Real Estate Investing: A Beginners Guide
Real estate has long been considered a surefire investment. Outside of increasing property value, real estate can provide you with shelter and even income from renting out some or all of your property. Despite how it might sound, real estate investment isn’t just for the rich and famous. From renting out rooms in your home to buying shares in a REIT to operating an apartment building, there are many ways to grow your wealth through real estate investment.
What is a real estate investment?
In its simplest form, an investment is putting money into something with the expectation that you’ll profit from it in the future. Purchasing a home to live in is an investment, especially if you make improvements to your property to increase its value.
While your home is an investment, it isn’t technically an investment property. An investment property is a building or lot you purchase with the intent of making money through rent, interest, dividends, or royalties rather than with the intent of using it as a primary residence (although you can live in an investment property; more on that later).
This distinction might seem over-particular, but it will have a significant impact on how you finance your purchase and pay your taxes.
Isn’t real estate investing for rich people?
While investing in real estate is certainly more accessible if you have money to burn, there are ways to get involved without millions or even tens of thousands of dollars in your bank account.
REITs
Similar to a stock or mutual fund, Real Estate Investment Trusts (REITs) allow you to pool your money with other investors to purchase and manage real estate. Many are publicly traded on the stock market. The cost to buy depends on the fund, but if you have a thousand dollars you can afford to invest, you probably have enough to buy a share of a REIT.
Unlike a traditional stock, the dividends paid out by REITs are taxed as regular income rather than at the lower capital gains rate. REITs are also known to be a safe but slower-growing investment than other types of securities, making them a great long-term investment but a bad choice if you’re looking to get rich quickly.
Financing
If you’re looking to make a more significant or hands-on investment than a REIT, you’re going to need financing. Many realtors won’t even show you properties until you have a proof of funds letter from a lender - or proof you have the funds to buy in cash - so getting your financing in order is the first step, no matter what kind of investment property you plan to buy. Even if you plan to invest in a residential property, you may not get a standard mortgage. In general, lenders require a 20% downpayment and may charge a higher interest rate for an investment property compared to a primary residence.
There are many ways to raise money for a downpayment from renting out rooms in your home to pooling funds with trusted friends or family members to traditional saving.
Once you have your down payment saved and a proof of funds letter, you’re ready to start searching for your next investment.
Starting Your Search
Now that you have your financing and budget organized, you’re almost ready to start searching for your new income property. But before you start touring homes, you need to figure out who your clients are. Renting out a property is a service and knowing who your customers are will help guide where you buy and what type of property you purchase.
The first question you’ll want to answer is whether you want to operate a long-term or short-term rental. We have more information below to help you with that decision. If you’re planning to run an Airbnb, you probably don’t want to look at properties miles from major tourist attractions and will have to keep zoning in mind. In contrast, tenants in a long-term rental are more likely to be concerned with access to work, schools, and grocery stores than Honky-Tonk Highway.
With both short-term and long-term rentals, you’ll want to consider who you’ll be renting to. Do you want to offer bachelorettes a place to crash (and possibly trash) between rounds of bar hopping or a home base for families touring local colleges, who may be less willing to splash out on a rental than the bachelorettes? If you want to run a long-term rental for families who’ll stay in the property for years or even decades, you’ll want to consider school districts and lead paint disclosures. Students will want to live close to campus, often with roommates, and may not expect as many amenities as families; but they’re likely to put more wear and tear on the property and you’ll experience more turnover. A single-family home has lower income potential but can feel less intimidating to manage than a more profitable but complex multi-family building and usually comes with a lower purchase price.
As you envision your ideal client, you’ll be able to narrow down your search area as well as the type of properties you’re looking at. The more targeted your search, the less time you’ll spend looking at buildings that don’t meet your goals.
Long-term Rentals
Long-term rentals (LTRs) come in all shapes and sizes, from single-family homes to massive apartment buildings. Both have their unique pros and cons. Multi-family homes generate more income and spend less time empty (i.e., losing money), but come with a higher initial investment and more complications, from managing multiple tenants to stricter regulations to more complex financing. Buildings with five or more units are considered commercial properties for financing and taxes and come with a whole new set of rules and regulations.
Compared to short-term rentals, long-term rentals provide more consistent income and fewer restrictions on where they can be located. While landlords have far more responsibilities to their tenants than Airbnb owners have to their guests, landlords also have the opportunity to vet their tenants. Long-term tenants generally put less wear and tear on a property, and maintenance is easier to plan and budget for.
For a comprehensive look at long-term rentals, check out our deep-dive article.
Owner-Occupied vs. Non-Owner-Occupied
As mentioned above, you may choose to live in your investment property or rent out rooms in your current home. If you don’t mind sharing your home with renters, renting out rooms is a great way for people to build their wealth. We have friends who have rented out their rooms to overseas students and have been able to completely pay off their mortgage as a result. The owner has enjoyed the company and made lifelong friends all over the world. If you enjoy company, this can be a great option to build your wealth or pay off your mortgage without investing in a second property.
