Real estate investing has long been a popular approach to wealth accumulation. Of course, real estate is is a powerful asset class if you want to earn income, grow wealth, or diversify your investment portfolio. But it is not an easy “get rich” scheme, as some would portray.
Getting started in real estate investing might be overwhelming for beginners. Numerous “gurus” on social media selling courses and potentially misinformation on the best strategy. In this blog, we will break down the important principles and tactics to help newcomers navigate the world of real estate investing.
What is real estate investing?
Real estate investing entails purchasing, renovating, managing, renting, or selling property to generate income or add value. It includes many properties, such as single-family homes, offices, apartment complexes, retail spaces, or undeveloped land. This is real estate investing in its broadest definition.
Rental payments, property appreciation, or both can generate income for real estate investors. In fact, for residential real estate, total return is almost equally split over rental yield and appreciation in property price.
Why Invest in Real Estate?
Real estate investing is popular for the following reasons:
- Potential for appreciation: Real estate can increase in value over time, allowing investors to accumulate equity and enhance their net worth.
- Cash flow generation: Rental properties can provide investors a stable cash flow stream through rental payments.
- Portfolio diversification: Real estate markets tends to respond differently to the stock and bond markets. However, some finance professionals would argue that you can achieve the same risk optimised portfolio with just stocks and bonds.
- Inflation Hedge: Real estate investments have historically resisted inflation since rental rates and property values rise in tandem.
Real Estate Investment Types
There are plenty of real estate investment choices with very different risk profiles and capital requirements.
- Residential Real Estate: Invest in single-family homes, flats, or any other residential properties for rental income.
- Commercial Real Estate: Investing in office buildings, retail spaces, industrial properties, warehouses or other commercial properties leased to businesses or corporations.
- Holiday Lets: Holiday huts, bungalows, flats or houses are properties purchased in prominent tourist areas for short-term rentals.
- REITs: Investing in publicly traded Real Estate Investment Trusts (REITs) that own and manage a property portfolio.
- Crowdfunding: Working with other investors to pool resources and invest in real estate projects together via online platforms or private networks.
Popular Investing Strategies
Whether you are buying a flat or an office building, investors tend to use debt to finance the purchase, which comes with its own risks and rewards. However, there are plenty of real estate investing strategies that can then be utilised alongside debt financing to maximise profits. We will focus on strategies directed at residential properties simply because commercial property investing is not for beginners.
Rental Property Investing
The most basic investment strategy is to invest in rental properties. This entails becoming a landlord, which can be time-consuming (& risky for beginners! you could break the law if you are not familiar with relevant regulations). Of course, property management can be outsourced but that comes with reduced returns. The process is fairly straightforward for this investment strategy, which goes as follows:
- Secure Financing: Whether buying in cash or using a mortgage, your finances should be in order before searching for a property.
- Find property of interest: should be within budget and hopefully offering a good rental yield.
- Make offer: Negotiate, negotiate and negotiate.
- Bring in a surveyor: It is always good practice to bring in a surveyor. You do not want to be surprised after you have completed the purchase. Pro tip: you can renegotiate if the survey identified a major repair needed as long as you have a quote for it.
- Complete: Finalise your sale. This will require regular check-ins with your solicitor and the agent.
- Find a tenant: Either yourself or using an agent. Each agent is different but they charge 4-6 weeks worth rent for this service.
- Manage the property: Again, either yourself or using an agent. Agents offer different levels of service, which can range from collecting deposit and rent only to fully managing the property on your behalf. Expect charges ranging from 5-15% of the monthly rent in charges.
- Pay the taxes: Don’t forget to pay the taxman. In fact, in the UK, tax treatment of rental income is not the best, which means that post-tax return is reduced quite a bit and may even push you in the red.
