TL;DR: There are a ton of ways to invest in real estate. I recommend focusing on equity investment in private deals targeting residential real estate with a focus on yield. You can do this through the direct purchase of single family homes, or through investment in syndicates. Both strategies are relatively passive and offer great returns.
There are an infinite number of ways you can invest in real estate. The categories below list the major dimensions you will want to consider:
- Publicly traded or privately held?
- Debt or equity?
- What type of real estate? Residential? Commercial? Retail?
- What type of return? Yield? Appreciation? Both?
- How will you make that return? Buy and hold? Value add?
I’ll go through each of these categories in more detail below, but if you want to cut to the chase, for the average investor looking to get into real estate, I recommend two strategies – both focus on non-public, equity investments in residential property with a primary focus on capital preservation and cash yields:
- Direct equity investment in single family rentals focused on yield with a buy and hold strategy. It’s straightforward to find investments in this category that yield 10%+ cash on cash, plus ~3-4% principal pay down, resulting in close to 15% returns
- Syndicate investment in residential properties focused on a mix of yield and appreciation through a value-add strategy. Typical deals will yield 8-10%, with expectations of 15-25% annualized returns over the life of the deal
The other strategies I consider are laid out below – all focused on residential because that’s what I understand best. They differ on a few dimension: the minimum check size, expected returns, level of control you have, and the effort and experience required. Those are all important considerations as you figure out what investment strategy is best suited to your situation.
From my experience, these strategies will offer the greatest potential returns for those looking to passively invest in (not manage!) real estate. The only drawback of syndicates is that they often (not always) require you to be an accredited investor. Direct investment in single family rentals have no such requirements, making it an option almost anyone can pursue, assuming they have the money. If you’re interested in learning more about any of these strategies, drop me a line at email@example.com and we can talk about how to get started.
Publicly traded or privately held?
Recommendation: Invest in private real estate deals for higher returns, tax advantages , and greater transparency and control
Personally, I focus exclusively on private real estate investments. Mainly because I’m interested in the higher returns, more favorable tax treatment, and greater control offered through private deals. But, if you need the liquidity, or you’re too lazy to put in a little effort for a greater return, public REITs can get you the real estate exposure you’re looking for.
Publicly traded real estate…
…is almost always held in the form of a Real Estate Investment Trust (REIT) and traded on the major public stock exchanges. The advantages of this are that it’s an almost completely passive way to invest, with a high degree of liquidity. With a publicly traded REIT you can cash out in minutes with minimal transaction fees.
REITs can pursue almost any real estate strategy, so if you want a certain type of exposure, chances are you can find it as a publicly traded REIT in some form or another. REIT distributions are generally treated as ordinary income and will be taxed at your top marginal tax rate.
Privately held real estate…
…can come in a number of forms:
- 100% direct ownership (either in your name or through a wholly owned LLC)
- Shared partial ownership (usually through an LLC or Tenancy-in-common)
- Limited Partner (LP) ownership through a syndicate or fund LLC
- Private REITs
Much like public REITs, privately held properties can span the entire range of real estate investment options. Also, like REITs, income from private real estate investments will most likely be passed through to the respective owners and taxed as ordinary income at the top marginal tax rate.
The big difference with private investments are that they often offer higher returns, more favorable tax treatment, and greater control. The downside is they require more effort, and are highly illiquid investments.
So… what’s better, public or private investment?
