When I tell people what I do for a living, I often get them asking me how real estate works. I’ve put together this post to help explain the basic of real estate investing and show you the most common real estate investing strategies there are.
How does real estate investing work? In short, REI simply means using property, with or without building(s), to increase your net worth. You can do this with your own home, or invest in long-term or short-term strategies.
Let’s talk about seven of the most common real estate investing strategies and help you figure out which one is the way to go!
Buy Your Own Home
The first investing strategy is also the most simple and the most common! Many people who buy a house don’t consider themselves to be investors, but that’s exactly what they’re doing. Sure, you get the awesome benefit of knowing that the piece of land and the building on it are yours (well, mostly yours. The bank has a claim), but you’re also buying something that’s steadily increased in value over the years.
Very, very few things that you buy actually increase in value. Boats, cars, electronics—they all depreciate, and pretty significantly. It’s incredible that something you literally use all day and all night and is the most expensive thing you own can also net you money.
Let’s talk about the ways your personal home can make you money.
This is what I mentioned before. It simply means that over time your property is likely to go up in value.
Here’s a historical look
Except for the housing crash of ‘08, prices have steadily increased. Take any point on that chart, go back 30 years, and you can see how much more your house would be worth once your mortgage is paid off.
This means that you are adding things to your house that force it to go up in value. This could be a kitchen remodel, a bathroom renovation, or adding landscaping. You could really go for a fixer-upper and add tons of value over a short period of time if you’re willing to do the work.
When you’re considering how to best add value to your house, be sure to read which projects add the most return on your investment.
Gain Equity Through Paying Down Principal
So obviously, over time, you’re paying down the loan that you took out to buy your new home. I know, paying off your mortgage isn’t generally considered an investment, but when the alternative is paying rent into your landlord’s pocket, paying down your principal seems like the best investment in the world.
When considering your personal residence as an investment and how much it will be worth to you in the future, consider looking at an amortization schedule.
Am amortization schedule shows you how much of your monthly payment goes towards the principal and how much goes towards interest.
Now, also consider that you don’t want to sell your primary residence in less than 2 years after moving, or any money you make will be subject to capital gains taxes.
So, take a look at your property and how much principal you’ll have paid off.
Here’s a real example of an amortization schedule for a $300k house at 3.5% interest:
You can see that after two years, you would have just over $11k in equity in your house! That’s assuming its value remains the same. Now, you can’t sell the house and walk away with the $11k—there are too many other costs (like a real estate agent) and you’ll need some money for your next down payment as well.
However, it your property has gone up in value $20k, and now you add the $11k to it, you might be on to something.
Home ownership provides you with up to 7 different tax benefits, as outlined beautifully in this post by Lending Tree.
The most common tax benefit is to deduct the interest you pay on your monthly mortgage payment. The government really likes to incentivize homeownership so they provide several types of ways to reduce your tax bill to Uncle Sam.
So, now we’ve talked about a few ways to increase your equity in the home (the difference between how much the house is worth and what you owe on it), but what good does that do you?
Options, options, options! Here’s what you can do with that equity:
- Sell your house and walk away with a profit. Be careful to consider the costs of selling your home, such as your real estate agent, upgrades you need to make before selling, or a new down payment for your next home.
- Cash-out refinance. Often a bank will lend you up to 80% of the value of the house upon refinancing. If you owe $200k on your house, but it’s worth $300k, you can likely get a loan for $240k (80% of $300k). In that scenario you would pocket around $40k!
- Refinance to lower your payment. Whether you can now get rid of your PMI (mortgage insurance) or take advantage of better rates, lowering your payment can add a nice monthly bonus to your bottom line.
- HELOC, or Home Equity Line of Credit. Usually you can borrow up to the same 80% number we talked about above. If you’d like a line of credit (or a home equity loan) for a home renovation, consolidate debt, or to buy a car, you can borrow against the equity you have in your home!
- Feel good about yourself and keep living there! Having that equity is a nice thing to have in your back pocket. Of course it’s not liquid money in the bank, but just knowing you have that asset where you can access a good chunk of change lets you breathe easier at night. So if you like where you live and want to keep paying that down that principal, go for it!
In short, buying your own home is most definitely an investment, and one that often pays out big later on in either cash or borrowing options.
There aren’t many cons to buying your own home, as the alternative is to pay someone else’s mortgage (and that’s not cool). However as a true investing strategy, it’s not one that’s going to provide you continuous cash flow, and costs you money each month as you pay down your mortgage. Not that those should keep you from buying a house with a long-term view, but something to keep in mind.
Buy and Hold Your Property
Earlier I showed you that graph about how property values almost continually go up (and always goes up if you wait long enough), so a common real estate strategy is to buy a property and hold onto it!
But in this strategy, it’s not going to be your primary residence—it’s going to be an investment property that you keep as a rental.
There are a few reasons why investors really like this strategy:
- Someone else is paying the mortgage each month. Imagine 30 years from now you could have a home, completely paid off, and it’ll be worth $500,000 at that point. That’s huge! Even better: if you’re still using it as a rental, the entire rent check goes straight into your pocket as cash. That’s incredible!
