Investing in real estate is a path many investors use to build wealth. There are a wide variety of investment opportunities available in the real estate market today. But which one will suit your needs best?
What Real Estate Investment Options Are There?
There are four main ways to invest in real estate:
- Residential rental properties
- Commercial real estate
- Real estate investment trusts
When considering how to invest in real estate, you want to understand the options available, required minimums, liquidity, your level of involvement, and how it will affect your taxes. You can use real estate as a way to diversify your investments.
Residential Rental Properties
Residential rental properties are homes that have one to four units. A single-family residence (SFR), duplex, triplex, fourplex, townhome, and condo are all types of residential properties. Investors may finance these homes through a traditional bank. This process is very similar to what you would use for your primary residence.
There are three primary ways to invest in rental properties: retail, turnkey, or distressed.
Investing Option 1: Retail
A retail purchase is a home that you buy off of the MLS using a realtor. The home most likely was not a rental before, but you’ll turn it into one. I purchased my second and third rental properties this way.
Investing Option 2: Turnkey
Turnkey rental properties are homes that an investor converted into a rental property and has a tenant in place. You can evaluate the purchase based on the purchase price and the rent(s) it receives. This is how I bought my first rental property.
Investing Option 3: Distressed
Distressed properties are homes that need repair and are unattractive to most buyers in their current state. Investors take on the risk of the unknown, then rehab the home to create value and attract tenants. This is the path I’ve taken for the last six rental properties I’ve bought.
Commercial Real Estate
CRE investors look to invest in apartments (five or more units), office buildings, strip malls, storage unit complexes, and much more.
The cash flow of commercial real estate (CRE) properties determines the value of the property and the terms of the loan. Your income, balance sheet, and credit score are secondary considerations when a bank underwrites this type of loan.
Real Estate Investment Trust (REIT)
A REIT is a real estate investment trust.
In layman’s terms, it is the real estate equivalent of a mutual fund. Like a mutual fund, REITs have multiple investors and focus on a particular sector of the market. For example, REITs may niche down to shopping malls, commercial properties, or retirement homes.
When considering a REIT investment, ask if it is a “traded REIT.” Publicly traded REITs are listed on a market index, just like stocks, and can be sold at a moment’s notice. Another option is the “non-traded REIT.” But be aware that this means that your REIT investment may be difficult to sell if you need to cash out.
With real estate crowdfunding, individual investors combine their money with others through online platforms to buy fractional shares of real estate investments.
The 2012 Jumpstart Our Business Startups Act (“JOBS Act”) paved the way for small businesses to raise money from everyday people. Since then, many real estate companies adopted crowdfunding as a way to raise money for their projects.
This method allows an investor to buy a piece of multiple properties to reduce their concentration risk. An investor chooses from many real estate properties listed on the company’s platform. If none meets their criteria, they can choose to wait for additional options or move their money to a different platform.
How Much Do I Need To Invest?
The minimum amount of money required to invest in real estate varies widely depending on the investment strategy or platform that is selected.
Commercial And Residential Real Estate
Commercial and residential real estate generally requires the largest up-front investment. Some investors pay cash for their properties, while others use bank financing. Most bank financing options require an investor to contribute a 20% to 30% down payment.
Real Estate Investment Trusts
REIT investors can start by buying as little as one share. Investors can buy shares of an individual REIT or they can invest in a real estate focused mutual fund. Fidelity, T Rowe Price TIAA-CREF, Vanguard, and many other big names in finance offer real estate mutual funds. Keep in mind that many mutual funds have minimum investment requirements, whereas you can buy a single share of stock through any brokerage.
Every crowdsourcing platform has its own minimum investment requirement. The lowest minimum we were able to find was $10 with Fundrise using the Starter Account, while others may require investments of $5,000 or more.
What Is The Time Commitment Required?
REITs and crowdsourcing have the lowest time commitment. They operate much like your stocks and mutual funds where someone else handles the day-to-day activities. If you own either of these, your biggest commitment is to review the periodic reports about your investments.
Owning a commercial or residential real estate property requires the largest amount of time. You may manage the property yourself or hire a property manager. Hiring a property manager does not eliminate your involvement. You are still involved. For example, approving repairs and upgrades, updating accounting each month, and paying the mortgage, property taxes, and insurance.
Investors who choose to manage their rental properties themselves now have a second job. They need to handle all aspects of the property, like finding and vetting potential tenants, collecting rent checks, and receiving tenant complaints or concerns.
How Real Estate Investments Affect Your Taxes
Any investor should be concerned about their tax liability. And your taxes are affected in specific ways depending on the type of real estate investment you make.
Commercial And Residential Real Estate Taxes
Commercial and residential real estate are typically owned individually or through a corporate structure, like an LLC. Income earned from owning rental properties is taxed as ordinary income.
Real estate depreciates each year. Depreciation is a non-cash item that is deducted from your rental property income. Sometimes, the depreciation is greater than your income.
In my situation, after paying mortgages and related expenses, I earn a profit from my rentals. But after deducting depreciation, that profit turns into a loss for tax purposes.
If I sell the property and don’t buy another one through a 1031 Exchange, then I will pay taxes on the depreciation I’ve written off.
One of the benefits of investing in REITs is that they must distribute 90% of their taxable income as dividends to shareholders. However, the tax burden on this investment also passes to investors.
While dividends from stocks and mutual funds can receive lower tax rates, REIT dividends are taxed as ordinary income. This is why many investors choose to hold REITs in a tax-deferred account like an IRA or 401(k).
Related: How To Buy Real Estate In A Roth IRA
Taxes from crowdsourced investments are treated as a partnership or ordinary income, depending upon the structure of the platform. Investors in crowdsourced real estate may receive a K-1 statement (partnership) or 1099 (ordinary income) to include in their taxes.
Which Real Estate Investment Is Right For You?
There are many nuances to real estate investing on your path to FI, so the “right” investment will depend on your approach.If you want a “set it and forget it” investment option, REITs or crowdsourcing are the way to go. Just don’t forget to place your REIT in a tax-deferred account so you don’t get hit with a nasty tax bill.
Owning rental properties requires a larger time commitment and is great for reducing your tax bill. They are a perfect option for someone who is FI. You have more time to devote to the properties and have the opportunity to receive the positive cash flow, which can be offset by depreciation.
- Podcast Episode: Real Estate Inside An IRA
- What You Need To Know Before Buying A Rental Property
- How Do You Know When To Sell A Rental Property