What's the Best Way to Invest in Real Estate?

By: , Contributor

Published on: Sep 11, 2019 | Updated on: Nov 20, 2019

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When most people hear the phrase real estate investing, they think of buying rental properties. It's a popular way to invest in real estate, but it isn’t the only way. There are several other paths, many of which don’t involve buying properties at all. For example, you could

  • rent out some (or all) of your home;
  • buy a vacation home to rent out some of the time;
  • buy a house, fix it up, and sell it at a profit;
  • invest in real estate investment trusts;
  • invest in a homebuilder;
  • invest in another real estate business, like a real estate website or brokerage; or
  • invest in crowdfunded real estate deals.

If you’re new to real estate investing, you probably aren’t familiar with all of these. Let’s look at them one at a time, along with the pros and cons of each. At the end, you'll be better able to decide which might be the best way for you to invest in real estate.

Buying rental properties

The most well-known way to invest in real estate is to buy rental properties. (In full disclosure, I own a few rental properties.) It’s a great way to invest in real estate, but it isn’t right for everyone.

There are some major drawbacks to owning rental properties. For one thing, it’s a very time-consuming way to invest in real estate. Hiring a property manager to oversee the day-to-day operations of your properties helps. But it takes a lot of time to shop for, analyze, negotiate, and keep up with rental properties. Far more than the time you’ll spend on more passive real estate investments.

There’s also more uncertainty involved. For example, if your rental property sits vacant for an extended time, your income drops to zero. If a major unexpected maintenance issue arises, it can wipe out a year’s worth of returns.

Furthermore, buying rental properties generally requires a large capital commitment. Expect to put at least 20% down when buying a rental property; many lenders require even more. In contrast, you can invest in real estate through real estate investment trusts (REITs) by purchasing just a few shares of stock (more on those later).

Finally, rental properties are an illiquid form of real estate investment. It can take several months to cash out of a rental property unless you sell it cheaply.

The upside is that the total return potential with rental properties is high. If I thought I could earn superior returns by only investing in REITs, I wouldn’t own properties. Many factors determine investment property returns, but rental properties can be very lucrative when things go right. Rental property investors also get tax benefits like annual depreciation deductions and the ability to use 1031 exchanges to defer taxation.

Rent out some (or all) of your existing home

Thanks to platforms like Airbnb, VRBO, and others, you can rent all or part of your home to generate rental income. This can be a great way to dip your toes into the world of real estate investing and generate an extra income stream. However, there are a few things you should know first.

For starters, there could be major tax implications if you choose to rent out your home on one of these platforms. If you only rent it every so often, you may be able to legally avoid taxes on your rental income. The IRS allows you to rent your home for as many as 14 days each year with no tax liability whatsoever. Beyond that, however, you’ll want to consult a qualified tax professional to help you.

It may also violate the terms of your mortgage to rent your home. After you’ve borrowed money, it’s rare for a mortgage company to physically confirm that you’re living in the home. But if you got a mortgage under the pretense of being an owner-occupant, many lenders won’t permit you to rent your property.

If you rent some or all of your home through one of these platforms, it’s important to comply with local regulations. For example, your city may require you to register and pay a fee to rent out your home. In some cities, particularly those with lots of tourism, it’s illegal to rent your property on a short-term basis without a special license. Neighborhoods with HOAs may have other restrictions.

I strongly advise against renting your home without meeting all the legal requirements. The penalties for violating these rules can be extremely harsh.

The takeaway is that there's a lot of gray area when it comes to renting your home through Airbnb or another site.

For example, if you only rent one bedroom of your home for a few nights, does it meet your city’s definition of a "short-term rental"? Or if one of your home’s bedrooms rents for 10 days and another rents for eight days this year, do you have to pay taxes since you technically didn’t rent out any space for more than 14 days?

Consult a lawyer, tax attorney, or other qualified professional to help you answer any of these questions.

Buy a vacation home

Another way to invest in real estate if you’re willing to buy property is to invest in a vacation rental.

There are several benefits to a vacation rental as opposed to a long-term rental property. For one thing, vacation rentals generally have more income potential than long-term rentals.

Say you buy a beach condo and rent it weekly. The sum of your weekly rental income is likely to be far greater than you could expect to receive from a similar property with a tenant on an annual lease.

