When it comes to real estate investors, I tend to group individuals into 3 categories: those that aren’t interested in it at all, those that are already investors and out there figuring it out and making things happen, and those that are interested and want to get started but aren’t sure where or how to begin. This article is for that third group, those that have finally realized for one reason or another that real estate would be an ideal way to diversify their investments, grow their wealth, and create tax-efficient streams of cash flow but they don’t know what to do first to get moving toward their goal of being a real estate investor.
In trying to give a framework to figure out where to start, I broke the thought process down into 6 categories which will hopefully help you hone in on what type of real estate investing might make sense for you and some steps to get you moving in the right direction.
1. WHAT DO YOU WANT TO ACCOMPLISH WITH REAL ESTATE?
This might not seem that important, but ultimately it is arguably one of the most important considerations as it will help you determine the type of investments to target and give you a framework to recognize whether you are meeting your own expectations as you go along. The list of what you might want out of real estate could include many things like:
- Diversification from stocks and bonds: Since real estate tends to have market cycles that are different from that of the stock market, this can be a way to diversify your portfolio. Having all of your investments cycle in sync with each other means everything is tied to similar drivers of performance, so diversification in this regard can give balance to your portfolio.
- Ongoing revenue/cash flow streams: With real estate you can build a portfolio over time that can eventually replace your income, potentially allowing for an earlier or more flexible retirement or supplement your income during your working years. Having options is good!
- Creation and growth of wealth: Many, if not most, of the wealthiest people have historically created or grown their wealth by investing in real estate. You might not aspire to hit the Forbes Billionaires List, but having your capital grow to a point where it can comfortably support you and your family and allow you the freedom to live your life untethered from the obligation to work a 50-60 hour week is a goal worth pursuing.
- Tax efficient investing: I see frequent comments about the tax benefits of real estate investing and indeed there are many. However, there is also a lot of confusion about how that works. You have probably heard of all the deductions that can be taken to create a passive loss on rental property. As a high income earner, you might likely be above the passive loss limitation income threshold to utilize any of that passive loss to offset a portion of your earned income (although this passive loss is carried forward for use in the future). However, that doesn’t mean all is lost. What people forget to realize is they have still likely had positive cash flow throughout the year despite this “paper loss”. It is this additional cash flow, not subject to the tax rate of the rest of your income, that brings down the overall effective tax rate for the year. In other words, it is not only the AMOUNT of money you are making each year but the TYPE of money.
- Hedge against inflation: Perhaps you remember a time when a gallon of gas was under $1.00 or a gallon of milk was $2.00. If so, you are familiar with inflation. Real estate is an asset class that responds along with inflation with higher property values and higher rents over time. Investing in an asset class that historically rises is one way of protecting and growing your capital over time.
2. WHAT TYPE OF INVESTOR DO YOU SEE YOURSELF BEING?
Active? Passive? The answer could be “both”, and that’s OK, but it’s important to take stock of what your time, interest, skill sets, location, financial status, etc. are in order to figure out a strategy. Some people love the idea of doing something hands-on, perhaps physically renovating a property themselves in their spare time, whereas other people have absolutely no time or interest in doing that but would prefer something they hardly have to think about much less a project to manage.
- Do you want to actively manage tenants, repairs, evictions, record keeping, and renovations? Some of these tasks can be outsourced to a property manager, but even then you will need to do some ongoing oversight and decision making even with a property manager if you want to own property on your own. As they say, you will need to “manage the manager”.
- What do you enjoy doing or are good/not so good at doing? Do you think you have the right personality and temperament that would make for a good landlord? Do you want to spend your time taking care of tenant issues or would this completely annoy you? Are you particularly handy and could carry out much of the maintenance and repairs on your property? Everyone has unique interests and skills that need to be taken into consideration in order to not end up ruing the day you became a landlord.
- How much time do you have to devote to rental properties? Someone working 60 hours a week might not have any regular time to give to overseeing property or tenants. Passive investing might make perfect sense as they could reap the rewards of real estate investments by leveraging other people’s expertise in the area. However, someone else might have considerable time to spend or have the ability to work part-time in one career while devoting the rest of their time to managing their rental properties. Again, everyone is different in this regard, but just make sure your strategy for investing is compatible with the amount of time you have available to give to it.
- What does your financial situation lend itself to? Does your investing plan seem more compatible with saving up chunks of $25-100k to invest in properties that you acquire over time or put into a large group investment? Or did you just come into a windfall of money that you want to figure out how to deploy into real estate? Or perhaps you only want to diversify into real estate with smaller amounts like $5-20k. Once again, how much money you have to work with will make more sense for some real estate investments than others.
