From the outside it can seem like people that invest in real estate have secret powers. One might get the sense they have a crystal ball, a time travel machine, or perhaps be “The ever impressive, the long contained, often imitated, but never duplicated … Genie of the lamp!”
While no investor would confess to having a genie at their disposal, the reality is they do have something not everyone has. They have knowledge. In particular, they have two types of knowledge.
The first is they have an understanding of their goals as they relate to real estate. This is imperative and informs what other knowledge is necessary. If I am going on a road trip, it matters a great deal to know my destination before I leave my house, lest I waste time and resources heading the exact opposite direction I intended to go. This is all the more true when it comes to goals. This doesn’t mean every detail of the plan has to be ironed out, but a direction is required if for no other reason than there is nearly an infinite amount of things one can learn when it comes to real estate, without a direction analysis paralysis becomes a major concern.
With a grasp on goals, let’s jump into the second type of knowledge. This is the juicy stuff. Savvy real estate investors understand the basics of these 4 paths to creating wealth with properties. This isn’t an all inclusive list, nor does one need to have intimate knowledge of each paths, but understanding the basics helps the savvy investor know when it makes sense to use each path. They are all tools in the real estate tool belt, and its always better to have more than a just a hammer in the belt, otherwise everything looks like a nail.
Without any more introduction, 4 basic ways to make money in real estate:
Real Estate provides a unique opportunity in which an investor doesn’t need to buy 100% of the investment to reap 100% of the reward. This is primarily done through the use of a mortgage on the property. To break that down, let’s use an example. I can buy a duplex and plan on living in one half and renting out the other. Using leverage (the mortgage of the property), a bank will only require 3-5% (depending on the loan product) for a down payment. THIS IS INCREDIBLE! I am able to live in and use 100% of the property in any legal manner I so choose, while only having to pay 3-5% up front! In this example, let’s say the property has a garage too. I could rent out the part of the duplex I am not living in, effectively paying the majority of the mortgage, while also renting out the garage to someone that wants to store their classic car. That might be enough to cover the rest of my housing costs and still leave me with a profit every month! I didn’t have to pay 100% of the cost for the property up front, but I am using 100% of it for my benefit.
Another way to think about this is called a Return on Investment or ROI. The idea here is that any investor wants each dollar put towards an investment (of any kind) to make more than the amount put in. Simply put, if I have $100 invested I might want to receive $105, $110, $150, etc. in return based on the risk of that investment. This is where real estate can shine. It is through leverage that an investor can put in a minimal percentage of the value of a property, and receive a maximal return for their investment.
2. CASH FLOW
This is what most people primarily think of when someone says real estate investment. Bottom line here, we are talking about rent. There are a few other sources of income that will impact cash flow, but rent is really the driving force. It is the top line, revenue driving portion of an income producing property and as such, it gets a written about a lot. I won’t claim to have new insight on that front, but what I will say is there is a less intuitive, sibling to top line revenue that plays just as important part in cash flow. It’s called expenses. This is the ying to revenue’s yang. For our purposes, cash flow is an equation as such: Revenue – Expenses = Cash Flow. Ultimately, any investor wants to be at least cash flow neutral, meaning the amount of money an investment is bringing in will be as much as all the associated expenses. Real estate is presents a great opportunity for cash flow because it is inherently an illiquid asset (it has fees and longer waiting periods for selling than other assets). Many people are turned off by this fact or feel like the return they get on the cash invested (ROI) just isn’t worth it, but the savvy investor sees cash flow in a different light. It isn’t the only way to make money in real estate, it is one way. In fact, it is best seen as a way to keep the lights on so to speak. Pocketing a few dollars every month might not seem worth it, and alone that could be true. Where cash flow becomes really valuable is when it is combined with other the other 3 ways of making money in real estate.
Now that I have lowered your standards for what to expect from cash flow, I want to raise your spirits a bit. It is possible to generate actual returns strictly from cash flow. As a rule of thumb, receiving $100 per unit in residential property is a good benchmark. Remember though, my thumb isn’t the same size as your thumb. Everyone’s goals a bit different. Don’t take this as a hard and fast rule. Rather, it is a nice starting point when evaluating property you might purchase. Remember, the price you pay for a property largely dictates how much you will make in cash flow. Be wise with your purchases and real estate will be your best friend, be haughty and you will run into many problems. This is something that is both and art and a science. there is always a degree of uncertainty that goes into any investment. Don’t mistake calculated risk for recklessness, nor endless analysis for truth. There is always some unknown factors at play.