In addition, buying a vacation rental can also give you and your family a place to vacation without paying for a hotel. Vacation rentals can also be cheaper to finance. Lenders have different definitions of "second home," but many let you get second-home financing if you live in the property for even a small portion of the year. Second-home financing is easier to get than an investment property mortgage, and also has lower interest rates, origination fees, and down-payment requirements.

On the other hand, there are some downsides. With a local rental property, hiring a property manager is optional. With a vacation rental that’s not near where you live, it’s necessary. There’s too much work involved with managing a vacation rental for an absentee owner to do on their own.

And property management fees are considerably more expensive when it comes to vacation rentals because of the increased amount of work involved. With a long-term rental, the industry-standard property management fee is about 10% of collected rent. With a vacation rental, expect to pay at least 25% of the property’s income.

Fix-and-flip a house

At Millionacres, we generally take a long-term view of investing in real estate. Fix-and-flips have become more popular in recent years, especially because they're the focus of some popular television shows.

In a nutshell, a fix-and-flip involves buying a property that needs repairs, fixing it up, and selling it (hopefully) for a profit.

This is more of a business than a real estate investment strategy and is generally not a good idea for inexperienced investors. However, there's money to be made by fixing and flipping properties, so it’s worth mentioning.

The stock market

Now we’ll get into some of the ways you can invest in real estate without buying property. One of the best passive ways to invest in real estate is through the stock market. There are a few different types of real estate stocks you can buy: real estate investment trusts, homebuilders, and other real-estate-related businesses. We'll go over each of them here.

Real estate investment trusts

The most obvious way to invest in real estate through the stock market is by buying into a real estate investment trust, or REIT.

A REIT pools investors’ money to invest in real estate assets. To be classified as a REIT, a company needs to meet specific requirements, such as earning at least 75% of its income from real estate and paying at least 90% of its taxable income to shareholders. If it meets these requirements, a REIT pays no corporate tax whatsoever on its profits. This benefit makes REITs an especially great choice for tax-advantaged retirement accounts like IRAs.

Most REITs specialize in a certain type of commercial properties. There are REITs that invest in apartment buildings, offices, hotels, data centers, self-storage facilities, healthcare properties, and more. There are also REITs that invest in mortgages and other financial real estate assets -- these are known as mortgage REITs.

There are several advantages to investing in real estate through REITs.

For one thing, it’s easy. You can buy shares of a REIT through any online broker with a few clicks of a mouse.

You have no ongoing obligations after you invest, and your money is spread across a portfolio of properties so you won’t be dependent on the performance of any specific property.

Plus, REITs are a very liquid type of real estate investment. If you want to cash out, you can do so immediately and at the full market value of your shares. In fact, REITs are by far the most liquid way to directly invest in properties.

It’s important to point out that REITs are generally designed for steady income and growth, not for extraordinary returns. Active investment methods like those above are more likely to produce truly extraordinary returns. REITs are designed for solid returns with an emphasis on consistency and safety.

The key point to know is that REITs let investors benefit from rental property ownership without the burden of owning properties themselves. Most REITs pay above-average dividends and, thanks to appreciation of the properties they own, can produce impressive total returns over time.

Homebuilders

As the name suggests, homebuilders are companies that primarily build and sell new homes. Homebuilders are more of a stock investment than a real estate one, but your investment’s performance is tied to the health of the real estate markets where the builder operates.

Homebuilding is a capital-intensive business and profit margins can be quite low. Plus, homebuilders can be a cyclical type of investment, meaning they're vulnerable to recessions and other weak economic conditions.

Here are some of the largest homebuilders you might want to take a look at:

  • D.R. Horton (NYSE: DHI)
  • NVR (NYSE: NVR)
  • KB Home (NYSE: KB)
  • Lennar (NYSE: LEN)

Real estate-adjacent businesses

There are other stocks that aren’t direct real estate investments but depend on a strong housing market for success. They make their money from real-estate-related activities.

Online real estate businesses such as Zillow (NASDAQ: Z) (NASDAQ: ZG) and Redfin (NASDAQ: RDFN) are good examples. They make their money in several ways, including selling services to real estate agents, originating mortgages, and even buying and selling homes themselves.

You can also invest in real estate indirectly through the stocks of companies that sell homebuilding supplies, such as Home Depot (NYSE: HD) and Lowe’s (NYSE: LOW). These companies not only sell lumber and other supplies to homebuilders but also benefit when homeowners decide to renovate and improve their homes.

