What Is Real Estate? A Guide To The Industry And How It Works
Dan Rafter10-minute read
April 06, 2021
Interested in buying a home so you no longer have to send those rent checks to your landlord each month? Maybe you’d rather buy your own apartment building, strip center or warehouse, with the goal of watching your investment increase in value.
This isn’t surprising: Real estate is attractive to both investors and those who want to swap renting with owning. It also comes with plenty of tax breaks. And if you do your research, you can boost the odds of your piece of real estate – whether it’s a home you live in or a two-flat that you rent out – appreciating in value before you sell, leaving you with a profit.
But while real estate is an attractive alternative or addition to stocks, bonds and mutual funds, it does come with risks and challenges. Investing in real estate isn’t quite as easy as buying stocks or sinking your money in CDs.
Here’s a look at how real estate works, what makes it an attractive investment and the steps and research you need to take whether you’re buying a home for you and your family or an investment designed to boost your bottom line.
Real Estate Definition
At its most basic, real estate is defined as a piece of land and the property – such as a house, office building, apartment, strip center or warehouse – that sits on it. These structures can be both above and under the ground. For instance, if you own a strip center with an underground parking lot, that parking lot would be part of your property.
If you are buying real estate, you should also understand what the term real property means. Real property is the land and any structures affixed to it that are factored into the value of the property. For instance, if you own a home, its garage would be considered part of its real property. A movable picnic table in your backyard, though, would not. Real property also gives you the right to use your property, including selling it or leasing out space in it, however you want.
Types Of Real Estate
There are several types of real estate available. You might purchase some – such as a single-family home or condo unit – to live in. You might purchase others – such as an office building, storefront or apartment building – to rent out to others. And no matter what type of real estate you purchase, the hope is that it appreciates over time so that when you do sell you earn a profit. Be careful, though: While real estate has been a sound investment over time, appreciation is not guaranteed. As with any investment, you can lose money when investing in real estate.
As its name suggests, residential real estate is any type of real estate in which people live. There are many types of residential real estate, including single-family homes, townhouses, condominiums and multifamily apartment buildings.
Many people purchase residential real estate for themselves as a place to live. But you can treat this type of real estate as an investment, too. You might buy a single-family home, renovate it and then sell it for a higher price. You can also buy a single-family home, rent it to tenants – collecting monthly rent checks to help cover the costs of any mortgage payments – and then sell after the property appreciates in value.
Even if you buy residential real estate primarily as a place in which to live, your home might still turn out to be a solid investment if it’s worth more when you sell than when you first purchased it.
Commercial real estate is any property that provides a business service and isn’t used as a living space. This includes everything from office buildings and shopping malls to restaurants, clothing stores, movie theaters, gyms and gas stations.
You can earn money by both holding onto the property until it increases in value, selling for a profit, and by leasing space in your property to business tenants. For example, if you owned a retail strip center, you’d charge that pizza restaurant monthly rent to lease space in it. If you owned an office building, you’d charge companies to lease space in the building.
You can also use commercial real estate as a home base for a business of your own. You might own an office storefront if you run an insurance business, for example.
You can also buy land, real estate that has no buildings or structures on it. If you purchase land, you can then develop or build whatever you want on it, as long as you follow the local zoning codes and regulations for that lot.
To finance the purchase of land, you can apply for a land loan.
Industrial real estate is any structure or piece of land primarily used for manufacturing facilities, warehouses, distribution centers and factories. This type of real estate can be pricy, but it’s also valuable.
As people spend more time shopping online, and as they expect the products they buy to show up at their doors in less time, the demand for industrial real estate has only grown. This makes this property type especially valuable as the odds of it appreciating in value are high.
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Understanding The Real Estate Industry
If you’re ready to buy real estate – whether as a primary residence or an investment – you should understand the basics of how this business works.
Development And Construction
New buildings – everything from homes and office buildings to apartment towers, distribution centers and shopping malls – get their start during the development and construction phase of real estate. This is when development companies, municipal officials, architects, contractors, engineers and builders work together to create a new real estate project.
Planning can be quick for some projects. Developing and building a new single-family home, for example, might only require a general contractor, several construction workers and an architect. Developing a major mixed-use development including shopping, hotels, offices and apartment buildings could be a far more complicated process that takes a year or longer to complete.
If you want to buy a home, it is usually easier to purchase one that’s already been built. Buying land and building a new home on the site, though, can leave you with a home that more closely fulfills your housing needs. After all, you can tell your architects and builders exactly what you want.
The same is true with commercial real estate. If you want to invest in a retail property, you can purchase an existing strip center. Or you can work with a developer, general contractor, engineers and architects to develop your own retail center that will include all your favorite features.
Brokerages And Real Estate Agents
You can purchase or sell real estate on your own. But navigating this process – finding the right property, qualifying potential buyers, signing documents and handling negotiations – can be time-consuming and confusing. That’s where real estate brokerages, real estate agents and REALTORS® come in.
Real estate agents – those who are members of the National Association of REALTORS® are known as REALTORS® – work with both buyers and sellers. They help buyers find real estate that suits their needs, whether these buyers want to purchase a small condo, a single-family home, an entire apartment tower or a commercial property. They also work with buyers who are ready to sell their real estate.
