So you’re interested in diversifying your asset portfolio with residential real estate investments? Diversity is great, but investing in real estate is just like any other investment strategy: it requires preparation and more than a little knowledge to be successful. Careless choices in real estate investment will likely subtract from your net worth, rather than add to it.
Here are a few basic principles that you need to understand before you get started in real estate investing.
1. You’re going to be using leverage.
You may or may not already be familiar with the concept of leverage. In layman’s terms, it basically means: using a little money to buy something worth a lot more. Truth be told, if you own your own home, you’ve probably already used leverage. If you purchased a $200,000 house, you probably didn’t buy it with $200,000. Instead, you made a down payment that was a percentage of the asking price and financed the rest with a mortgage.
This is the same formula that you will use with real estate investing, and it works marvelously to your advantage. How? Just as you did with your own home, you’re buying an asset worth significantly more than the amount of money you need to purchase it. This is advantageous to you as an investor because you can buy a fortune in assets with only a fraction of the value of those assets. You only need $200,000 (or less in some cases) to buy a $1,000,000 property.
It gets even better. The amount of your return is based on your down payment, not the value of the asset. To continue with the example above, if you bought a $1,000,000 property with $200,000 down and it increases in value by 10% over a year, then you might think that you have a 10% return on your investment, right? But the reality is that you actually have a 50% return on your investment. You invested $200,000, not $1,000,000. So, when the property increases in value by $100,000 you actually saw a 50% return on the $200,000 investment.
2. You’ll probably want a property manager.
Unless you plan on dealing with the hassles of maintenance and tenant complaints yourself, you’re probably going to be better off with a property manager. Ask yourself: do you want dinner with your family interrupted because a tenant is calling to complain about a leaky toilet? Do you want the phone to ring in the middle of the night with a complaint that the air conditioning isn’t working? If the answer to either of these questions is “no”, then you’re already leaning in the direction of a property manager.
Property managers will take a percentage of the gross rent (how much of a percentage depends on the property type), but in exchange they give you peace of mind and more flexibility with your schedule. Not only will they handle routine maintenance tasks, they’ll also handle the process of screening new tenants and showing the property to prospective tenants. You’ll probably find that they’re worth the additional investment, especially with larger properties.
3. As with any other investment, look for a bargain.
When shopping around for stocks, you probably don’t want to look for the stock that is the most expensive relative to its earnings, right? Think the same way with real estate investments. Look for bargains. In some cases, you may need to find a “fixer-upper”. You’ll have to put some money into the property to make it marketable, but do the math and see if it’s worth it. In other cases, property owners might be trying to sell quickly, and there can be good reasons for that (sickness, financial distress due to something unrelated to the property itself, etc.). Shop around for wholesale real estate investment opportunities.
Look to diversify your real estate portfolio just as you do your other assets. Diversifiying within real estate is a great way to minimize your risk while still enjoying outstanding returns.
How do you diversify? One option is to diversify geopgraphically. Avoid the temptation to purchase only properties in your immediate area. If that area is hit by any kind of disaster (be it economic or natural), then your entire real estate portfolio is hit as well.
Another option is diversify in terms of the types of residential properties you purchase. You should have some Section 8 housing (that’s government-guaranteed rent), some middle-class properties, and some upper-income properties.
Residential real estate investing is an exciting and financially rewarding means of enhancing your net worth. Just be sure that you have a thorough understanding of what’s involved and how it affects your investment strategy before you dive in.