- Passive monthly cash flow. If you do your homework, you should end up with a property that not only pays for its own mortgage, but also adds a little something extra to your bank account each month! This may require you to put down a larger down payment (so your monthly mortgage is smaller) and certainly requires that you understand rent in the area. Is it a high quality neighborhood that’s likely to go up in value over time? Even if you’re breaking even today but are relatively certain you can raise rent in the next few years, that may work out to your benefit.
- Tax Benefits! I talked above about a few tax breaks that come from your primary residence, but there are even more when it comes to renting out a property! You can deduct things like fixing things that break, the depreciation of the structure of the house and appliances, travel costs (if you routinely check on the property), and even legal fees for things like evictions or disputes. You can read a full breakdown of these over at Smart Asset.
So…why doesn’t everyone do rentals? They sound incredible! There are certainly a few cons to consider.
First, the cost of getting started can be hefty. Many people buy a home they feel like would be an ideal rental property, and then move out a few years later, keeping that first residence to be a rental. However, most mortgage companies will want you to prove that you have 6 months’ worth of mortgage payments in the bank for your rental property (in case you can’t find a tenant). Add in that you’ll need a down payment for your new home, and that’s a lot of cash you need on hand.
Next, you cannot use an FHA loan to acquire a rental property. If you’re unfamiliar, the FHA loans are government-back loans that allow you put 3.5% down, but then you do have to pay private mortgage insurance (PMI) each month. It’s extremely appealing for the small up-front cash required, but you cannot use it to acquire a rental property. You can however use an FHA loan on a primary residence, and then later move out and use that as a rental, even though it has an FHA loan attached to it. Just a little catch you have to be aware of.
Also, a lot of owners get frustrated at being a landlord. You have to find tenants. You have to deal with repairs. You need to maintain the property. And you might have to evict tenants. Sure, you can hire a management company, but they’ll usually take 10% of the rental income, making it nearly impossible for you to be cash flow positive each month. In fact, so many owners of rentals get frustrated that I often target them as possible sellers when I’m looking to acquire property.
Fix & Flip Strategy
One of the most common types of real estate investing, fix & flips mean that you purchase a property in need of repairs, rehab the property, and then sell it for a profit.
The positives are significant…a big fat paycheck! In fact, Do Hard Money’s average profit for our fix & flippers is over $33k per deal! (And many of those bring $0 to the closing table).
Many people love doing fix & flips. The process of figuring out what parts of the house to rehab, and essentially getting to design the new fixes yourself is satisfying. Walking through the house at the end is a great feeling, and you’ve helped to upgrade the entire neighborhood as well.
However, the cons are there as well.
- Many investors can’t find deals. This is easily the #1 reason would-be fix & flippers quit. There are too many other investors out there trying to find deals (thank you, HGTV). Often, you’ll need software to uncover hidden gems.
- It’s a long process. The idea is easy, but in practice there are many, many steps to making a flip work. The people who succeed are the ones who are determined, passionate, and will push through any stumbling blocks (because they always come up).
- There’s the potential to lose lots of money. Perhaps you miscalculated what the after repair value of the house would. Maybe you can’t sell the house fast and the loan fees rack up. Maybe unexpected expenses added $10,000 to your project. I also see investors underestimate how much repairs are going to cost. You can avoid all of these issues by working with an experienced company who can take you step by step to minimize the possibility of failing on a deal
Buy, Rehab, Rent, Refinance. This is an incredible marriage of fix & flips and rentals!
BRRR investing strategy goes like this:
- Buy – you’re going to look for motivated sellers willing to discount their properties, just like when you’re looking for a fix & flip property.
- Rehab – At this point, you’re going to rehab the property, similar to a fix & flip as well
- Rent – Now, it gets fun. Instead of selling the property, you’re going to find a renter! Once you have a renter in place, it becomes easier to refinance the property.
- Refinance – A regular bank won’t give you a loan for a short-term rehab project. You’ll likely need hard money for that. At this point, you’re now looking for a 30-year conventional loan, and it’s easier when you have a renter already in place to pay your mortgage!
There’s something else to consider when refinancing the property…will the bank off you a cash-our refinance or only pay off debt? Heres’ what I mean:
Let’s say you get a loan for $160,000, but then you rehab the property you acquired and now it’s worth $260,000… With a traditional refinance, banks often lend you up to 80% of the value of the house. So 80% of $260,000 would be $208,000, meaning you could walk away with $48,000. However, some banks will only lend you the $160,000.
That’s a no go. Why?
Because you want to take that $48,000 and invest that into your next deal! Done right, the BRRR deal can sustain itself over and over again, allowing you to essentially acquire properties repeatedly with only using profit from the previous deal. That’s incredible!
To find the banks that will lend this way, you can network with other investors, go to online forums, or just go around and talk talk to some banks.
Now even though this real estate investing strategy is becoming a favorite among real estate investors, it’s not without its drawbacks.
First, if you’re brand new, BRRR can be daunting. You have to understand both fix & flips and buy & hold in order to execute this properly.
Second, it can be tough to refinance the loan. If you don’t already have something in place, it’s a little scary. At Do Hard Money, we help BRRR investors smoothly transition to one of our partners for a conventional loan.