Like most things it depends what you’re looking for:
- Ease of access / cost to buy and sell / liquidity – Public REITs are super easy to access, as they’re traded on the world’s largest public markets. The cost to buy or sell is as low as your brokerage will allow, which could be free if you work with a company like Robinhood. If you want to sell, it can be done in minutes, getting you your cash almost instantly. Public REITs are highly liquid. Conversely, private real estate investments take time to identify and close, and often incur material transaction costs from the various advisors involved. If you want to sell, it could take months before you see your cash. Private real estate is highly illiquid. Advantage: Public Investments
- Diversification – If you want diversification, public REITs will probably get you there faster. Because you can buy as many or as few shares as you want, or even a REIT ETF, you can quickly get broad real estate exposure. That said, investing through syndicates is another way to get broad exposure to different asset classes and markets if you’re looking to diversify. Advantage: Public Investments
- Degree of investor involvement – Public REITs are completely hands off. Buy the shares and sit back for the ride. This is also generally true of private investments as well, unless you’re buying property directly, at which point you’ll have a lot more interaction with the management of that property (even with property management in place). Advantage: Public Investments
- Liability / risk to investor – As an owner of a public REIT, your risk exposure is limited to the amount you spend on the shares. In certain private real estate deals, if your name is on the deal directly, or if you’re the one managing the property, you could be personally liable for lawsuits associated with the property and its management. Advantage: Public Investments
- Transparency of investment activities – While public REITs have lengthy disclosure documents and financial results mandated by the SEC, they also often have larger pools of funds and broader investment mandates. The result is that when you buy a public REIT you likely don’t have a great idea of which properties they are actually investing in. With private deals where you buy direct or invest alongside a syndicate, you will know exactly which property is being purchased, and what the investment plan is. This is a huge advantage for someone who values transparency and control. Advantage: Private Investments
- Expected returns – From my experience, public REITs generally offer lower returns when compared to comparable private investments (see the Vanguard REIT VNQ on the chart below). It seems investors will pay more for an asset once it is bundled up into a public REIT structure. This difference in price is likely be attributable to the fact that public REITs are available to a broad swath of the population who then compete up the price. Another reason might be that there is a liquidity premium paid for owning a public REIT – i.e. people are willing to pay a little more for the liquidity and flexibility it provides. If you don’t need that liquidity or flexibility, then you don’t need to pay that ‘premium’. For this reason, I think there are better returns investing in private deals. Advantage: Private Investments
- Tax implications – In addition to higher returns, private investments also offer potentially more compelling tax benefits. When you invest privately you can roll your investments from one deal to another thereby avoiding capital gains and depreciation recapture. When you pass away, your heirs will get a step up in basis thereby locking in capital gains and depreciation recapture for free. Arguably a REIT can take advantage of similar benefits within the REIT ownership structure, but once you sell shares of a REIT it is treated as a sale of stock. You can’t roll that money into another REIT and defer capital gains. Advantage: Private Investments
- Control – With private investments you have a lot more influence and control over how the assets are managed. You can invest to force appreciation on the property. You can decide if you want to refinance. Most importantly, you can make sure you never become a forced seller. With a public REIT you’re at the mercy of someone else’s management decisions, which might not be aligned with your interests all the time. Advantage: Private Investments
- Correlation with stocks – Lastly, because public REITs basically look like stocks, they tend to behave like them as well from a price perspective. This means they go up and down with the stock market. Private real estate tends not to be correlated with the stock market as closely, so it can be a good balance to your portfolio. See the table below from the Oaktree Overview of Investment Real Estate that highlights the negative correlation between NCREIF (proxy for private real estate) and the S&P 500. Conversely, the MSCI US REIT (RMZ) is a good public REIT proxy. Advantage: Private Investments
In summary, public REITs are a good option for lazy investors who want a completely passive, diversified way of accessing real estate returns. If you want the opportunity to generate outsized after-tax returns, with greater control and transparency, you’ll want to consider private real estate investments. From my experience, it only takes a little extra effort to access the right private investment opportunities that will secure your financial future, and help you reach Ramen Retirement sooner.
For a little more insight into the public vs. private tradeoffs, I thought it worth including Oaktree’s overview below. I find their characterization of things, while correct, a little unsatisfying as it speaks largely in generalities.
Debt or equity?
Recommendation: Invest in real estate equity for higher returns, tax advantages and inflation protection
Do you want an equity or debt position? My personal opinion is that for individual investors, investing in debt is a mistake. The only people who might benefit from investing in debt are people later in life who need the high certainty of return because they haven’t built up a large enough stream of equity driven cash flows to comfortably cover their lifestyle. If you follow the guide to Ramen Retirement, it’s my hope that you’ll be retiring long before your old age, and build up enough of a nest egg that holding debt isn’t something you need to consider.
