How to start investing in real estate

Types of real estate investing

There are two main types of real estate investing: active and passive. The main difference between the two is whether you own or manage the property.

Active investing

Active real estate investing is the more hands-on approach. You buy and manage the property directly.

This can include buying a house to rent it out either as a short-term vacation home or a long-term residence for tenants.

Another common form of active investing is property flipping, where you buy a home below the market price, renovate it to boost its value, and sell quickly for a profit.

Some of the benefits of active investing are:

• You can collect rental income
• You build equity
• Property values usually appreciate
• You control how the property is used
• Tax benefits

However, there can be downsides, such as:

• Higher up-front costs
• Higher ongoing costs
• It’s less liquid
• Managing the property can be a full-time job
• More research is required on markets and landlord laws

Passive investing

Passive real estate investing requires less effort because a third party does some or all of the work for you. Crowdfunding, real estate investment trusts, and real estate funds allow you to invest in real estate without acting as a landlord. Passive investing also can be good for investors who want to avoid the high up-front costs of active investing.

Here are some of the potential perks of passive investing:

• Lower up-front costs
• Less research and expertise needed
• It’s more liquid

Keep in mind that there may be drawbacks, such as:

• You split profits with other investors
• You have less control over the investment
• More taxes and fees for third parties
• You must share the tax benefits

7 steps to start investing in real estate

If you’re ready to jump into real estate investing, arm yourself with information. Learn more about your investment options and establish your financial goals. All investments come with risk, and some real estate investments are riskier than others.

1. Learn the basics of real estate investing

Anyone considering investing in real estate should learn more about how it works. It’s helpful to understand how market conditions affect which types of investments might be the best bet. The current market also affects whether and how you can finance an investment and how soon you can expect to make money from it.

Learn basic real estate topics such as profitability, cash flow, and financing. Learning the vocabulary and understanding key concepts now will help you approach bigger topics later, such as how to make money in real estate and how to build a real estate portfolio.

One option is to take a course from a real estate trade group, such as the Institute of Real Estate Management or the National Apartment Association. Both offer webinars, courses, and certifications.

2. Determine your risk tolerance

Real estate investing comes with risk. How much risk you take on varies based on your investment type. As an investor, you’ll have to determine your level of risk tolerance, which the U.S. Securities and Exchange Commission defines as “an investor’s ability and willingness to lose some or all of an investment in exchange for potential returns.” In other words, it’s not just how much you are willing to potentially lose, but also how much you can afford to lose.

Your risk tolerance will depend on your personal and financial situation. For example, if you have a family to support, a mortgage payment, and a lot of monthly expenses, you may want to choose safer investments. On the other end of the spectrum, if you don’t have dependents or much debt and a decent amount of disposable income, you might be able to handle a riskier investment.

Building a diversified portfolio is one of the best ways to avoid taking on too much risk. If you have multiple assets with various levels of risk, your portfolio likely will stay afloat even if the market takes a turn or one asset underperforms.

3. Decide what type of investment you’re making

Real estate investing can be as hands-on or hands-off as you want. First-time investors may be more comfortable with a lot of third-party involvement and guidance, while more experienced investors may prefer more autonomy.

Here are some common types of real estate investments to choose from:

• Real estate investment trusts. A real estate investment trust is a company that makes a profit through real estate, often by owning income-producing properties or office buildings. As an investor, you can buy a share of the company to add real estate to your portfolio. In some ways, this is like a mutual fund. REITs come with low up-front costs but can be subject to market volatility.
• Rental properties. A rental property is a home or apartment you buy to rent out to tenants. As your tenants pay rent, you build an income stream and equity in the property. Rental properties have high up-front costs and can require a lot of work to maintain and manage.
• Commercial real estate. Commercial real estate refers to properties rented to businesses, hotels, retail stores, and offices. Typically, investors enjoy a longer lease term, translating into a more consistent cash flow. However, commercial real estate also can be sensitive to market changes.
• Crowdfunded real estate investment platforms. Crowdfunded real estate investment platforms allow individual investors to contribute capital to a real estate project of their choice. In many cases, the funds are illiquid for an extended period.
• Mortgage-backed securities. A mortgage-backed security includes multiple mortgages that loan issuers bundle together and sell to traders in the bond market. It’s a very indirect way of investing in the mortgage industry.
• Tax lien investing. Tax lien investing involves buying at auction tax lien certificates, which are created when a property owner fails to pay their property taxes. Ultimately, you can claim ownership of the home if it’s foreclosed on, but the original owner could pay their tax bill and keep the property.

