Owning homes, apartments or commercial buildings can be an excellent source of current and future income. Rental properties can help diversify your portfolio, generate cash flow, and build your overall net worth. However, successful direct investment in real estate, such as buying residential or commercial properties, or making a private investment in a fund which does, requires that you know the financial risks as well as opportunities and are in a good position to take them.
To know if you’re truly ready to invest in real estate, here are some questions you should ask yourself:
Why are you investing?
Make sure you know why you are looking to invest in real estate. Typical reasons include:
- Wanting to own your own real estate business
- Rental income
- Investment gains through “flipping” (buying a property, improving it, then selling it quickly)
- Buying a vacation home both for your use and for rental
- Portfolio diversification
What type of real estate investment are you targeting?
The type of real estate investment you choose depends on your ultimate goals, your tax situation, your capacity for financial risk and your net worth. There are many ways to invest directly in real estate, such as single-family homes, 2-4 unit buildings, apartment buildings and commercial buildings. There are also privately managed real estate investment funds, such as real estate investment trusts and limited partnerships, where you can invest in a diversified portfolio of properties. To dive deeper into types of real estate investments, see this article on what to look for in an investment property.
Do you have the cash?
You’ll need a fair amount of cash, a good credit score and a stable financial position to invest directly in real estate. Make sure you have:
- Zero credit card or other high interest debt
- Cash for the down payment (typically 30 percent for an investment property)
- Additional cash savings to cover any property improvements
- Cash savings to cover a minimum of one year of the property expenses (taxes, utilities, property manager, maintenance, etc)
Realistically, to invest in and maintain a $200,000 property, you’ll need at least $60,000 – $80,000 in cash savings. To evaluate if you are financially ready to invest directly in rental real estate take this quiz.
How will you finance the purchase?
Investment property mortgages are generally not insured, so buyers are expected to put down 20-30 percent of the property’s value as a down payment. The FHA and Freddie Mac do have lower down payment mortgage programs for owner-occupants of multi-family properties, so check those out if you’re planning to live in the building.
You’ll need a high credit score (740 or above) to get the best mortgage interest rates. Before you speak to a lender, check your credit scores for free at annualcreditreport.com or an app like Credit Karma and if needed, take steps to try and improve your credit score quickly.
Are you able to accept the risks?
While real estate investments can help you build your net worth and generate income, there are substantial risks. Make sure you’re protected. Risks include:
- Market risk – the real estate market is unpredictable and has a slow cycle
- Vacancy risk – the property doesn’t rent or rents for less than you projected
- Liquidity risk – you can’t sell the property or your share of the investment fund easily
- Location risk – you pick the wrong location or something happens which changes location value
- Diversification risk – you don’t have enough capital to build a diversified real estate portfolio
- Tenant risk – your tenant doesn’t pay the rent or trashes the place
- Legal risk – you face litigation from a tenant, neighbor or local government
What’s your exit strategy?
You can’t walk into an investment like this with the mindset of, “I just want to make as much money as possible.” That’s a recipe for disaster. Before you invest, make sure you begin with the end in mind with a clear picture of what your exit strategy will be.
Under what circumstances would you sell your investment? How much time will you give it? What does success look like, e.g., rental income, appreciation, etc.? When would you want to cut your losses if they occur? This is a very important and often overlooked step in the process, but it can make a big difference in the ultimate success of your venture.
Not sure if you’re ready yet?
If you’ve evaluated your situation and real estate knowledge and decided you’re not quite ready to be a hands on investor in real estate, that does not mean you must refrain from all real estate investments. If it fits your financial situation, you can invest in real estate mutual funds or exchange-traded funds (ETFs) in your retirement or brokerage accounts. That way you’ll still be exposed to the diversification that real estate provides, without exposing yourself to the financial risks you’re not ready to take.