Investing in real estate is another way of investing in your future. In fact, real estate and wealth building often go hand in hand. While there are several different strategies you could pursue within real estate, the idea is the same: to help you build wealth so you can reach your long-term financial goals.
If you are interested in real estate investing, you’re not alone. Real estate is a major asset class that is included in the strategies of many portfolio managers and on the radar of savvy investors looking to earn passive income.
In 2022, commercial real estate investment volume reached $1.4 trillion. While this amount was down 20% vs. 2021’s record year, the market has been up against some tough economic headwinds, such as rising interest rates and high inflation.
The U.S. real estate sales and brokerage market is valued at $222.3 billion in 2023, according to IBISWorld. This market has been growing at an average pace of 2% annually in the five years leading up to 2023. Property prices are generally used to gauge demand in the real estate market.
Successful real estate investors tend to be in it for the long haul, demonstrating the importance of looking at this market through a long-term lens. In this blog, we will explore strategies to build wealth through real estate investing.
The Fundamentals of Real Estate Investing
Real estate investing is not a one-size-fits-all industry and can be further broken down into several categories. Certain types of real estate investing cater to retail investors while others are better suited for institutions.
However, one common theme shared among them is that real estate investing is designed to produce an income stream in addition to any potential price appreciation.
- Residential: If you’ve ever wanted to purchase a home as an investment property, then you are familiar with residential investing. By renting out a residential property, returns generally fall in the ballpark of 3%-5%. While lease terms vary state-to-state, they generally run in the range of six months to 12 months in duration, so you might have to deal with turnover.
- Commercial: Commercial property returns can be more lucrative between 9%-12%. Lease terms are usually for multiple years as commercial tenants have often invested their own money to make the space unique to suit their needs and aren’t quick to abandon it. Commercial real estate properties tend to be more vulnerable to changing economic cycles: demand rises and falls commensurate with conditions in the economy. Residential real estate is less vulnerable in this aspect.
There are a number of different strategies that can be pursued under each category.
- Buy and Hold: The idea here is to purchase a home and hold onto it as its value appreciates over time. You could hold for the short term (3-5 years) or the long term. Increase the value by investing in the property, raise the rent (if you are renting it out) or ride the wave of a white-hot real estate market.
- Fix and Flip: This strategy could get you on your way to building wealth, but it’s not as easy as it looks on TV. It involves purchasing a house that needs work, doing the remodel (or hiring someone else to do it) and then selling the property for a profit.
- Rental Properties: This is a type of active real estate investing in which you manage the property and rent it out to tenants. It’s designed for long-term investing, allowing you to collect rent payments for years as income.
Depending on an investor’s risk/reward profile, leverage could also play a role in real estate investing. It’s a strategy in which the investor doubles down on their investment with debt in an attempt to bolster returns over the long term.
Put another way, it’s using other people’s money (it even has its own acronym – OPM) combined with some equity for a down payment on a property that will generate income for you over time.
If you finance, say, 80% of the property, you only must drum up the remaining 20% to purchase the property. That type of leverage isn’t usually allowed in the stock market due to the risk factor, so it’s a potential opportunity in real estate investing. That’s not to say there aren’t any risks, such as vacancies or weakening home prices.
The Wealth-Building Benefits of Real Estate Investing
There are several wealth-building benefits associated with real estate investing. Among them is appreciation, representing the increased value of a property over time.
The value of a property fluctuates in response to real estate market conditions combined with any enhancements the homeowner has made to improve the property. As real estate prices increase, so too is a real estate investment property’s value likely to rise.
There are a couple of ways to look at it.
Home Equity: This is the difference between the balance on your mortgage loan and the value of your property. The more monthly payments you make, the higher your equity in the property becomes. Home equity can also build as the property’s value rises in a strong market.
Price Appreciation: Historically home values increase over time, depending on factors like location, demand, the market, comparisons to other homes in the community, etc. While there are exceptions to this rule, if you zoom out over the long term, the data show a positive trend.
In the 12 months leading up to 2022, U.S. property values increased nearly 19%, as per the Federal Housing Finance Agency. Over the past several decades, the average annual increase has been more modest at around 4.3%. In the decade leading up to 2023, home prices rose at an average rate of 7.7% per year.
Meanwhile, investors in rental properties generate cash flow, which is the money that is left after all expenses are satisfied. It’s the profit that the investor gets to keep after paying to keep the lights on.