Real estate agents help market properties, handle the negotiations between buyers and sellers and make sure all the right paperwork is signed during a real estate transaction. They don’t do this for free, usually getting paid a percent of a property’s sale. For instance, if you are selling a single-family home, you might have to pay 5% – 6% of your property’s sales price in the form of a commission. The real estate agents representing the seller and the buyer split the commission, with each getting 3% of the home’s sales price.
If you buy real estate as an investment, you might have to pay for a property management service. As the name suggests, such services manage properties that you purchase but don’t live in. They handle everything from maintenance and rent collection to emergency calls from renters at 2 a.m.
Say you own an apartment complex in another state. You might hire a property management company to handle the maintenance of that property. This company would hire a landscaping service, cleaning service and security service. Your property management company might also screen potential tenants, market units when they come up for rent and handle evictions if tenants stop paying their monthly rent. If a renter’s furnace conks out, the property management firm would take the call and send out a repair service.
Few people can purchase real estate with cash. Most must take out loans. That’s where mortgage lenders come in.
If you want to buy a single-family home for a primary residence but you don’t have the cash to make this purchase, you’ll work with a mortgage lender. You’ll provide this lender with documents that prove your income, such as your most recent paycheck stubs, bank account statements and tax returns. Your mortgage lender will also check your three-digit credit score and your three credit reports, all to make sure that you can pay back the money you borrow.
If you are approved for a loan, your lender will pay the sellers of the property you are buying. You then pay back your lender every month with a mortgage payment. You’ll have to pay interest on these payments, which is how lenders make a profit.
Lenders don’t originate loans for free, charging a range of fees to close your mortgage loan. This varies, but you can expect to pay 2% – 5% of your home’s purchase price in closing costs. On a home costing $200,000, then, you can expect to pay $4,000 – $10,000 in closing costs.
Investing In Real Estate
Ready to tackle real estate investing? Be prepared to do your research.
The key to maximizing your real estate investment is to study your local market. If you want to purchase a single-family home, for instance, you should study housing market indicators such as the median sales price of homes in your neighborhood, how long it takes homes to sell and whether home values are on the rise.
The same is true if you want to invest in commercial real estate such as a warehouse, office building or strip mall. You’ll need to research how much other owners are charging tenants for rents, how much traffic pours through retail areas and how high the vacancy rates are of neighboring office buildings or strip centers.
The more research you do, the higher your odds of investing in a property that will increase in value over time and bring in a steady stream of rental income.
Of course, there are different strategies for investing in real estate.
- House flipping: This is when investors purchase single-family homes for a low price. They then renovate these properties and sell them for a higher price. The key is to purchase a home for a low enough price, and to avoid overspending on improvements, so that when you sell you make a solid profit.
- Rental properties: You can rent out apartment buildings, single-family homes, condo buildings and commercial properties. Your monthly rent collections might cover part or all of your mortgage payment, offsetting the costs of holding onto real estate while you wait for it rise in value. If you collect enough rent, you might make a monthly profit without having to sell your investment.
- REITs: Buying into REITs – real estate investment trusts – is an easier way to invest in real estate. REITs are companies that own real estate, both residential and commercial. When you buy into a REIT, you purchase a share of these properties. It's like investing in mutual funds, but instead of stocks and bonds, you are investing in real estate. You earn money from REITs through regular dividend payments and when the value of a REIT increases. If the value goes up, you'll earn a profit when you sell.
- Real estate crowdfunding: In real estate crowdfunding, investors pool their money then use it to invest in REITs. This gives people who might struggle to come up with enough money to invest on their own a chance to invest in real estate.
The Pros Of Real Estate Investing
There are plenty of advantage to investing in real estate.
Real estate can bring diversity to your investment portfolio. Maybe your investments in the stock market take a fall. If the apartment building you own is appreciating and bringing in monthly rent checks, this can act as a financial buffer.
Real estate can also bring in passive income. If you own an office storefront, you’ll collect monthly rent from the companies leasing space in it. If you own an apartment, you’ll earn monthly rent checks from your tenants. And if you own a single-family home, you can rent it to a family that will also send you monthly rent checks.
And you can live in your real estate investment. If you own a single-family home, you can live in the property while you wait for its value to rise. Once it does, you can sell and collect your profit.
Finally, real estate comes with certain tax advantages. You might be able to deduct the interest you pay on mortgage loans, the money you pay in property taxes and some of the expenses involved in owning and maintaining real estate. These deductions can significantly reduce your tax bill.
The Cons Of Real Estate Investing
While investing in real estate can prove profitable, it also comes with certain drawbacks.
First, it takes a significant amount of funds. Homes, apartment buildings, office buildings and retail centers are not inexpensive. Most investors will have to take out loans to invest in real estate, at least when they are starting their investment careers.
Real estate investments aren’t liquid, either. When you invest in stocks, it’s easy to gain access to your money. You simply sell your stocks. Gaining access to your funds with real estate is more challenging. If you want the money you invested in a warehouse back, you’ll have to sell it. That can take a long time, keeping you from those investment dollars.
Finally, as in all investment types, profits aren’t guaranteed. Your single-family home or condo building might not appreciate. It might lose value after you purchase it. If you are renting space in a commercial building, you might struggle to find tenants, especially if a more attractive retail center opens two blocks away. And your apartment tenants might stop paying rent, forcing you into the costly and time-consuming eviction process.
The Bottom Line
Investing in real estate can be a smart financial move, if you understand your market, are willing to take on the risks and you borrow only what you can afford to pay back.
If you want to learn more about buying real estate, explore the Rocket Mortgage® Learning Center.
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