The difference between investing in debt vs. equity is as follows:
- Risk of capital loss – Debt will have lower risk of capital loss. The equity holders will need to be wiped out before debt holders see a loss. Advantage: Debt
- Certainty of nominal cash flow – In the same way that equity is the first to take a capital loss, they are also the last to get paid. Debt holders will get paid from property cash flows first, so the interest being collected is more certain than that of equity holder profits. Advantage: Debt
- Time / effort invested – Debt is pretty passive. Make the loan and collect your checks. Equity investing requires a little more effort up front to vet the deal, and it may require more direct involvement during the life of the deal depending on whether you’re managing the asset yourself, hiring property managers, or investing through a passive vehicle like a syndicate. Advantage: Debt
- Potential returns – Returns on debt will be lower than equity. Residential loans for single family and multifamily can generate returns in the 4-10% range depending on the type of asset loaned against, type of loan (long term vs. short term), and the seniority level of the debt. Equity returns can vary dramatically, but you should expect to be rewarded with higher returns in exchange for the added risks outlined above. In 2018, I won’t consider equity deals that have less than a 15% expected annualized return over the life of the deal… and that’s on the low end. Advantage: Equity
- Risk of purchasing power erosion (i.e. inflation) – While debt has a lower risk of capital loss, it has a much higher risk of purchasing power erosion (otherwise known as inflation). Holding debt has no protection against inflation. While we’ve lived in a super low inflation environment for the last decade (2008-2018), it could rear its head anytime. When it does, your bond starts to lose significant purchasing power, while your equity position will generally maintain its value, or even benefit. In the case of levered real estate investments, inflation helps you because your outstanding debt becomes a smaller share of the total property value. Advantage: Equity
- Tax implications – Lastly, debt does not offer any of the tax benefits of real estate. Interest earned from loans is taxed the same as regular income. So is the profit earned from real estate investments. The difference though is that you can depreciate the value of your property against your real estate earnings, which helps reduce your taxable profits. For a property leveraged at 70-75%, it’s likely you can report little to no profit in the early years of ownership, while still collecting significant cash flow from the investment. The kicker is that you can avoid paying back that depreciation write-off by ‘trading up’ to larger properties with a 1031 exchange. Eventually when you pass those assets to your heirs through your estate, they will get a step up in basis and it will wipe out the outstanding depreciation recapture. Effectively all those depreciation tax deferrals can become permanent tax savings! Advantage: Equity
So really, the tradeoff here is that debt offer lower risk of capital loss, higher certainty of cash flow, and less active involvement. Equity offers the potential for higher returns, inflation protection, and major tax benefits. I prefer the latter.
What type of real estate?
Recommendation: Focus on residential or commercial multifamily when you start, particularly if you’re investing directly. Exploring other asset classes is probably best done through a fund or syndicate partnership, or with a very strong mentor holding you hand
Real estate investments can include land or any type of building built on top of it. My best piece of advice when choosing an asset type goes back to rule #3 of my investment rules to live by:
The best way to ensure you never lose money is to invest in things you understand intuitively… The reason for this is obvious – things you really know well will be things that you can place a clear value on. This will let you buy well, and sell well.
For me, and I think most people starting out, this means focusing on residential real estate – property built to house people. You can start with single family homes, and work up from there to multifamily buildings.
That said, there is a whole universe of real estate options available, each with slightly different risk and return profiles. Below is an overview of the categories you might consider:
- Residential single family: Homes built to house a single family – typically at least 3 beds, 1 or 2 baths. You can finance these properties with conventional loans (30 year fixed rate). Price point and returns can vary dramatically based on the market / neighborhood and quality of the property. In good neighborhoods of tier 1 cities, it will be impossible to find a single family home that will generate positive cash flow on day one, though appreciation will likely be higher. Tier 2 / 3 cities throughout the midwest (Kansas City, Indianapolis), have a large inventory of properties that can generate 8-10%+ cash returns on day one, though with substantially lower expectations for appreciation. It’s worth noting that these returns all assume property management in place – this is not assuming any self-management, which I believe is a bad idea. Risk during a downturn is moderate, and really depends on whether the downturn means job losses and people leaving the region in search of work elsewhere. Otherwise, residential rental property can actually benefit from downturns as people defer home ownership and rent for longer.