If you are looking for the single best way to grow your net worth in real estate, look no further. Appreciation is just that. For those unfamiliar, appreciation is the amount a house increases in value over a period of time. This is usually expressed either as a percent (think, my house appreciated 6% this year!) or as a dollar value (since I bought, my house has increased by $100,000!!). To understand why appreciation is so powerful, all we have to do is remember the timeless saying, “It takes money to make money.” This is very apparent with an example. Let’s say I have $1000 if I receive a 5% return by investing it for a year, I will have $1050 to start the next year. If I have a $100,000 property and the property appreciates in value 5% in one year, it is now worth $105,000. I don’t know about you, but 5% of $1000 doesn’t seem like nearly as good of deal as 5% of $100,000. This is the power of appreciation. A home can consistently appreciate (a nice hedge against inflation), without any work being done to it. If combined with leverage and cash flow, this makes for a very powerful trifecta for any real estate investor!
I would be doing any reader a dis-service if i didn’t mention the downfalls of appreciation. While it is true that it is the best way to increase net worth, it does have a dark side. Appreciation can only be a secondary means of generating wealth. Said in a different way, it cannot, I repeat, IT CANNOT be the only way an investor intends on making money in real estate. The reason for this is that appreciation is dictated not by the investor, but rather by the market. If we look back at the financial crisis and subsequent collapse of the real estate market in 2008, the ones that were most impacted were those that assumed appreciation would always be there. In other words, they didn’t understand that, while given a long enough time horizon, housing will always go up, it can in fact go down in the short term. They didn’t understand short term market cycles, and assumed they would always be able to sell for more than the bought. THIS IS A GAMBLE. Please do not make this mistake. Buy prudently, with calculated risk. Always have multiple strategies available so you are not forced into selling when you don’t want to. Know market fluctuations can be your biggest friend or your worst enemy.
4. FORCED EQUITY
Anyone that has ever watched Chip and Joanna Gains knows what I am talking about here. This is the idea that you can take a property in need of repair, bring it up to it’s highest and best use, and someone will not only pay a premium for it, but be excited to do so. This is a fixer-upper. This section is deserving of it’s own blog article (and will probably get it in the future! Be on the lookout for that!) to really get into the weeds as provide concrete examples of why it can be very advantageous for someone to adopt this as their strategy for making money in real estate. For the time being, I just want to lay out the basic structure of how this process works.
Step 1: Buy an inexpensive property that is below market value due to its condition. That is a loaded sentence if I have ever written one. Questions you might be asking yourself: what do you consider inexpensive? What does below market value mean for the Twin Cities? How would I know how to properly assess a property’s condition? All of these and several more are very important. This is where it helps to have a guide. It can be an experienced real estate agent, a partner that has done things like this before, a trusted general contractor familiar with the area, etc. There isn’t a specific way you have to do it, but you will need someone to show you the ropes, and the more experienced team you can put together, the better position you will be in. This method to making money in real estate can be more risky than others, at least to those without experience.
Step 2a: Know what is worth fixing and what is better left as is. Again, this comes back to experience and expertise. There is so much value in having people on your team that understand what is important to the end consumer and what isn’t. Without this knowledge, any investor will over emphasize their preferences and under emphasize things that will be important to the end consumer.
Step 2b: Have an exit strategy. Is this going to be a flip (something that is fixed up, and sold within 1 year of purchase), a rental property investment for 10 years, or a primary residence for the rest of your life? All of these different outcomes and holding periods will dramatically impact how you know what is worth fixing and what isn’t.
Step 3: Execute. The only way for this to work is to have people who do what they say they are going to do, for the price they said they would do it for. While this seems like something that should go without saying, unfortunately it isn’t. Vet the people that will be doing the work for you, even if that means vetting yourself. Not everyone has the time, skills, or capacity to do a renovation well. While a DIY project might look like it saves you money, remember to take into account the your own level of skill and how much you would bill out your labor for if you were working for someone else. DIY can be a great way to save a few dollars, and for some people it is a competitive advantage against the market, but for someone that charges $300 /hr at their law firm/office/business chances are they would be better off sticking to what they are good at, and finding a trusted professional to do what they are good at.
In summary, the goal for any investment property is to be using multiple of these strategies in unison, which allows for compounding wealth generation and risk hedging. One of the best features of real estate investment is the different paths to making money, but all investments are not going to look the same. The goal is to have an open mind to any opportunity, verify with conservative analysis, and create a trusted team to help. You don’t need to be a genie to make money in real estate, nor should you want to be. After all, they might have phenomenal cosmic powers, but just an itty bitty living space!