What to Know Before Investing in Real Estate
Estimated reading time: 11 minutes
Real estate is one of the most popular assets among self-directed IRA (SDIRA) investors, and it’s easy to see why. Many investors are already familiar with this asset class due to their previous experience as homeowners. Plus, property ownership is often seen as one of the best tools for gaining diversification and protection from stock market volatility.
In recent years, real estate has experienced significant gains in capital appreciation. On average, residential real estate has provided a 10% annual return on investment (ROI). Real Estate Investment Trusts (REITs) have averaged even higher returns at about 12% ROI.
Learning everything there is to know about real estate investment requires more than a single course; it’s a lifelong education. That said, before making any investment decisions, all real estate investors should start out with a foundation of essential knowledge.
In this article, we outline 10 things you should know before investing in real estate. This includes tips on conducting due diligence, the benefits of illiquidity, and how to simplify the property management process.
1. The Difference Between Cash Flow and Appreciation
Similar to stocks and bonds, many invest in real estate for the potential of capital appreciation. However, real estate often allows for significantly greater cash flow than other assets.
Cash flow refers to a simple equation: rental income minus operating expenses. That’s all there is to it. These expenses may include property management fees, maintenance costs, property taxes, insurance, mortgage payments, and other operational expenses.
Positive cash flow occurs when the rental income exceeds the expenses, resulting in a surplus of funds. Negative cash flow, on the other hand, occurs when expenses surpass the rental income, leading to a shortfall.
Cash flow is particularly important for investors who are seeking a consistent stream of income from their properties. Rental properties that generate positive cash flow can provide a steady source of passive income. These funds can then be used to cover expenses, reinvest in other properties, or contribute to the investor's overall financial well-being.
On the other hand, appreciation refers to the increase in the value of a property over time. This might occur due to changes in market conditions, upgrades to the property, or improvements in the surrounding area.
As the property owner, you can enact minor upgrades like repainting or landscaping, or take on major renovations such as adding extra rooms and modernizing the kitchen. Buyers will also consider paying a premium if new schools, parks, shopping centers, or infrastructure upgrades are made to the neighborhood.
It’s important to note that property appreciation is not guaranteed and can fluctuate over time. Real estate markets can be cyclical, experiencing periods of growth followed by corrections. Prudent real estate investors carefully assess market conditions. They consider factors like location, property condition, and future potential when making investment decisions.
2. There Are Pros and Cons to Illiquidity
Real estate isn’t an asset you can offload over lunch. It’s a long-term investment and depending on your strategy, it may be years before you’re able to turn your investment into a profit.
This illiquidity may actually be an advantage if you’re investing with your retirement funds through an SDIRA. Most IRA and 401(k)s only allow investment in stocks, bonds, and mutual funds. SDIRAs allow you to invest your retirement funds in any asset the IRS allows, including real estate.
If your property is owned by your real estate IRA, selling during an economic downturn or before the asset has matured is practically off the table. You will not only experience a loss on the property, but you may also have to pay a hefty income tax and a 10% early distribution penalty if you’re under the age of 59½.
Some real estate investors may actually benefit from this additional disincentive to sell. It may help them ride out short-term rough patches and come out the other side with their investment portfolio intact.
3. Knowing the Market is Half the Battle
Investing in your local real estate market means you have firsthand knowledge of the area's neighborhoods, trends, and dynamics. This familiarity can help you identify undervalued properties, emerging neighborhoods, and opportunities that might not be apparent to non-local investors.
Local investing also allows you to tap into your existing network and connections. You may have contacts in the real estate industry, such as contractors, real estate agents, and property managers, who can provide valuable support and expertise.
You’ll also build expertise in a specific geographic area. Over time, you'll develop a deep understanding of the local real estate landscape, which can give you a competitive edge over investors who are less familiar with the market.
Finally, local investment may allow you to contribute positively to your community. By revitalizing properties, providing quality rental housing, and supporting local businesses, you can have a direct impact on the neighborhoods you're investing in. This could be a high priority for Community Builder investors, who hope to affect positive change in the world with their portfolio.
However, it's essential to note that local investing also has potential downsides, such as limited diversification and susceptibility to localized economic downturns. As with any investment strategy, careful research and consideration of your goals and risk tolerance are crucial before making investment decisions.
4. Conducting Proper Due Diligence is Crucial
Conducting thorough due diligence is essential when purchasing real estate to ensure a well-informed investment decision.
While internet research is a starting point, it hardly scratches the surface:
- Physically visit the property to gauge its condition, neighborhood, and needed repairs.
- Review financials, and rental agreements, and calculate potential returns based on accurate data.
- Check for legal issues, and property records, and evaluate market trends for future appreciation potential.
- Assess the property's potential for growth and improvement through renovations or upgrades.
Remember that due diligence is an ongoing process that requires careful consideration and research. Taking the time to thoroughly evaluate a property before purchasing can help you make a confident investment choice and mitigate potential risks.
5. Leave Wiggle Room in Your Budget
Determining your budget for a real estate purchase is a critical step to ensure you're making a financially sound decision.