3. WHERE SHOULD I INVEST?
This is an issue not unique to new investors but will be a question to consider with any investment you make. If investing as an active investor, your best choice for consideration is your local area. All things being equal, investing in your own metro area will generally be easier as you are there to personally build the relationships critical for your success, tackle any problems that arise, and have a familiarity with an area that is best appreciated by living there. That being said, local investing won’t always work out for you. Perhaps you live in a rural area that isn’t conducive to the business model needed to make a rental work well or perhaps you live in a market that has such inflated property prices that you can’t find anything that cash flows well (or at all!). The options at that point would be to either find an area out of state/area you would be comfortable investing in or you could invest passively in other larger investment groups (syndications) where it is not necessary for you to be geographically close to the property or to make the effort yourself to develop a team in a distant market.
If you choose to invest out of your area, I would first recommend investigating the areas within a half a day drive or less away from you. If you can get there easily without having to take time off of a day job or catch a flight that will be your next best option. Another good option is choosing a market that you have some connection to in some way – perhaps you went to school there before, you have relatives or friends there so have previously spent time there and have a grasp of the city, etc. Just like you will need to do if investing in your local market, you will have to make contacts in that distant market to build out your team. You will also need to go and spend some time there getting familiar with the different neighborhoods and making personal connections with your contacts. Part of investigating a target market can be done from behind your computer, but you definitely need to get out there and establish a working familiarity and a strong contact network if you are going to invest out of your local area. If you don’t have the time to ever do that, perhaps you shouldn’t consider investing at a distance.
4. WHO DO I NEED ON MY TEAM AND WHERE DO I FIND THEM?
Below is a list of some of the main players you will need. As to how to find them, I have found the best contacts come from personal recommendations from other investors that have worked with them. I have always felt that good people lead you to other good people. Ultimately, real estate is as much a relationship business as it is an investing venture. Nurture good relationships with people and that will take you a long way!
- Realtor: I would recommend working with a realtor that has experience/expertise in sourcing investment properties. Any realtor could find you listings for investment properties, but a realtor with experience working with investors throughout the acquisition phase will be a huge resource along the way compared to even the best residential real estate agent. A good realtor will have leads on many of the other key individuals you need on your team as well.
- Attorney: In some states you may need an attorney to work with for title and escrow services. Other areas a separate title agency can perform this service. Either way, you likely will want the input from your attorney on setting up the most appropriate entity structure for your property. Even after you have acquired property, you will need someone to assist you with reviewing your tenant paperwork and handling evictions, etc. if you are managing the property yourself.
- CPA: You likely have an accountant already, but make sure they have enough knowledge about rental properties to make the most of your tax planning. Most accountants will have some experience with this, but certainly some have more of an expertise in this area than others.
- Property manager: Personally, I am biased toward using professional property management. I suppose if you are just considering the management of one or two single family homes (local to you), I can see how self-managing probably makes sense. However, for building a portfolio of units I think a property manager is the way to go. Of course it is an additional expense which you pay a decent amount for each month. However, if you think about what all that encompasses it seems like a good deal to me. In my experience, I could not manage tenants and toilets NEARLY as efficiently and optimally as I have experienced with a GOOD property manager. Certainly I have heard many stories of BAD property managers that can lead you to believe you are better off on your own, but a GOOD property manager will make your investment much easier and potentially more profitable.
- Mortgage broker: Once you find a good realtor to work with they can likely connect you with several good recommendations for financing. Just like with the realtors, you are better off working with a broker that has experience sourcing lenders that are used to financing income properties. This is particularly important when looking for financing on something beyond a 1-4 unit property. A broker will be able to review your situation and type of property and have a network of lenders to give you multiple options for financing. Again, options are good!
- Connections to syndication sponsors: Beyond understanding the mechanics of how syndication works (www.physicianrei.com/how-does-real-estate-syndication-work) if you are looking to invest passively in real estate syndication, you will want to make connections with those that are sourcing those opportunities and also learn what the past investor experience has been with those groups. It is never too early to make those connections as you want to have an established relationship and comfort level with the offering group in order to have access to and be prepared to invest when an opportunity arises that you are interested in.
5. DO I NEED TO SET UP AN ENTITY TO HOLD A PROPERTY BEFORE I START?
I see this question come up a lot and the answer is NO. As with any of this, it is not my intention to give you legal or professional advice, so you should always consult with your own attorney in regards to your plan. However, I will explain what many people do and at what point you need to do it. You will likely want to set up an entity to hold your rental property, often times an LLC is the recommended entity. The entity itself is for asset protection purposes not for tax purposes, although the way you elect for your LLC to be taxed can impact your taxes (something to discuss with your CPA). There is no need to set up the entity before you start looking for property as you want to be much more certain of the exact property you will be purchasing before you set it up. As there are expenses associated with setting up a legal entity and filing fees to be paid to the state in which you set it up there is no need to commit yourself to those expenses until you are quite certain you will be utilizing it to hold a particular property in a particular state. Depending on who is setting up the entity for you, you should conservatively leave yourself 2-3 weeks to get this set up once you are in escrow and moving toward closing. If you are financing a property make sure your lender is aware and OK with utilization of an LLC to take title prior to closing.
