How to Invest in Real Estate

1. Build your emergency fund

Houses are built on top of foundations to help keep them stable. Just like houses, your finances also need a stable foundation. Part of that includes your emergency fund. We recommend that, before purchasing a home, you should have a fully-funded emergency fund. Your emergency fund should be a minimum of three months’ worth of expenses.

How big your emergency fund should be is a common question. By definition, emergencies are difficult to plan for. We don’t know when they will occur or how much they will cost. But we do know that life doesn’t always go smoothly, and thus that we should plan ahead for unexpected emergencies.

Emergency funds are important for everyone, but especially so if you are a homeowner. When you are a renter, your landlord is likely responsible for the majority of repairs and maintenance of your building. As a homeowner, that responsibility now falls on your shoulders. Yes, owning a home can be a good investment, but it can also be an expensive endeavor. That is exactly why you should not purchase a home before having a fully-funded emergency fund.

And don’t forget that your monthly expenses may increase once you purchase your new home. To determine the appropriate size for your emergency fund, we recommend using what your monthly expenses will be after you own your new home, not just what they are today.

Open your Safety Net Get Started

4. Research and Analyze

allMake sure you do proper due diligence on all aspects of every deal. There are a lot of so-called “deals” touted, but you need to make sure you get it right. How much will the rehab cost? What are the monthly holding costs? What permits do you need and how long will it take to get them? The list of questions you need to be answered is extensive.

A property is a huge investment, not a consumer product that can be returned if you don’t like something about it. That foundation crack will need to be fixed and will be expensive. The mold in the back of the closet might need professional mold remediation, which is also expensive. It’s way too easy to go into the red on a property. Checking it out personally before I buy is simply a must-do every time.

Calculate

Obviously, make sure your numbers are right when evaluating deals. I frequently see investors focus on the listing price of active comps (similar properties currently on the market for sale) when estimating a property’s after-repair value. The listing price of a property is really just a guestimate arrived at by an owner or real estate agent. The real market price of a house is the final price agreed to by the buyer and seller. Recently sold properties are more indicative of a similar property’s market value than active or even pending listings.

It takes knowledge, experience, and persistence to research and analyze deals. And you’ll always regret it if you don’t do so thoroughly!

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When is a house not a good investment?

This is not to say that homeownership is the right strategy for everyone.

Many first-time buyers today are priced out of their local real estate markets. Some are unable to afford the steep down payment, closing costs, and monthly mortgage payments involved.

“Single-family existing home prices rose in all metro areas in the last quarter of 2020, while 88% of the metro areas had double-digit price gains,” Evangelou says.

The silver lining to these statistics is that homeowners have quickly built more equity in recent years, and sellers are reaping huge rewards. Today’s prospective buyers may benefit from these same perks over time, too.

“Purchasing a house should primarily be about matching your needs for space, community, and your family, and secondarily be about adding value or resale.” —Michael Fischer, Director and wealth advisor, Round Table Wealth Management

However, Johnson reminds readers that home equity can dissipate quickly, as seen during the financial crisis over a decade ago.

“Real estate is generally very illiquid — meaning not easily converted to cash unless you tap into your home’s equity,” he says.

“Because homes aren’t actively traded and the market is relatively illiquid, many investors assume that home values won’t fluctuate much. Homeowners convince themselves that the value of their home is more stable than that of stocks, but that concept is illusory. Home prices can fall precipitously, as history has shown us.”

Fischer says a home may not be a good investment if you don’t anticipate remaining in or renting out the home for at least five years, or if the local housing market has increased significantly over the past few years.

If the latter is true, “you may be better served looking at a nearby market that has yet to appreciate,” he adds.

How does location factor in?

Deciding where to buy is often almost as big of a decision as which home to buy. For those living in urban areas like New York or San Francisco, a fairly common question that arises is whether or not to make the move to the suburbs.

A huge draw of the suburbs is you can often get a larger home for the same budget. But, on the other hand, there are many perks and conveniences of city life that can’t be easily replaced when you move away.

How Do I Determine The Potential ROI For My Rental Property?

When looking for a great investment property, the first question you need to ask is “Can I actually make money?” If the answer is no, it’s obviously not a great investment. To see how much money your property could potentially make, you’ll need to consider the return on investment (ROI). The ROI can be calculated by first finding the property’s net annual income. This is the rent money that’s left over after you’ve paid the taxes, insurance, property management fees, expected repairs (plan to spend 1% of the property value on this), potential vacancy periods, HOA fees (if applicable) and any utilities that aren’t going to be covered by the tenant. To find the ROI, take the annual income and divide it by the amount you spent on the property. For example, if the net annual income is $7,500 and you spent $100,000 for the property, your ROI is 7.5%.Use this calculation to see if each rental property is a good potential investment.

9. Accurately Calculate the Expenses of Owning a Rental Property

 landlord insurance property taxes homeowners assoThe main operating expenses — which are easy to calculate and budget for monthly — are:

  • landlord insurance
  • property taxes
  • homeowners association (HOA) or condo fees
  • property maintenance
  • mortgage payments.