If you’re hoping to qualify for a loan, lenders often use your debt-to-income (DTI) ratio to assess your ability to take on additional debt. Calculate your DTI by dividing your total monthly debt payments by your gross monthly income. Most lenders prefer a DTI below 43%, but this can vary.
Remember that the cost of a property goes beyond the purchase price. You'll need to budget for closing costs, which can include fees for appraisal, title search, attorney's fees, and more. These costs typically range from 2% to 5% of the purchase price.
Additionally, think about ongoing costs such as utilities, maintenance, and potential homeowners association (HOA) fees. These expenses can vary based on the property's size, location, and condition.
You may want to leave some room in your budget for unexpected expenses, changes in interest rates, or fluctuations in income. Having a cushion can help you manage financial uncertainties without putting your investment at risk.
If you’re investing with an SDIRA, remember that you can apply for a non-recourse loan or even partner your IRA with other funding sources if you need more capital.
6. Be Willing to Walk Away
If you’re not willing to walk away, you’re not really in a negotiation.
When you're prepared to walk away from a deal, you hold the upper hand. Sellers and other parties involved are more likely to take your offers seriously when they know you won't hesitate to back out if the terms don't meet your expectations.
If you're emotionally attached to a particular property or deal, you might overlook red flags or compromise on unfavorable terms. Walking away maintains your control over the investment process. It can help prevent you from being pressured into decisions that might not be in your best interest.
7. Finding the Right Investment May Take Time
Move fast and break things — this motto might work for Silicon Valley startups, but it doesn’t hold much water in the real estate purchase process.
Savvy investors always do their research, and would much rather be overprepared than underprepared. In evaluating a prospective real estate investment, there are dozens of variables you and your team need to assess to make an informed decision.
8. You Can Simplify Property Management Without Outsourcing
Property management is a fundamental aspect of many types of real estate investments, particularly in the context of rental properties. If you’re interested in purchasing a rental property, you have two main options to consider: self-management or hiring a professional property management company.
While self-management offers direct control over your investment, it demands a significant commitment of time, effort, and knowledge. Managing tenant relations, ensuring property upkeep, and paying for necessary repairs are vital for sustained occupancy and profitability.
On the other hand, hiring a property management company involves outsourcing the operational responsibilities to professionals with expertise in property management. These companies specialize in handling various aspects of property ownership, including tenant interactions, maintenance, marketing vacant units, and legal compliance.
Utilizing a property management company offers several advantages. First, their experience can provide valuable insights into optimizing your investment. Second, their established networks of service providers ensure timely and efficient maintenance and repairs.
Moreover, property management companies typically have rigorous tenant screening processes to minimize tenant-related issues. Outsourcing these tasks can alleviate stress and free up your time for other pursuits, making property management less demanding.
Many SDIRA holders opt for a property management company to maintain an arm’s length relationship with the assets in their account. This may afford increased peace of mind in maintaining compliance with the IRS rules.
If your properties are owned by your SDIRA, there is one easy way to make self-management much easier. Upgrade to the myDirection Card from Entrust. With this prepaid Visa card, you gain instant access to your IRA funds. Pay for repairs, renovations, and taxes with a single swipe, eliminating waiting times and cutting down on administrative fees.
9. Invest Time in Your Tenant Screening Process
The late filmmaker John Frankenheimer once said, “Casting is 65% of directing.” The same could be said for choosing the right tenants for your rental property.
Here are some steps you can take to attract and select the right tenants:
- Conduct Thorough Screenings: Check their credit history, employment and income verification, and rental history. Ask pre-screening questions during initial inquiries to gauge applicants' suitability. Ask about their rental history, reason for moving, and any pets they have.
- Contact References: Speaking to previous landlords can provide insights into their behavior as tenants. If possible, arrange a face-to-face meeting with potential tenants. This can help you gauge their personality, communication skills, and professionalism.
- Trust Your Gut: If something feels off during the screening process, trust that feeling. It's okay to consider other applicants.
10. Diversification is Key
Real estate is often a major component of a well-diversified portfolio.
However, there are dozens of types of investment properties available, and investors should consider what real estate investments can protect them during economic downturns. Properties like self-storage investing, commercial real estate, and industrial properties may be able to hedge economic downturns.
Different types of real estate assets may perform differently under various market conditions. By holding a mix of assets, such as residential, commercial, and even REITs, you can reduce the overall volatility of your portfolio and potentially achieve more stable returns.
Diversification can provide a steady income stream even if one property experiences vacancies or rent reductions. A portfolio with a variety of properties and assets can help balance out income fluctuations and ensure a consistent cash flow.
Plus, investing in multiple geographic locations reduces the impact of localized risks such as natural disasters, economic shifts, or regulatory changes that might affect a specific region.
Explore Your Real Estate Investment Options at Entrust
With enough foresight, thorough due diligence, and a little bit of luck, you may be able to find a great addition to your real estate portfolio.
If you haven’t already, consider opening an SDIRA. With this powerful investment vehicle, you can invest your tax-advantaged funds in any asset the IRS allows, including real estate, private equity, private lending, and more.
Want to learn more about investing in real estate with your retirement funds? Download our 5 Steps to Investing in Real Estate Report. Inside, you’ll find a simple five-step guide to opening an SDIRA and a breakdown of what your SDIRA can and can’t own.