How to Know if Real Estate Investing is Right for You

Are you intimidated by real estate investing? You shouldn’t be.

Real estate investments are one of the most powerful and profitable investment strategies available today. In fact, Gallup surveys find that people have considered real estate the best long-term investment for eight years in a row.

Here’s the best part: you don’t need to be a seasoned pro to get started. You don’t even need prior real estate experience, because there’s so much more to it than owning a home or flipping houses. You can be as active or passive of an investor as you’d like, while still enjoying a steady passive income stream, tax incentives, leverage, and long-term growth. 

In this post, we will cover:

• The benefits of real estate investing
• How real estate investing compares to other types of investing
• What is the ROI for real estate investing
• Who can invest in real estate

Are you ready to take the first step toward learning how to generate extra income, build wealth, and gain financial freedom?

The Benefits of Real Estate Investing

The benefits of real estate investing are clear and significant. From tax benefits to steady passive income, here are the main advantages you’ll enjoy as a real estate investor:

Cash flow

For real estate investors, cash flow is the income left after paying out expenses such as the mortgage, taxes, insurance, vacancies, repairs, capital expenditures, utilities and any other expenses that affect the property. If you have renters, your goal is for the rent you pull in each month to exceed your expenses, resulting in a positive cash flow. Your cash flow will typically increase as you purchase more properties and increase rents to keep up with current market conditions. 

Mortgage Principle Paydown

When you get a loan for a property, you make a mortgage payment every month. Principle paydown is simply the part of the mortgage each month that is applied to the loan balance instead of the interest. On an interest-only loan, the principle paydown amount is zero. On an amortized loan (a loan where you make scheduled payments on the principal and interest over time), the higher the amortization, the less principal is paid down each month.

Appreciation

Appreciation is the increase of a real estate property’s value over time and, alongside long-term buy/hold passive income, is how investors make most of their money. Despite inevitable fluctuations, real estate values have consistently increased, and that’s unlikely to change. 

Leverage

Real estate leverage is when you tap into borrowed money such as conventional loans, personal loans, or other assets to expand your potential return on investment. With leverage, you can buy a more costly house—or more homes—than can afford to pay for outright.

Case Study

Now that we have a basic understanding of some of these terms, let’s see how they all work together in the following real-life example. 

Example: You just purchased a single-family home priced at $300,000 with the intent of renting out this property as a long term buy/hold investment. 

Leverage: Let’s say you, the investor, made a 20% down payment of $60,000 and obtained a mortgage loan of $240,000 to purchase the $300,000 home. In this case, the investor is using leverage of 4:1, meaning they are using $240,000 of borrowed money to control a property worth $300,000.

Appreciation: If the value of the home increases by 5% in one year, the value of the home would be $315,000. In this case, the investor’s equity in the property would increase by $15,000, which would be the appreciation on the home.

Mortgage principal paydown: Assume the mortgage has a 30-year term and the interest rate is 3.5%. If the investor makes payments on the loan from rent received by the tenant, over time the balance of the loan will decrease, and the investor will continue to build equity in the property. For example, after five years, the outstanding balance of the loan would be roughly $218,000, and the investor’s equity in the property would be approximately $82,000 (assuming no appreciation in the property value occurred).

Cash flow: Assume the investor rents out the property for $1,500 per month and the monthly expenses including mortgage payment, property taxes, insurance, and maintenance costs equal $1,200. In this scenario, the investor would generate $300 in positive cash flow ($1,500 – $1,200) each month. This positive cash flow can be used to pay off the mortgage balance more quickly or as a steady stream of income for the investor.

Depreciation

Tax benefits are abundant in real estate investing, and depreciation is key among them. You heard us right: not only do real estate investors benefit from appreciation—they also benefit from depreciation. 

The IRS views properties as assets, just like cars. Depreciation covers an asset’s “wear and tear” over time. When a property is purchased, the cost of the property can be depreciated over a period of 27.5 years for residential properties and 39 years for commercial properties. This means that each year, a certain percentage of the cost of the property can be written off as a business expense.