Be sure to factor in unexpected costs as well. You’ll have regular maintenance costs, such as replacing HVAC filters. And you’ll likely have repair costs that will vary year to year based on when appliances break or wear out and need replacement.

The initial purchase of the property has unique expenses, including closing costs (such as transfer and recordation fees), lender and title company fees, and escrow items such as property taxes and mortgage insurance. Budget for future expenditures such as a new roof, water heater, and appliances.

Why Is Real Estate Considered to Be an Inflation Hedge?

Home prices tend to rise along with inflation. This is because homebuilders' costs rise with inflation, which must be passed on to buyers of new homes. Existing homes, too, rise with inflation though. If you hold a fixed-rate mortgage, as inflation rises, your fixed monthly payments become effectively more affordable. Moreover, if you are a landlord, you can increase the rent to keep up with inflation.

How should I value my home as an asset?

The costs of homeownership can be a huge portion of your monthly expenses. But over time your house could also become one of your largest assets. As you start paying down the principal on your mortgage, you also start building home equity, or the amount of ownership of your home. If you decide to sell your home in the future, you will likely have cash on hand to spend on something else.

A useful formula to remember: Home equity = current home value – current mortgage balance

13. Close on your house

Once all contingencies have been met, you’re happy with the final walk-through and the closing agent has given the green light to close, it’s time to make it official and close on your home. In this final step, your lender will issue you a “clear to close” status on your loan.

How to get started: Three business days before your closing date, the lender will provide you with a closing disclosure that outlines all of your loan details, such as the monthly payment, loan type and term, interest rate, annual percentage rate (APR), loan fees and how much money you must bring to closing. At the closing, you (the buyer) will attend, along with your real estate agent, possibly the seller’s agent, the seller, in some cases, and the closing agent, who may be a representative from the escrow or title company or a real estate attorney. This is also the time where you’ll wire your closing costs and down payment, depending on the escrow company’s procedures.

Key takeaways:

  • Before closing, review the closing disclosure carefully and compare it to the loan estimate to ensure closing fees and loan terms are the same. Ask questions about your loan and correct any errors (like your name or personal details) before you sign closing paperwork.
  • On closing day, review all of the documents you sign carefully, and ask for clarification on anything you don’t understand.
  • Make sure you’ve been provided all house keys, entry codes and garage door openers before leaving closing.
  • You’ll leave closing with copies of the paperwork (or a digital file) and your new house keys. Be sure to store your paperwork in a safe place for future reference.

Once all of the paperwork has been signed, the home is officially yours and you’ll get those house keys. Congratulations! Now comes the fun part: moving in and making the house your home.

5. Calculate Your Monthly Affordability

The upfront costs are just one component of home affordability. The other is the ongoing monthly costs. Betterment recommends building a financial plan to determine how much home you can afford while still achieving your other financial goals. But if you don’t have a financial plan, we recommend not exceeding a debt-to-income (DTI) ratio of 36%.

In other words, you take your monthly debt payments (including your housing costs), and divide them by your gross monthly income. Lenders often use this as one factor when it comes to approving you for a mortgage.

Debt Income Ratios

There are lots of rules in terms of what counts as income and what counts as debt. These rules are all outlined in parts of Fannie Mae’s Selling Guide and . While the above formula is just an estimate, it is helpful for planning purposes.

In certain cases Fannie Mae and Freddie Mac will allow debt-to-income ratios as high as 45%-50%. But just because you can get approved for that, doesn’t mean it makes financial sense to do so.

Keep in mind that the lender’s concern is your ability to repay the money they lent you. They are far less concerned with whether or not you can also afford to retire or send your kids to college. The debt to income ratio calculation also doesn’t factor in income taxes or home repairs, both of which can be significant.

This is all to say that using DTI ratios to calculate home affordability may be an okay starting point, but they fail to capture many key inputs for calculating how much you personally can afford. We’ll outline our preferred alternative below, but if you do choose to use a DTI ratio, we recommend using a maximum of 36%. That means all of your debts—including your housing payment—should not exceed 36% of your gross income.

In our opinion, the best way to determine how much home you can afford is to build a financial plan. That way, you can identify your various financial goals, and calculate how much you need to be saving on a regular basis to achieve those goals. With the confidence that your other goals are on-track, any excess cash flow can be used towards monthly housing costs. Think of this as starting with your financial goals, and then backing into home affordability, instead of the other way around.

Flipping Houses

Like the day traders who are leagues away from buy-and-hold investors, real estate flippers are an entirely different breed from buy-and-rent landlords. Flippers buy properties with the intention of holding them for a short period—often no more than three to four months—and quickly selling them for a profit.

The are two primary approaches to flipping a property:

  1. Repair and update. With this approach, you buy a property that you think will increase in value with certain repairs and updates. Ideally, you complete the work as quickly as possible and then sell at a price that exceeds your total investment (including the renovations).
  2. Hold and resell. This type of flipping works differently. Instead of buying a property and fixing it up, you buy in a rapidly rising market, hold for a few months, and then sell at a profit.