Finally, companies that make money from real estate transactions are another way to invest. For example, Realogy (NYSE: RLGY) owns real estate brands including Century 21, Coldwell Banker, Sotheby’s, and more. Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is another example. This stock is a great way to invest in real estate and a bunch of other businesses at the same time.Crowdfunded real estate

Real estate crowdfunding is a new way to invest in real estate without buying properties. It has grown in popularity dramatically in recent years.

Here’s how it works: An individual or company (known as the deal sponsor) identifies a real estate investment opportunity. Typically, these involve buying a single property, completing a value-adding project, and selling the property at a profit. For example, a sponsor may plan to buy an older hotel, renovate all the rooms and common areas to increase the room revenue, and sell it a few years later.

The sponsor will then list the opportunity on a crowdfunding portal. There are a few highly reputable portals, such as CrowdStreet and Realty Mogul, which regularly have several crowdfunding opportunities to choose from.

The sponsor usually contributes some of the project’s capital and aims to raise the rest from investors. After the required funding is raised, the sponsor can use the funds to acquire the property and execute its plans.

Crowdfunded real estate is a higher-risk form of real estate investing, so there are some downsides to be aware of.

For one thing, crowdfunded real estate is the most illiquid way to invest in real estate. With REITs or other stock investments, you can cash out at the push of a button. With a rental property, it may take a few months, but you’re free to sell whenever you want. With a crowdfunded real estate investment, your money is tied up for years. Most crowdfunding investments have target holding periods that range from 3–10 years, and there’s no guarantee that the property will be sold by the end of this timeframe.

There’s also a great deal of execution risk compared to simply buying a property to rent out. Crowdfunded real estate investments generally rely on some sort of value-adding project, such as a renovation or adding additional amenities.

If a renovation project takes longer than expected or costs more than expected, it can dramatically lower the investment’s returns. Plus, there’s no guarantee that a project will result in the desired income or value increase. For example, if a sponsor renovates a hotel and there's a recession going on when the renovations are completed, the property’s actual income and the deal’s projected income can be very different -- and not in a good way.

Having said that, there’s a lot of money to be made on successful crowdfunded real estate investments. It’s not uncommon for deals to target (and achieve) annualized returns in the 15–20% range for investors.

Since the industry is still young, there isn’t much concrete data, but the early results are promising. For example, as of July 2019, CrowdStreet has had 17 completed deals listed on its platform, and here’s a rundown of the results:

  • 10 of the 17 met or exceeded the deal sponsor’s target internal rate of return (IRR).
  • 14 of the 17 produced IRR of 14% or more.
  • 10 of the 17 produced IRR of 18% or more.
  • Only 1 of the 17 deals lost money for investors.
  • The other 16 all produced positive IRRs of at least 12%.

Of course, this only represents a small percentage of the deals on CrowdStreet’s platform, as the site is young and most funded deals are still active investments. So it’s fair to assume that more performance data will become available in the coming years.

The takeaway is that crowdfunded real estate is a high-risk, high-reward type of real estate investment. Many deals produce great returns for investors, but some go the other way. For example, the one money-losing deal so far that originated on CrowdStreet’s platform lost roughly 70% of its investors’ contributions.

What's the best way for you to invest in real estate?

The title of this article is actually a trick question. There are many ways to invest in real estate and there are many differences between them. For example, I wouldn’t put buying shares of a homebuilder and buying into a crowdfunded real estate deal in the same investment ballpark.

With that in mind, the better question to ask is which type of real estate investment strategy is right for you. It’s important to weigh the pros and cons of each and to consider your personal investment goals and risk tolerance before deciding.

It’s possible that the best way for you to invest is a combination of more than one of these. For example, I own a few rental properties, actively invest in REITs, and my wife and I are considering buying a vacation home to rent out.

The bottom line is that there isn’t a best way to invest in real estate for everyone, but there’s probably a way that's ideal for you.

Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends NVR, Zillow Group (A shares), and Zillow Group (C shares). The Motley Fool recommends Home Depot, Lowe's, and Redfin and recommends the following options: long January 2021 $120 calls on Home Depot and short February 2020 $205 calls on Home Depot. The Motley Fool has a disclosure policy.