- Residential multifamily: Any buildings with 2 to 4 units – duplex, triplex, fourplex. Anything with 4 or less units will still be considered ‘residential’ real estate, and will most often be sold through residential brokers / agents on the Multiple Listing Service (MLS). These properties can also be financed with ‘conventional’ mortgages (the same as single family homes), which means access to relatively cheap, long term financing. Considering that an individual is only able to hold 10 conventional mortgages in their name, it can be a good idea to consider these larger residential multifamily properties, instead of single family homes, because you can write a bigger check for each of those 10 conventional mortgage slots. Risk and return is very similar to single family rentals.
- Commercial multifamily: This includes 5 unit buildings all the way up to large 300+ unit apartment complexes. Once you get into 5+ unit buildings, conventional financing is no longer available. This means you need to borrow from commercial lenders, where rates will vary and the available length of fixed rate financing will typically be shorter. Returns will vary in a similar way to single family real estate mentioned above – tier 1 cities will be expensive. Tier 2 and 3 cities offer some compelling yields with lower appreciation. Investing through syndicates is a good way to get exposure to these types of assets – I am part of one syndicate that buys large (100+ unit) buildings in the midwest, typically generating 12%+ cash on cash returns in the first year, while repositioning the assets to increase their value upon exit, targeting 20%+ annualized returns. Risk during a downturn tends to be slightly lower than single family homes, because these properties tend to be slightly more affordable to rent, and the larger scale means any given vacancy is a smaller share of total expected revenue. Typically properties in the 5-20 unit range attract direct investors who are moving up from single family or smaller multifamily investments. 100+ unit buildings attract larger, more sophisticated investors – this is where you’ll see professional real estate developers buying properties and syndicating the deal. The 20-99 unit range attracts a mixed bag of investors. If you have good property management in place for a particular market, those types of properties can be compelling as they’re too large for most independent investors, and too small for most syndicators / institutional buyers.
- Mobile home communities (MHCs): With MHCs you typically own the land and the infrastructure (water, power, shared buildings / amenities etc.) that support the community. Your tenants own their own mobile homes and hook them up on a pad that they rent from you. I haven’t invested in MHCs myself (yet!) but would definitely consider it. Returns tend to be focused on yield (I’ve seen preferred cash returns in the 8%+ range, with annualized total returns targeting ~15%). Risk during a downturn is typically lower than other property types, because with a MHC your tenants own their mobile home and it’s expensive to uproot and move it somewhere else. Also, there really aren’t a ton of great options for them to go into cheaper housing. The next step lower on the rung is probably living out of their car. Lastly, there isn’t a lot of new MHC supply coming online, because most communities are opposed to new MHC development. In my opinion, this is the sort of thing you want to invest in through a fund or syndicate. You definitely don’t want to be managing a MHC yourself, and if you get a good syndicate General Partner, they will be able to force appreciation on the property by making the right investments to change up the tenant profile and increase occupancy.
- Self Storage: Most should be familiar with self storage facilities. Rent out space for people to put all the ‘stuff’ they own but don’t need. It’s a nice stable business. Returns are mostly focused on yield, and risk during a downturn is also probably lower than residential real estate. This is also an asset class I would probably only touch (for now) through a partnership or syndicate. I’ve seen returns advertised in the range of 8%+ cash yields, with ~15% total annualized returns. Similar to MHCs, but a slightly different asset and risk profile.
- Retail: Short story is you buy retail space – main street buildings, strip malls etc. and rent it out to retail tenants. It’s a slightly different beast because lease terms typically include some concessions to tenants for investing / changing up the space. Also, leases tend to be long term (10+ years), and businesses are generally pretty good tenants as long as they aren’t going out of business. Given the current environment for retail (see: Amazon), I would be very careful about investing in retail for now. Prime retail real estate in major urban centers will probably be fine, but the second tier suburban malls will likely continue to take a beating over the next decade as big box retailers continue to implode, leaving large buildings without anchor tenants.