And lastly, finding a tenant in the time frame you need can be tricky. You might not be able to get your refinancing without a tenant, but you also can’t really have a tenant move in during the middle of the rehab. You want to time this right, but also not leave yourself without an empty property for longer than necessary because the interest costs on the loan will start to pile up.
This is one of the most popular investing strategies, and you’ll see why!
What you’ll do for wholesaling is go out and find a property, just like you would for a fix & flip. However instead of getting funding for the deal, you’ll assign the contract to another investor for a finder’s fee! Usually this is somewhere between $2,500 and $15,000, depending on the profit available in the deal. I’ve seen wholesalers make over $50k on a single deal!
Here’s why this is an amazing real estate strategy:
- They’re quick. You’re only the deal as long as it takes to find another investor to take the deal from you. Often you’re getting a check in 1-2 weeks.
- It’s a much simpler process. Make an offer, assign the contract to another investor, collect check. Done!
- No rehab. Trust me, they sound fun, but they’re usually the biggest source of headaches.
- No loan! There’s no worrying about meeting loan deadlines and paying off loan costs & interest on time. You can’t really lose money on a wholesale deal, except maybe your earnest money.
- They’re still profitable! Sure, they’re not as profitable as a fix & flip, but there’s much less work involved.
- Fewer out-of-pocket costs for you. You’ll likely need some earnest money, but I rarely do more than $500 when I’m planning to wholesale a deal. I also write it into the contract that I only pay earnest money when they accept my offer, so my money is only tied up if there’s going to be a deal.
Because of their simplicity, wholesaling is a favorite among new investors, especially ones who don’t have money for a down payment or are more risk averse. There are still some drawbacks, but they are minor.
For example, if you don’t already have an investor lined up, it can be tricky. You should still be able to back out of the deal and get your earnest money back, but an inexperienced investor might lose that deposit.
Most wholesalers spend a lot of their time finding deals (obviously), but also networking to create a list of cash buyers. Cash buyers are investors who have enough money to pay for the deal themselves, or are going to get cash with hard money or a private lender. Basically, you’re trying to build a list of fix & flip investors who will likely take the property from you.
Most fix & flippers jump at the chance to network with wholesalers, but there’s still the legwork involved to find them. We’ve spent 20 years building a list of tens of thousands of investors, so we help our wholesaling members by sending out their deal to our list, after we’ve vetted all the numbers.
Fund Real Estate Deals Yourself!
Now we’re talking about the other side of real estate investing—where you have the money and you fund deals. As the lender, you’ll earn money passively while a fix & flipper does the work themselves. This is what I did. After years of actively fixing & flipping, I used the money I had earned to become a hard money lender. That’s how Do Hard Money got started. I still have a portfolio of rental properties and take on many other real estate investing projects, but the ability to fund deals is an incredible way to build your net worth.
Private lenders are usually getting double digit returns on their money, and in my experience provides better returns than any other passive strategy out there.
Of course, it’s not without risk. If the borrower defaults, or does something shady or even illegal, you can lose a good chunk of your money.
The good news is that if something happens, you’re the owner of the property, and you can find another fix & flipper, finish the property yourself, or try to sell it as-is to recoup as much of your money as possible. Although becoming the owner of a property when you were simply expecting to be the money behind the deal can be frustrating. I’ve had to take back deals when a borrower defaults, and even though I have the experience to take care of the property and turn a profit, it’s a process I don’t want to deal with.
Fractionalized or Crowdfunded Real Estate
Funding deals sounds great…but what if you don’t have $300,000 available to lend to a real estate investor?
That’s when fractionalized real estate becomes super attractive! This means that you, along with other lenders, will each fund a portion of the deal and then in turn, you own a fraction of the property. When profit is realized, you’ll get the percent of the cut equal to the percent you funded.
You can do this with a group that you put together or join, and each of you put in $20,000 or so.
But many companies out there have made it even more accessible for people without a lot of money to participate in fractionalized real estate lending.
These companies will often let you invest as little as $100. They’ll do all the research of finding the properties, and then they’ll do the rehab work or maintaining the rental property. They’re very easy for a beginner to get involved in.
I love this strategy because becoming a lender is my favorite way to invest, but now it’s accessible to everyone. Different companies invest in different things: some are looking to fix & flip, others do commercial real estate…you should check out these apps and decide which ones are investing in the properties you want, and if they give you the amount of control to pick properties that you are looking for.
So how does real estate investing work? The overall idea is simple:
Buy a property and make money through resell, renting, or you can fund other people who’d like to buy properties and flip them!
But which real estate investing strategy is right for you?
For a property you want to live in, figure out how to purchase your own property! Use as little of your own money down as possible (using an FHA, USDA, or other government-backed loan) and try to buy in an area that seems primed for growth.
For long-term cash flow, you’ll want to own rentals. If you’re ready for a bigger, more profitable challenge, look more into BRRR investments.
For a simple, quick way to make $5k+ per month, wholesaling might be the perfect strategy.
Then last but not least, for the highest and most passive returns, look into funding deals yourself or with a group.
Hope that helps you understand better how real estate investing works!