Every investor must target the cash flow that is right for them based on the property they are purchasing. However, one industry barometer is to aim for at least 1% of the price paid for the property in rental income. The higher the rental income vis-à-vis the purchase price, the greater the cash flow.
Another way to measure wealth building from a rental property is the tax benefits. You can take tax deductions for things like mortgage interest considering it’s a business expense, experts say. Take advantage of other tax deductions like depreciation and property tax on rental properties, which lower the income on which you’re taxed.
Diversification and Risk Management in Real Estate Investing
One of the most attractive features of real estate investing is the diversification that it brings to a portfolio. Diversification is a strategy to offset any risks and maximize returns. So rather than sticking to a strict stocks and bonds allocation, you gain exposure to real estate as well, a completely separate asset class. Diversification doesn’t stop there, and you can continue to diversify within a single asset class, including real estate.
The most popular types of real estate assets are residential and commercial. But you could diversify further into areas like hospitality, storage, student housing, etc.
The easiest way to gain access to some of these market niches is by investing in real estate funds, a type of passive investing. This approach is lower on the risk profile as you are not responsible for purchasing the properties or managing them when something goes wrong. You just collect the income as long as the cash flow keeps coming.
Real estate is also an extremely local market. While there are certainly national trends to observe, not all real estate markets are the same. Some jurisdictions perform better due to several factors, chief among which is demand but also factors like home prices.
In 2022, some of the top U.S. real estate markets were –
- Austin, Texas
- Tampa, Florida
- Raleigh, N.C.
- Nashville, Tenn.
- Charlotte, N.C.
Cities that made the list last year won’t necessarily reclaim their title. Local real estate market dynamics shift, again depending on factors like home values, being affordable, population growth, jobs, entertainment, weather, etc.
Long-Term Wealth Building through Real Estate Investing
Wealth begins to become apparent thanks to compounding returns, something Albert Einstein considered the “eighth wonder of the world.” Warren Buffett is a fan of it, too. It’s how you make money in real estate and it’s a similar tactic to earning dividend income from stocks.
The way it works is that investors take the proceeds from a piece of property and reinvest them into another real estate asset. It’s a way to grow one’s net worth without having to dip into their own pockets. The proceeds are directed from things like rental income or earnings from flipping a property, for example.
Compounding represents the profits generated from the original property plus the proceeds earned from reinvesting those profits into yet another piece of land.
Rising property values also count. For instance, let’s say a property increases in value by 5% annually for a decade. The owner of the property will see their net worth increase, not to mention higher cash flow from raising the rent over time.
Compounding is a long-term buy-and-hold strategy for wealth accumulation in real estate. In other words, investors must not only be strategic, but they must also exhibit patience.
Tips for Successful Real Estate Investing
As with any type of investing, it’s important to identify your goals and know your risk tolerance before investing in real estate. There are different types of risk to consider, such as market risk, which could be the threat of a recession. This is out of your control and something that a diversified portfolio could help to offset.
There’s also a financial risk in using debt to finance the property. The trend of rising interest rates in 2022/2023 has reminded us that interest rates can go up, making the cost of servicing the debt more expensive. Be sure and clearly understand the terms of your investment and any financing you’ve agreed to, the duration of loans and your expected rate of return.
You can’t escape risk entirely in real estate investing. The thing to remember is to expect returns that are commensurate with the risk that you are inheriting.
Conclusion
Real estate investing has the potential to build wealth over time. It’s a generational strategy. But it requires a well-thought-out and disciplined investment approach as well as a long-term outlook.
There’s no shortage of opportunities in real estate investing. After doing your own research, it’s just a matter of identifying the strategy that works best for you and then watching your wealth accumulate over the years.
*DISCLAIMER: As an accomplished entrepreneur and executive with extensive FinTech and Real Estate investing expertise, I’m frequently asked questions about how I grow my company, my thoughts on a particular market or industry, and a range of related topics. I’ve written these articles to help answer your questions in the simplest ways possible. The opinions expressed are my own. Please be aware that I am not your financial advisor. I am not offering you financial advice. Please consult with an accredited financial advisor before investing. These articles are for educational purposes only. If you have any questions you’d like me to answer, please use my contact form, and I will work to answer your questions in a timely manner.