If you’re planning to rent out part of your house, make sure neither your mortgage nor your homeowner’s insurance includes any clause that would prevent you from renting out the property. It’s also worth contacting your insurance agent to make sure you have appropriate liability coverage. Owner-occupied homes, even those with up to four units, often qualify for regular mortgages, which have lower interest rates and require a lower down payment than non-owner-occupied investment properties.
Of course, living in your investment property requires you to be more hands-on than you would be with a non-owner-occupied property. Even if you’re renting out a separate unit on your property, you’ll still be interacting with tenants on a regular basis. It can be easier to rapidly respond to issues but your tenants will expect those issues to be dealt with quickly. Living on the property and managing it yourself also gives you the option to cut out expenses like property managers, yard maintenance, and even general home maintenance if you’re handy.
Non-owner-occupied properties come with different financing and insurance requirements but put some distance between you and your tenants. In the case of a multifamily home, having all of the units rented out means more profit.
Non-owner-occupied rentals also must comply with the Fair Housing Act, meaning you cannot decline to rent to a tenant based on race or color, religion, sex, national origin, family status (i.e., whether the tenant is married or has children), or disability.
Federally, owner-occupied rentals with up to two units are not required to abide by the FHA as the owner is looking for people to share their living space with rather than just tenants. However, local governments might have their own rules about fair housing, so be sure to do your due diligence.
Short-term Rentals
Nashville is a popular tourist destination, and many investors have decided to get in on the action. Short-term rentals (STRs) exploded in popularity over the last decade as services like Airbnb and VRBO made operating your own vacation rental business accessible to anyone with a mobile phone. STRs have the potential to be more profitable than long-term rentals but are more likely to spend long periods vacant and generally experience more wear and tear than a residential rental. While short-term rentals may seem less intimidating than long-term rentals, they’re actually heavily regulated in Music City.
Owner-occupied and non-owner-occupied short-term rentals require permits in Davidson County, and non-owner-occupied STRs can only be operated in neighborhoods with specific zoning.
At the time this article was written, Metro Nashville was no longer issuing new non-owner-occupied permits in areas zoned single- or multi-family residential. Properties that already have permits can apply for renewal, but the permits are non-transferable. This means that, even if you purchase an existing Airbnb in a residential neighborhood, you won’t be able to continue operating it as an STR. You can learn more about where and how STRs are allowed to operate at this link.
Owner-occupied STRs have far fewer limitations on where they can be operated but still require a permit, including proof of residence. With so many aspiring vacation rental moguls attempting to falsely claim their investment property is owner-occupied, Metro Nashville now requires four different forms of proof of residence. Both owner- and non-owner-occupied STRs are required to provide proof that you notified your neighbors in writing of your plans. STRs also must pay room, occupancy, and sales tax.
Whether you’re applying for financing to purchase a property or for a permit through Metro Nashville, you’ll need proof of insurance. While Airbnb offers liability insurance to their hosts, there are a lot of exclusions and exceptions, and anecdotally, hosts have had bad experiences with their policies. Your homeowner’s insurance may require an additional rider to cover short-term rentals (and may not cover any damage from renters if you don’t have one of these riders). There are also companies that offer policies specifically tailored to STRs.
Short-term rentals don’t get less complicated once you get a permit. Chat with an investor who operates their own short-term rental and you’ll hear stories about constant cleaning, bad reviews, property damage, and the financial strain of keeping up the property during extended vacancies. While they do come with the potential for larger profits than a long-term rental, the amount of day-to-day work involved can be a dealbreaker for some investors.
Property Management
Managing your own investment property can be fun and fulfilling, but not everyone wants to be hands-on with their new project. Property management companies can be a great option for owners who don’t want to worry about the day-to-day tasks involved in maintaining an investment property.
In general, property managers for long-term rentals charge less than managers who handle short-term rentals due to the more frequent additional work involved in turning over an Airbnb.
A good vacation rental manager can handle everything from listing your property to cleaning between guests and refilling shampoo bottles. Of course, this service comes with a price. The majority of vacation rental management companies charge a percentage of the booking revenue, usually between 10% and 30%, depending on how much of the management the company handles. Occasionally, you’ll find companies that charge a flat rate per booking or, even more rarely, per month.
In comparison, property managers for long-term rentals charge far less. Some will charge a flat rate, but many charge between 8%-12% of the rent collected. The property manager will handle rent collection, finding new tenants, turning over apartments, and maintenance requests. Long-term rentals require less day-to-day maintenance, making them less work for professional property managers. Of course, that also means they can be easier for owners to maintain on their own.
Conclusion
We’ve only scratched the surface of investing in real estate, but we hope we’ve piqued your curiosity. We’ll go into further detail on financing, long-term and short-term rentals, and more in future articles. If you’re already ready to dive into investing, contact our Real Estate Rockstar team at Benchmark.
We’ve put together a guide to help you focus your research and better equip you as you navigate the real estate market. Click the button below to get the guide.