4. Choose a real estate market

The market where you buy plays a huge role in determining what’s a good real estate investment.

Start by figuring out how much you can afford to invest and look for properties that fit your budget. Look at that area's economy and job market to determine whether it’s growing. It’s also important to consider the population growth and what the renter population is like.

Certain areas are in high demand, making them competitive but promising for investment. They’re fast-growing locales with opportunities and entertainment available. So, you need to research what the best places to invest in look like to you. Also, you’ll need to consider your preferences. Some investors choose to manage their own properties, which is easier if you live nearby, but it’s not impossible to invest in markets outside of your local radius.

5. Start searching for properties

When you find something you may want to buy, research the investment property and the area around it. If the property is in poor condition or in an undesirable location, it’s less valuable.

You can identify the profitability and volatility of an individual property using analytic software and reporting services. A great place to start would be by using our guide to the most promising places to invest in real estate in the U.S., which was compiled based on population, median home sales price, gross rental yield, vacancy rate, and housing price growth index.

6. Figure out financing

Once you’ve found the right property to invest in, you must figure out how to finance it.

You’ll find that finding financing for an investment property can be trickier than getting a mortgage for your primary residence. Lenders have stricter mortgage criteria for investment properties because the borrower is more likely to prioritize paying their primary residence, which means the lender is taking on more risk.

It’s still possible to buy an investment property with a traditional mortgage, but you’ll likely be charged a higher interest rate. Other options for financing include:

• Freddie Mac’s investing property program. This is designed to help borrowers get the financing they need for investment properties with one to four units.
• Real estate crowdfunding. Crowdfunding involves asking the public to help fund the venture. You’ll ask other investors to help you finance your real estate investment and share the risk with them.
• Holding multiple mortgages. You may be able to take out more than one mortgage to help finance your real estate investments. However, this can be risky, and some banks are unwilling to let you hold multiple mortgages at once.
• Loans for flipping houses. You may be able to obtain a loan from a private lender specifically to flip a house. A hard money loan, a home equity loan, or a cash-out refinance may be a better way to fund house flipping ventures than a traditional mortgage.
• Opportunity zones. Opportunity zones encourage investing in disadvantaged communities by providing incentives under the Tax Cuts and Jobs Act of 2017. This is a good option for anyone who wants to revive an economically underprivileged area.

7. Monitor your gains and losses

While each investor will have different goals, they all share the general objective of building an income stream and making money. It’s important to assess your progress toward these general goals by tracking your gains and losses.

For example, if you’ve invested in a REIT, you’ll want to track how your dividend payments compare to your up-front costs to determine when you’ll break even and start making money. If you’ve purchased an investment property, you’ll want to know how many months of rental income it will take until you’ve offset your up-front costs.

You can use profit and loss statements to tell you whether your investment is moving toward profitability or losing money.

You can use several different ratios and calculations to help you understand your progress. Some work better for specific properties, like residential versus commercial, so doing your homework before using one is important. Examples of metrics you may need include net operating income, internal rate of return, and operating expense ratio.

What are the pros and cons of real estate investing?

Like all financial decisions, real estate investing has advantages and disadvantages. How you weigh these pros and cons will depend on your priorities, financial situation, goals, and risk tolerance. If you’re just starting with real estate investment, you might prefer something less risky with lower up-front costs. If your income is high and debt is low, you may be more comfortable with higher up-front costs and illiquidity.

The bottom line: Real estate investing takes knowledge and time

Real estate can be a lucrative investment option, but it’s not without its costs and risks. Whether you take an active or passive approach, it’s important to understand how the market works before diving in. Investing in real estate can be a way to generate additional income, benefit from property appreciation, and diversify your portfolio, as long as you understand that the asset won’t be liquid.

If you’re looking to get into real estate investing, Rocket Mortgage could have the financing option that’s right for you.