- Office: I’ve never invested in office space, so can’t speak from experience. But this is also pretty straightforward. People work for companies. Most companies have those people come to the same place every day to do their work. Office real estate makes up the buildings where those people work. In a similar way to retail, concessions are made to tenants for building modifications, and lease terms are typically quite long. Of course, office space is not having the same troubles that retail is facing. This is probably a pretty good, stable, long term asset class, but requires a little more sophistication to manage the complexity of tenant negotiations, which is why it’s probably better to access this through a fund or syndicate.
- Industrial: Again, I don’t have direct experience in this space. Only thing I can say is that I don’t understand this segment very well, so I would generally stay well away from it. But people need buildings to manufacture things, for managing logistics and shipping of products etc. This would typically involve long term leases. Industrial might be the one category that is slightly dissociated from general economic and population trends – in some ways, industrial uses are better for areas that are less populated by people. But again, I’m no expert in this space, so do your own diligence if you’re going to dive in.
To summarize, here is a high level overview of what was just discussed:
With all of these property types, it’s important to remember that more than anything else, you want to be investing in an asset that will become increasingly valuable over time – or at the very least a property that will hold its value with inflation. With real estate, this generally happens when demand for that real estate goes up and supply is too slow or unable to respond adequately. This means you’ll want to look for the following characteristics (which I also cover in my real estate investing rules):
- People moving to an area – following jobs or other desirable characteristics
- Employers moving to, and hiring in, an area – driving population growth
- Properties priced below their current replacement cost
- Constraints to new supply growth (regulatory, geographic, environmental etc.)
Those drivers will affect all property types described above.
Research this yourself and figure out which property type fits your particular risk profile and comfort level. Above all, invest in something you know and understand, which for me starts with residential real estate.
What type of return are you targeting?
Recommendation: Focus on yield. Cash generating properties will put money in your pocket from day one and get you one step closer to Ramen Retirement. Buying for appreciation involves a greater level of risk, and is cash flow negative in the beginning
With real estate, you can break returns into yield and appreciation. Yield is cash in pocket today from the cash flows of the property. Appreciation is cash in pocket tomorrow from the eventual sale of the property.
Every real estate deal sits somewhere on this spectrum of yield and appreciation. If a property is selling for a price that let’s you generate cash flow from day one, it’s likely the expectation of future appreciation is relatively low. Conversely, if you buy a property that won’t cash flow on day one, then implicitly you’re betting that the performance and value of the property will appreciate either due to market driven factors, or forced appreciation.
Investing for yield
Investing for yield is making a bet on stability. You’re buying a property with the expectation that the current rent will at least remain stable. This will be true if people continue to want to live near your property, and if they’re able to pay the prevailing market rent. Moreover, you have to believe there won’t be an influx of cheaper supply that will come on the market. If those things are true, then the property should generate cash flow as expected.
For the purposes of reaching Ramen Retirement, I focus on yield. Generating 10%+ after-tax cash returns is pretty good for my purposes. I never expect appreciation when running the numbers on these types of properties. If I can underwrite a ~15% return from cash flow and principal pay down, I’m pretty happy with that. If there is any appreciation, it will be a pleasant surprise. All I hope to do is keep up with inflation.
To find these types of properties you need to look in 2nd or 3rd tier cities in the heartland. Look in the B class neighborhoods (skews towards working class), with good but not luxury finish. The idea here is that you’re buying a property that on day one will generate a good return. Don’t expect rental rates to go up dramatically, but make sure you’re buying in a stable neighborhood that would be insulated from economic shocks or downturns.
Investing for appreciation
Investing for appreciation is betting on a more prosperous future. Implicitly you’re betting that in 3, 5 or 10 years the performance and value of your property will increase in a material way. If this is true, you’ll eventually start generating yield from the property, and ultimately be able to sell that property to someone else, realizing a large capital gain in the process. This sort of bet should ultimately be predicated on the belief that more people will want to move to an area, they’ll be able to pay more for rental housing, and new supply can’t be built quickly enough to meet that new demand.
