Real estate accounts for 60% of the world’s mainstream assets — and a significant portion of all national, corporate and personal wealth. With that in mind, real estate investing clearly deserves consideration from any individual or business looking for asset classes in which to invest a portion of their capital.
However, before you can make informed decisions about whether or not to invest in real estate, and which of the many types of real estate might make the most sense for you, you first need to understand real estate investing basics.
Here we will provide you with a broad introduction to real estate investing, beginning by answering a question that few people and even some seasoned real estate investors cannot fully answer: What is real estate?
What is Real Estate?
When they hear the term real estate, many people think of land, or homes, or other types of buildings and structures. Those are components of real estate, but they are far from a complete definition.
Here is how the Uniform Standards of Professional Appraisal Practice (USPAP), the industry guidebook for real estate appraisers, defines real estate: “An identified parcel or tract of land, including improvements, if any.” That reference to improvements is key to your understanding of real estate, because it underscores the fact that real estate also includes anything fixed or permanently attached to the land — a far broader category than most people realize.
Improvements, as understood in the real estate context, can include a home, store, office building or other type of structure built on the land. But it can also refer to anything else permanently affixed to that property, including fences, roads, streams, trees and even the utility systems on the land. Finally, real estate can also include several rights inherent to a piece of property — such as air rights, water rights and the mineral rights to any natural resources in the ground under the land.
This is why USPAP also includes a definition in its guidebook for real property, which it explains is often used interchangeably with real estate. USPAP defines real property as “the interests, benefits, and rights inherent in the ownership of real estate.”
What is a Real Estate Investor?
With that all-inclusive definition of real estate in mind, we can now define a real estate investor as an individual (or business or other entity) investing in the real estate market by purchasing, leasing or otherwise acquiring rights to a piece of real estate or any of the rights inherent in a piece of real estate.
This is why we stated in the introduction that there are so many types of real estate investing. Investing in real estate often consists of those categories of investments that most people immediately think of when they hear the term — such as owning residential or commercial properties and renting those properties out, or purchasing such properties to quickly improve and resell for a profit.
But it can also refer to a myriad of other investment opportunities, including purchasing and then leasing the mineral rights to a parcel of land, or investing in a Real Estate Investment Trust. And today, real estate investing can even include participating directly in a large deal through a real estate crowdfunding platform.
What Are the Potential Benefits of Real Estate Investing?
Although no type of investment can offer a guarantee of a profit or even protection of the principal, historically real estate has been one of the safest asset classes for investors, while at the same time offering potential for gains.
Real estate investing offers several possible benefits generally not associated with other types of investments. Here are just a few of those benefits:
Leverage
One of the most powerful opportunities real estate investing offers is the ability for investors to leverage their capital several times over. In other words, real estate investors can use borrowed funds to invest in a piece of real estate they could not afford to purchase outright, but then realize all of the potential profit from ownership of that property. It is also important to point out, however, that with increased leverage comes increased risks.
Tax Advantages
Real estate can also provide several types of tax benefits. For example, the government treats real estate profits as capital gains, which are taxed lower than employment income. Additionally, the tax basis of your investment properties can decrease with time, because the tax code allows you to depreciate your real estate every year. Also, if you are generating cash flow from a rental property, you can potentially enjoy those profits free of self-employment taxation.
Increased Control Over Investments
Another aspect of real estate investing that some people find valuable is the increased control they enjoy over their investments. When you purchase stocks or mutual funds, you must then simply wait passively for those assets to increase in value. Unless you are a major shareholder in those companies, you will not have much say in their operations, which often means that there is essentially nothing you can do to directly improve the value of your investments.
When you invest in real estate, however, you can enjoy some control over almost every variable — acquiring knowledge or negotiating skills to secure a better deal on the purchase, improving the property, finding creative ways to generate additional revenue (adding laundry machines to your apartment complex, for example), etc.
Real Estate Investing Risks
Of course, no discussion of real estate investing would be complete without also discussing the risks involved. As with any investment, real estate carries the risk of loss. In the case of investing actively in real estate, such as buying a residential property to rent out, you carry the ongoing risk of vacancies, which will lead to a lack of income on that property, as well as a downturn in the real estate market, which can reduce your equity in the investment.
There are also risks involved in passive real estate investments — such as owning stock in real estate-related businesses, owning shares in Real Estate Investment Trusts (REITs), or investing in deals through real estate crowdfunding platforms, all of which we will discuss further in a future post. In the case of these investments, the value of these assets might decrease over time.
For these reasons, both active and passive real estate investments will require you to do your own due diligence and research beforehand, just as you would do with any other type of investment.
Check back for our next article where we’ll dive more into real estate investing companies and what they do.
