Real Estate Investment Opportunities for the Long Term

Source: Flickr user Mark Moz.

There are many ways for people to invest in real estate, such as fixing and flipping properties and building houses to spec and selling them at a profit. However, from a long-term perspective, the best ways to invest in real estate are buying rental properties and investing in real estate investment trusts. Both can be excellent ways to build wealth, and both have their pros and cons.

Here’s a rundown of these two approaches to investing in real estate and how to determine which is right for you.

Buying properties puts you in control — but it can bring headaches
The most obvious method of investing in real estate for the long term is simply buying a property, renting it out, and holding it for the long run.

Source: Flickr user Mark Moz.

This method has many benefits. First, it puts you in control of your investment. You decide how much you pay for the property, the rent you charge, and the tenants you allow to live there.

This method can also be rather lucrative, at least on paper. As a simplified example, let’s say you spend $100,000 to buy a house that you can rent for roughly $1,000 per month. A good rule of thumb is to estimate the rent potential at 1% of the property’s value — not a perfect estimate but a decent starting point. Furthermore, we’ll say you put 25% down on the home ($25,000) and obtain a 30-year mortgage at 4.25% interest. To keep our numbers simple, let’s say the sellers paid the closing costs as part of the deal.

So your property is bringing in $1,000 per month. Let’s look at your cash flow, bearing in mind these costs might be higher or lower depending on the property and its location:

Expense Monthly Amount
Rent collected +$1,000
Mortgage (principal + interest) -$369
Property taxes -$83
Insurance -$50
Vacancy reserve -$100
Maintenance reserve -$50
Total $348

Note: Assumes property taxes are 1% of the property value per year, and 10% and 5% of the rent is put into reserves for vacancy and maintenance expenses, respectively.

Your theoretical cash flow from the property is $348 per month, or a 16.7% annualized rate of return based on your original $25,000 investment. You’re also building equity in the house: During the first year, you’ll pay off $1,265 of the outstanding mortgage balance. Further, home prices tend to appreciate over time; to be conservative, we’ll assume average annual growth of 2%, or $2,000 in the first year.

In all, this adds up to a total one-year return of $7,441, or 29.8% on your original $25,000 investment. Sounds pretty good, right?

However, no investment that could return nearly 30% per year comes without risk. For starters, there is the risk that the property will sit vacant for several months at a time, earning a negative return (you still have to pay the bills). You could also be forced to evict a tenant, which is neither easy nor free. Or you could run into some expensive unexpected maintenance problems, such as replacing the house’s HVAC unit. In reality, you’re unlikely to achieve an idealized return like this on a consistent basis.

On top of that, owning and managing rental properties involves a substantial time commitment. If you don’t want to worry about the day-to-day operations or finding tenants, prepare to pay about 10% of the rent to a property management company.