This is an equally valid way to invest, and if you pick the right market at the right time you can generate tremendous returns considering you have the power of leverage working in your favor. For example, investing in San Francisco real estate in 2013 would have generated a ~60% gain in property price by early 2018 – assuming you mortgaged the property with 75% debt, a 60% increase in property value results in a 240% return on the cash you put down. Compared with yields of 15% a year for 4 years, appreciation clearly outperforms in this case. But investing for appreciation won’t pay the bills today. It also requires a greater degree of speculation and uncertainty. If you’re interested in reaching Ramen Retirement, appreciation plays won’t help. These type of investments would be better made later on once you’ve covered your cost of living through various passive income streams.
To find these types of properties, you’ll want to look in the better parts of tier 1 cities – San Francisco, Seattle, New York, Boston. Rent will not usually cover all expenses and a mortgage, so if you take out a larger mortgage on the property, expect to be covering that shortfall for a number of years until rents increase enough to put you in the black.
How will you make that return?
Recommendation: Buy and hold is a good strategy if you are looking for a passive investment that will generate solid returns – this is best done with properties you own directly, because you have complete control over the decision to sell. Value add is a better strategy for active real estate investors, but it requires a lot more time and effort – if you have a full time job you’d like to keep, then value add opportunities are better for investments in syndicates where the General Partner can put in the work to unlock the added value
For every deal you consider you should have a plan that outlines what your goals are and how you intend to achieve them. This doesn’t need to be complicated, just have to answer a few key questions:
- How do you expect to make your return – what do you have to believe about the future?
- What (if anything) will you change about the property to meet those returns – improvements, additions, amenities? How do you expect that to impact property value?
- How long do you plan to hold the property?
- What will be your criteria for selling?
Generally speaking there are two strategies that fall out from this.
Buy and hold
With a buy and hold strategy, the goal is simply to hang onto the property collecting cash flows from it for the foreseeable future. In this case, the holding period would be some version of forever. There might not be any plan to dramatically change or improve the property – simply continuing to rent it out is a viable strategy. This makes buy and hold perfect for passive investors looking for low effort real estate investments. This is best done when you are investing directly in a property because you can control the decision of when to sell, and how to handle the corresponding tax implications.
The alternative is to pursue a ‘value add’ strategy. The idea here is you want to come into the deal with a clear plan to improve or enhance the value of the property. Typically, a property will have been neglected for a number of years, and current rents will be below markets rates. The opportunity is to make the right investments to improve the units and bring rents up to market rates. It requires investment and expertise to create this value and force appreciation in rent. Typical enhancements focus on:
- Cosmetic updates of rental units
- Adding amenities (covered parking, dog parks, BBQs, Rec Rooms)
- Rebranding the property and actively changing up the tenant mix
The goal is to make investments that will help increase rents most. Foundation repairs or other items that don’t impact the day-to-day tenant experience will not result in rent increases, and will not help with driving appreciation and property value.
The ultimate goal would be to sell the property after completion of the value add strategy, often 3-5 years down the road. This strategy works well for syndicated deals, because the General Partner is able to focus on the real estate deal 100%. It is their day job. Executing the value add strategy is what they do, and part of how they can generate outsized returns for themselves and their investors. It’s what makes investing in a syndicate compelling, because often they will be able to unlock value that an individual investor couldn’t or wouldn’t have the time to pursue themselves.
This is harder to do as a direct investor, unless you have the time and / or team to execute on the value add strategy.
Bringing it all together
As mentioned above, my strategy today focuses on residential investment through single family homes and syndicate investments. These are two great ways to get direct real estate exposure with a healthy emphasis on yield (key to Ramen Retirement). I have considered investments in larger multifamily properties and will likely go there in the future, though not in any rush at the moment.
We all have unique goals with our investments. Figure out what your goals are, and tailor your investment strategy to match it. Knowing what you’re looking for is the first step to finding it.
Enjoy the journey!