Predating modern stock markets, real estate is one of the five basic asset classes that every investor should seriously consider adding to his or her portfolio for the unique cash flow, liquidity, profitability, and net worth characteristics as well as the diversification benefits it offers.
In this introductory guide to real estate for new investors, I want to walk you through some of the basics and point you to more in-depth content on certain concepts so you can learn about them if you feel it is an area in which you want to become more knowledgeable. I'll also explain some of the different ways you might acquire or take ownership in real estate investments.
First, let's start with the basics. What is real estate investing?
What Is Real Estate Investing?
Real estate investing is a broad category of operating, investing, and financial activities centered around making money from tangible property or cash flows somehow tied to tangible property. There a myriad of different types of real estate investments a person might consider for his or her portfolio.
Investing in Real Estate to Generate Rental Income
In its purest, simplest form, the core concept behind real estate investing is that the investor, also known as the landlord, acquires a piece of tangible property; raw farmland, land with a house on it, land with an office building on it, land with an industrial warehouse on it, doesn't matter for our purposes at this point in the discussion.
He then finds someone who wants to use this property, known as a tenant, and they enter into an agreement. The tenant is granted access to the real estate, to use it under certain terms, for a specific length of time, and with certain restrictions, some of which are laid out in Federal, state, and local law and others of which are agreed upon in what is known as a lease contract or rental agreement.
In exchange, the tenant pays for the use of the real estate. The payment he or she sends to the landlord is known as "rent".
For many investors, this has a huge psychological advantage over investing in stocks and bonds. They can drive by the property; see it, touch it with their hands. They can paint it their favorite color or hire an architect and construction company to modify it. They can use their negotiation skills to determine the rental rate, allowing a good operator to generate higher so-called capitalization rates, or "cap rates", which we talked about a bit in Making Money from Real Estate Investing.
From time to time, real estate investors become as misguided as stock investors during stock market bubbles, insisting that capitalization rates don't matter. Don't fall for it. If you are able to price your rental rates appropriately, you should enjoy a satisfactory rate of return on your capital after accounting for the cost of the property, including reasonable depreciation reserves, property and income taxes, maintenance, insurance, and other related expenditures. Additionally, you should measure the amount of time required to deal with the investment as your time is the most valuable asset you have; the reason passive income is so valuable to investors.
(Once your holdings are large enough, you can establish or hire a real estate property management company who will handle the day-to-day operations of your real estate portfolio in exchange for a percentage of the rental revenue, transforming real estate investments that had been actively managed into passive investments.)
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