With either type of flipping, you run the risk that you won’t be able to unload the property at a price that will turn a profit. This can present a challenge because flippers don’t generally keep enough ready cash to pay mortgages on properties for the long term. Still, flipping can be a lucrative way to invest in real estate if it’s done the right way.

5. Shop for a mortgage

Getting preapproved for a mortgage is helpful when you make an offer on a house, and it gives you a firmer handle on how much you can afford.

How to get started: Shop around with at least three lenders or a mortgage broker to increase your chances of getting a low interest rate.

Key takeaways:

Sign up for a Bankrate account to determine the right time to strike on your mortgage with our daily rate trends.

When Should You Start Investing in Real Estate?

There’s a lot of hype around investing right now. With inflation rising and stocks and cryptocurrency going crazy, many people feel like real estate is a safer bet. (There’s something reassuring about the fact that you can actually touch a piece of property, right?)

New real estate investing companies are letting people buy partial ownership of an investment property—and then make part of the profit. That sounds great, but it’s important to keep a few things in mind.

First, always do your homework on any company before investing in it—and make sure they’re not just going to tie up your investments in debt. (Ugh, no thank you!) Besides, there’s a lot of corporate hoopla to deal with if you use a real estate investing company. But when youpay cash for your own investment property, you get to call the shots and make the money.

Also, just because the trendy economic nerds say it’s the right time to invest, that doesn’t mean it’s actually the right time to invest. You should start investing in real estate only when your personal finances are in order.

If you’re familiar with what we teach at Ramsey, you may be wondering where investing in real estate fits into the 7 Baby Steps or your overall wealth-building plan. We like the way you’re thinking!

You should invest in real estate only after you’ve already paid off your own home (so, after Baby Step 6). That means you’re completely debt-free with an emergency fund of three to six months of expenses saved. You should also already be investing at least 15% of your income into retirement accounts, like a workplace 401(k) or Roth IRA.

And remember: Don’t buy an investment property until you can pay 100% down.

Why Pay Off Your Own Home First?

We get it—waiting until you’ve paid off your house probably sounds like it’ll take a really long time, especially if you feel like opportunity is knocking at your door right now. But trust us on this. It’s worth it to wait until you’re really ready.

Let’s take Greg as an example. He owes $150,000 on his own house. Since he has a 15-year fixed-rate mortgage at 2.5% interest, that means he pays $1,360 a month on his mortgage, including taxes, homeowners insurance and such.

Greg brings home $5,500 per month—so his mortgage payment is a little less than 25% of his monthly take-home pay. Way to go, Greg!

He wants to make faster progress on his financial goals, and he thinks having rental income will help. So he decides to finance a rental property.

Greg finds a great rental house for sale for $150,000. He uses the $30,000 he has in savings for a down payment. Then he takes out a 15-year fixed-rate mortgage at 3% interest for the other $120,000 (uh-oh). That adds a second mortgage payment of $1,120 to his monthly budget.

But he isn’t worried, because he plans to rent out the house for $1,500 per month. That’ll cover the mortgage on the rental and put a little extra cash in his pocket. Greg thinks it’s a great plan. (Spoiler alert: Greg is wrong.)

What Greg doesn’t know is that it will take three months to find renters, which means he’ll pay $3,360 in mortgage payments on his new rental while it sits empty. For those three months, paying the mortgage on his own place and his rental will take up 45% of his income!

And all that time, Greg’s going to feel like he can barely breathe. What will he do if the air conditioning unit goes out or the dishwasher starts leaking? What if his kid gets sick? What if he loses his job?

Don’t be like Greg. Don’t rush it. Real estate can be a fantastic investment—if you do it the right way. So be smart. Pay off your own house, invest in your retirement accounts, and save, save, save so you can pay in full for your investment properties. When you’ve done all those things, then it’s the right time to invest in real estate.

Getting Started

While there are many variables to consider when purchasing your first investment property, you should start by doing your research. Look at housing prices and neighborhoods and begin saving for a down payment. And when you’re ready to dive head first into the real estate game, you can start by getting preapproved for a mortgage.

5. Hire a qualified real estate agent with experience in investment properties

Unless you already have your real estate license, it’s in your best interest to hire a qualified real estate agent who has experience with buying investment houses. They can help fix-and-flip investors time their purchase and sale, put it on the market for the right price, and find the right buyers. Or alternately, they can help buy-and-hold investors pick the best property, find renters, and advise them on landlord-tenant law. However, a knowledgeable and experienced real estate agent can also help with many other invaluable things:

  • Helping you to understand your local housing market
  • Keeping you apprised of current market trends
  • Finding the best properties for investing
  • Helping you secure competent contractors
  • Utilizing legally appropriate lease language (for buy-and-hold investments)
  • Ensuring that you abide by Fair Housing laws

You’ll definitely want to find someone who will not only walk you through the various steps of the process but who will also act aggressively on your behalf.

Be sure to do your own research on any potential agents. You may want to check their reviews on places such as Google and Yelp and ask them for references, especially from other investors. Just remember that there is no substitute for hiring a local agent who not only understands the local market, but also has experience working in it.

Header Image Source: (Jens Mahnke / Pexels)

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