House Flipping
House flipping is another popular strategy where the investor sources a property in need of refurbishment, renovates the place and sells it in a span of months. Most investors engaged in house flipping have DIY experience or have a trusted network of tradesmen. The process is identical to the above up and until completion, with the following differences and considerations:
- Estimate the renovation costs: Before even making an offer, the renovation scope needs to be well defined and costs estimated. Unlike the property itself, these costs will be paid up in cash in most cases. There are some bridge financing companies that are willing to lend for large renovation projects, but the interest on these loans tends to be very high.
- Decide on Execution Strategy: You need to have your resources well defined and lined up for the renovation project if you want to make the profit and move on to the next project quickly. This includes deciding what work you will be doing yourself and what contractors are you bringing in.
- Managing the project: Whether you are doing the bulk of the work yourself or not, you will need to stay on top of your budget and track your spending. Any overspend can quickly translate to reduced profits.
- Sell the property: After completion, the property is ready to sell for a premium, at which point you should have some profit left over after paying the bank and all closing fees.
BRRR
The Buy-Refurbish-Refinance-Rent (BRRR) strategy is a variation combining aspects of house flipping and rental property investing. The premise of the BRRR is that you can increase the property value after renovation, so you can refinance and get whatever you spent on the deposit (and potentially the refurb) back from the bank before renting it out. This can be done successfully as well but there is an important consideration with this strategy: banks will not allow you to refinance within 6 months of closing (check with your lender). This means you may need to consider bridge financing during the refurbishment and refinance as soon as the property is ready.
HMOs
Homes of Multiple Occupations (HMOs) are another popular strategy amongst property investors. This involves buying a multi-bed property and converting the living room to another bedroom. The property becomes an HMO with the kitchen and bathroom being communal areas shared by the tenants. Of course, the ensuites remain accessible only to the tenant of the room, typically paying higher rent compared to the other tenants. Again, there are subtle yet important considerations with HMOs:
- Finding Tenants: Estate agents do not tend to work with bedrooms often. As such, finding and vetting tenants becomes the sole purpose of the investors. This may be time-consuming, especially given that these tenants will move-on at some point to a flat or a house.
- Tenant Expectations: The bills for HMOs are usually the responsibility of the landlord as well. This may come with variability as energy usage varies from tenant to tenant.
- Regulations: HMOs are subject to special regulations and landlords must ensure compliance to avoid hefty fines.
Rent-to-Rent
The Rent-to-Rent (R2R) strategy is another popular strategy, at least on social media, for property investing. I would say this is not property investing as much as it is a risky business activity. The R2R strategy involves renting a house, converting it to an HMO and managing the property portfolio. It becomes obvious quickly that you don’t need a large upfront investment compared to the other strategies, but this comes at the risk of operating at a loss if you don’t find tenants quickly or your occupancy rates dip for a while. Of course, getting the landlord’s consent to sublet is critical to operate without breaking the tenancy agreement.
Holiday Lets (AirBnb)
Another strategy is to acquire flats or houses in cities and other tourist destinations and let them out on Airbnb. This can be profitable of course, but does require another level of servicing, one that is almost on par with hotels. There are specialised property managers who offer such services for a fee if you can’t do it yourself, but it needs to be done. Also, properly assessing returns with this kind of investment is a bit complex, because rental rates and occupancy rates vary seasonally and annually.
REITs
Fractional ownership in rental properties without the headache? Enter REITs. These are traded publicly on financial markets and can be bought easily and cheaply from a broker like Trading212 or AJBell. REITs will offer dividend yields ranging from 3% all the way to 7%. However, the value of REIT shares can go down as interest rates go up or commercial real estate valuations come down. It is always a good idea to know exactly what kind of real estate is owned and operated by the REIT.
Crowdfunding
Crowdfunding is like investing in REITs, but instead of owning a slice of a company owning a large property portfolio (the investment trust), you will own a slice of a company owning a particular property. There are numerous companies facilitating this kind of investing, you can find a list of them here. But beware the risk of default, many of the companies on this list are start-ups who can go bankrupt, so make sure that your shares are in a special purpose vehicle that is shielded from creditors in the case of bankruptcy.