To calculate depreciation, divide your property’s value by 27.5 years for residential properties, and 39 years for commercial. 

If your duplex is worth $800,000, your depreciation expense is $29,091 ($800,000/27.5). Let’s say your duplex generates $80,000 in income for the year, and you pay 25% in federal income tax, then:

• Taxes owed without depreciation = $80,000 x 25% = $20,000
• Taxes owed with depreciation = ($80,000 – $29,091) x 25% = $12,727.25

In this scenario, you would save $7,272.75 (20,000 – $12,727.25) in taxes, all thanks to depreciation. That’s more than $600/mo! 

Hedge Against Inflation

Real estate investors hedge against inflation in several ways: property values generally rise at a rate higher than inflation (though this can be heavily dependent on individual market conditions), and rent generally increases to keep up with inflation. Also, fixed-rate loans mean your monthly mortgage payments remain the same, despite inflation. For example, if you have a 30-year fixed-rate loan for $1,000/mo, you’ll pay $1,000/mo for 30 years, even though that $1,000 thirty years from now isn’t worth what it is today.

How Real Estate Investing Compares to Other Types of Investing

Stocks, certificates of deposits (CDs), bonds, and gold can all help you accumulate wealth. However, real estate has unique offerings that other investments lack: you often control your net income. With other investments, your money is in the hands of company officers. While this is true with some forms of real estate investing, like crowdfunding and real estate investment trusts (REITs), many forms put you in control of your own investments. 

Here’s how real estate investing measures up to other investment opportunities:

Stocks and Mutual Funds

Like real estate, stocks and mutual funds tend to increase over time, and investors can enjoy a return on investment (ROI). For example, the median return for the S&P 500 is 8.6%. You can also diversify your portfolio by investing in multiple companies simultaneously. 

However, the stock market is unpredictable. Market volatility causes dramatic shifts in stocks, and many investors watch their money accumulate, only for their growth to be leveled by circumstances beyond their control. 

CDs and Bonds

Certificates of Deposit (CDs) are low-risk, low-reward investment opportunities. Their profit potential is directly linked to interest rates. While you may enjoy a small return on investment (ROI), it’s nothing compared to what real estate investors make. CDs also lack many tax benefits real estate investors enjoy, like depreciation and leverage. Current average annual percentage yields (APYs) for CDs range from 1.18-1.5% according to Bankrate.

Bonds share many of the same qualities as CDs, as well as their setbacks. They are low-risk and low-reward, and their tax benefits are minimal compared to what you’ll experience when investing in real estate. 

Gold

Historically, gold also consistently appreciates in value. However, you have no control over how quickly gold accumulates in wealth, and it accumulates at a much slower rate than real estate properties.

What is the ROI for Real Estate Investing?

Your return on investment (ROI) can vary substantially based on your experience, location, investment type, and numerous other factors. However, real estate investors usually build more wealth than they would with other types of investments. 

Here are the average annual ROIs for the most common types of REI investments:

• Residential Real Estate: 10.6%
• Commercial Real Estate: 9.5%
• Real Estate Investment Trusts (REITs): 11.8%

These numbers show that all three of these real estate investing avenues usually provide greater returns than the S&P 500. It’s worth noting that the above ROIs generally don’t account for aggregate cash flow over time, nor the advantages of using leverage to maximize cash-on-cash return—most real estate investors will tell you that these ROIs will be substantially higher.

Who Can Invest in Real Estate?

Not long ago, investing in real estate was only an option for people who could afford to put 20% down. Luckily, a lot has changed in the last couple of decades.

Almost anyone can invest in real estate, and sometimes with little to none of your own money! However, we strongly recommend getting a healthy real estate education before getting started. If you’ve decided real estate investing is right for you, you’re in the right place. BiggerPockets is here to help you every step of the way.