Traded REITs issue shares and are traded on an exchange, while privately held REITs or non-traded REITs are not available on any exchange. All types of REITs will focus on particular sectors of the real estate market, such as nursing homes or shopping malls. There are also several exchange-traded funds (ETFs) and mutual funds that target the real estate investor by investing in REITs and other investments in the real-estate sector.