What Are The Risks?
Real estate investment, like any investment, comes with risks alongside the rewards. Understanding and managing the following risks is critical to success:
- Market Risk: Fluctuations in real estate markets can affect property values and rental demand. Keep an eye on interest rates as they move the market in the UK.
- Cashflow Risks: Vacancies, unplanned maintenance, or non-paying renters can all impact cashflow and lead to unprofitable periods.
- Financing risks: Borrowing money to finance real estate ventures entails interest rates, loan terms, and potential default risks. Keeping leverage under control and fixing rates for longer are essential to managing these risks.
- Property Management: Property management is critical for preserving and increasing the value of the investment. If you don’t have the time to manage the property, bringing in professionals is recommended.
- Legal and regulatory risks: Real estate investments are subject to rules, tenant-landlord laws, and environmental regulations. Another benefit to outsourcing property management is having professionals staying on top of compliance with legal and regulatory requirements.
- Liquidity: Selling property can take months to complete, so consider the capital being tied up for some time when invested in property.
Critical Success Factors
We touch upon the critical success factors to increase chances of succeeding in real estate investing.
Define Your Goals
This may sound cliche, but it is very important. Your goals will influence a few decisions that we consider success factors. Are you trying to supplement your income or replace your income? Are you trying to rely on property for retirement? if yes, how far are you from retirement? These answers will determine how much income you are after, how many properties needed to achieve this income level using different strategies etc.
Do Your Research
As with any investment, doing your own research is imperative to manage risk. This is no different with real estate. You should spend ample time understanding the local real estate market by viewing properties, online and in person. You should also research your financing options, the tax treatment and the investment strategy. All of these will feed into the cashflow forecast.
Run the Numbers
This is where real estate differs from other asset classes, you need to forecast cashflows before pulling the trigger. Regardless of which strategy you consider, you must be able to set-up simple models capturing your capital investment, your operating costs and income. This skillset will de-risk the investment and allow you to make decisions confidently and quickly. Things to consider in your model should include:
- Capital investment including the deposit, legal fees, land tax, surveying fees and product fees. For refurbs, the refurbishment costs need to be considered as well.
- Operating expenses including mortgage payments, maintenance and repairs, property management fees, service charges and ground rent if applicable.
- Expected rental yield based on properties in the area, This allows you to calculate gross yield (rent payments per annum/capital investment) and net yield (rent payments per annum less operating expenses/capital investments)
- Taxes. It is tricky in the UK since interest expense is not fully deductible so you may actually end up losing money because of taxes (which is absurd because you should only pay taxes on profits, right?)
- Scenario planning by playing with the numbers. What happens to the bottom line if the mortgage payments went up or if occupancy drops to 75% from an assumed 90%.
Select the Investing Strategy
We have introduced a few strategies above, and they come with different capital requirements and risk levels. Selecting the most appropriate strategy is a critical success factor. The strategy that best matches your risk appetite, skills, available capital, time, and goals will increase chances of achieving net positive return.
Deciding On Ownership Structure
If you aim to retire or replace your income using property, it is pretty much a given that you will be working on building a property portfolio. Owning the properties in your own name or in a limited company becomes a very relevant and important decision to make. Most will say that if owning multiple properties, it is best to keep them in a limited company. But opening and maintaining a limited company comes with responsibilities and obligations. This decision will have a meaningful impact on tax treatment and profitability. Of course, speaking to an accountant specialising in taxes will prove useful here.
Conclusion
Real estate investing may seem like a lucrative endeavor, but it requires careful consideration and due diligence, otherwise it can be an expensive ordeal. We introduced different types of properties for investment, investment strategies, relevant risks and critical success factors. It is imperative to acquire some key skills and knowledge before making real estate investments.
Also Read: The Complete Mortgage Guide: Everything You Need to Know Before Applying