6. HOW DO I FINANCE A PROPERTY?
It would be nice if we could all just plop down a chunk of change to purchase properties outright, but most of the time this isn’t the case unless you are purchasing low to moderate priced single family homes. More likely, you are looking at coming up with a down payment of 20-25% of the purchase price and financing the rest. For most residential (1-4 unit) properties, you should plan on 20% down. However, for commercial loans (anything on 5+ units) you will need to plan on at least 25% (sometimes 30%) of the purchase price to put down. In addition to the down payment amount you also need to factor in how much you will want to keep liquid on hand to deal with any renovation work or to hold as reserves on a property. So where do people come up with these down payments? A few ideas are:
- Savings: This is the most common scenario. If you make a practice of saving a portion of your earned income each month, eventually you will have a chunk saved up that you can put toward a down payment. Again, you want to always maintain a liquid amount in your emergency fund or a reserve account to give yourself a margin for anything unexpected that comes up, so don’t plan to scrape your reserves down to zero.
- BRRRR: This strategy has been popularized on Biggerpockets and stands for Buy, Rehab, Rent, Refinance, and Repeat. Basically, this entails buying a property that needs some work, getting the work done (yourself or by others), then refinancing out your original investment so you end up having that property as a rental with little to no money tied up in the property and the refinance funds available to roll into another similar property. Once you have been able to accomplish a first deal this way, you will then be able to keep repeating the same scenario on future properties and create kind of a snow ball effect to building a portfolio. Obviously this strategy looks good on paper and there are significant variables that come into play as to how successful of a strategy it would be for you, but definitely a plan worth considering.
- House hacking: Another popular scenario from Biggerpockets, this involves buying multi-family property which you then use one of the units as your own personal residence. This could be combined with the BRRRR method for even greater effectiveness, but either way is a good way to reduce your own housing expenses AND have some additional income from the rental unit(s) of the property. Like every strategy, this may or may not work well for your lifestyle or family situation but can certainly be a way to get started and could be much more manageable than saving enough to buy a separate primary residence and a rental property.
- HELOC: If you already own your primary residence, adding a HELOC can allow you to tap into the equity that you have in that property. Many people are uncomfortable with the thought of any additional debt and would not want to go this route, but for those that like to utilize leverage and are confident in their ability to get a greater return on the investment of that money then this might be a strategy to consider. Don’t forget to factor in the tax implications of your returns on invested money when running the numbers on this scenario.
- Hard money loans: Hard money loans are essentially borrowing high-interest, private money. I would not necessarily recommend this, especially for new investors. There could be a place and time for utilization of these loans by some investors, but generally the costs and risk are steep. If this is your only option to consider, I would recommend waiting to invest and continue saving for a down payment.
- Retirement funds (SDIRA): Retirement funds can be utilized for investing in real estate. The funds have to be transferred to a custodian that handles self-directed accounts as you do not have this option through traditional retirement custodians like Vanguard or Fidelity. Just like any other retirement account, there are rules you have to follow to keep your account qualified as a retirement account. You can find an article on some of those rules here: www.theentrustgroup.com/blog/7-self-directed-ira-real-estate-investment-rules. Also, there can be some tax implications that you should discuss with your CPA before setting up a self-directed IRA. This relates to the gain on the leveraged portion of a real estate investment within an IRA (Unrelated Business Income Tax, or UBIT), a separate topic beyond the scope of this article but something to be aware of.
- Bonus/windfall: Perhaps you get a productivity bonus each year (lucky you!) or you received some money from an inheritance. There are always a lot of things we would LIKE to do with “extra” money, but hopefully you give great consideration as to whether you are utilizing those lump sums of money wisely. Sure, you’ve worked hard and deserve to enjoy the fruits of your labor, but often times people end up spending their money on material things to compensate themselves for the hard work they do, only to find that that money evaporates and the material thing didn’t bring as much happiness as they thought it would. To me, financial freedom seems more satisfying than most material possessions that so many people obsess over. Each to their own, but just choose wisely and consciously.
Hopefully this has given you a few insights into how to get started if you are interested in pursuing real estate. I’d love to hear how your experiences have been similar or different to this and any additional recommendations for new investors.
As always, reach out with any questions or comments! Happy investing!