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الأربعاء، 5 فبراير 2020

How to Invest in Real Estate to Achieve FIRE

The goal of the FIRE movement is to obtain financial independence through smarter spending, saving and investing more money than is typically recommended. The eventual goal of FIRE practitioners is to retire early — hence the acronym FIRE, which stands for Financial Independence, Retire Early. According to FIRE enthusiasts, it’s “complete freedom to be the best, most powerful, energetic, happiest and most generous version of you that you can possibly be.”

People who practice FIRE tend to save or invest 50% to 75% of their income. They live frugally in the meantime and avoid taking on unnecessary debt or making large unnecessary purchases. The FIRE movement has especially influenced the saving habits of younger generations. Those between 18 and 37 years of age save nearly 16% more of their annual income for retirement when compared to older generations.

One popular investment for achieving FIRE is real estate. In most cases, it means buying rental properties, then collecting rent from tenants to boost one’s income. But being a successful real estate investor — with the goal of becoming financially independent and retiring early — requires education and planning. There’s much more to practicing FIRE, though, especially when it comes to real estate.

Everyone who practices FIRE does so in a different context. Some have children while others do not, and some have high-paying jobs while others make a middle-class income, but there are a few basics to FIRE that are necessary to retire early.

First, you must start planning for retirement as soon as you can, ideally the moment you reach adulthood. You must keep your regular expenses as low as possible by avoiding debt and you must look for ways to increase your income. If you do have high-interest debt such as a student loan debt, you should pay it off as quickly as possible to avoid suffering unnecessary losses from interest.

You must also make saving and investing your biggest priorities. The younger you are the more aggressive your portfolio can be, but you should also diversify. This means putting money away in tax-advantaged retirement accounts, but it also means making investments in other important areas — like real estate.

The pros and cons of investing in real estate

If you’re investing in rental real estate to achieve FIRE, you need to know how to leverage properties to improve your cash-on-cash investments each year. If you want to make money through rental income, it also means you need to know how to be a landlord. There are a ton of pros and cons for investing in real estate for FIRE, including:

The pros of investing in real estate

1. Quick way to fast FIRE

You have the potential to achieve FIRE faster by investing in real estate than if you invest in retirement accounts or other stock market products alone. You’ll need an initial down payment if you want to buy property, but you can finance the rest with other people’s money — money provided by real estate investors who have the cash on hand to make the investment but don’t have the time to manage it.

This will provide you with a steady return of rental income, which you can use to supplement your existing income and put more away for retirement. If you need to, you can use traditional mortgages to finance your property purchases, but you’ll need to calculate whether your monthly income will be worth the monthly payments you’ll need to take on that debt.

2. Less volatile than the stock market

When you retire and begin withdrawing from your retirement investments, you’ll still be beholden to market forces. If the market crashes as soon as you start to cash out, you could be the victim of “sequence of returns” risk, and because you’re no longer contributing to your retirement, you run the risk of your portfolio diminishing faster due to your withdrawals.

On the other hand, the income you receive from rental properties is ongoing. If you maintain them and keep the properties occupied, they’ll keep generating income for you well into your retirement. Investing in real estate is much less volatile than investing in the stock market.

3. Adjusted returns 

When you put money into an investment fund, you must adjust for inflation when predicting your returns, but rental prices rise alongside inflation and as the cost of business goes up. As a landlord, you can raise the rent after each leasing agreement is complete, usually once a year.

The cons of investing in real estate

1. They’re expensive

Even if you finance the bulk of your real estate investment with other people’s money, investing in real estate still comes with a high upfront cost. Buying property means shelling out thousands of dollars and then spending additional cash on closing fees, insurance, maintenance and repairs. If you don’t have the money on hand, it could take years to save it.

It’s also important to factor in that you may end up with vacant houses during some points in your real estate investing. Markets fluctuate and rentals can sit empty for months, or even years, if you aren’t careful about where you buy. It’s also crucial to think about what it will cost to invest in a property manager to take care of the day to day needs with your properties and handle things like broken appliances or damages done by renters.

If the real estate market crashes, it could be an even bigger hit to your finances, as you’ll have to keep paying on the home while it loses value or risk selling it at a loss. Real estate markets fluctuate constantly, and it can be a big risk if you aren’t careful.

It’s also important to consider diversification. If you invest a significant portion of your savings in real estate, that investment is tied to a small handful of physical assets or a single physical asset. Physical assets are susceptible to depreciation through forces other than the market. If you can’t keep tenants, you won’t earn rental income, either.

2. Lots of work 

Investing other people’s money in real estate requires you to take on the bulk of the work involved with managing the properties. If you’re investing in rental properties and collecting rent, that means acting as a landlord, and being a landlord is an entire profession in and of itself.

Landlords must ensure their properties are safe, clean and livable. You may also be responsible for taxes and utilities. If tenants don’t pay the rent, you’ll need to ensure they know they are overdue. In a worst case scenario, you may need to evict tenants who don’t or can’t pay, which costs time, money and also involves the legal system.

3. Very little liquidity

When you invest in the market, you can sell stocks when you need cash, but that isn’t possible with real estate, as selling a single property can take months, or even years in some cases. Real estate is a good long-term investment, but it’s not the best choice if you think you’re going to need that cash back in the near future.

How to invest in real estate

You don’t necessarily need to take the landlord route to invest in real estate. There are many ways to do it. Your first step should be to decide which type of real estate investment is best for you.

1. Decide what kind of real estate you want

Owning rental property 

If you’re confident you can act as a good landlord and keep tenants, this is perhaps the safest and most predictable way to earn income through real estate. You’ll know exactly how much you’ll make each month and you can factor that into your FIRE plan.

House flipping

If you’re particularly handy, or if you’ve partnered with someone who does home improvement work, you could also consider house flipping. This typically requires much more sweat equity, but the payout could be substantial if you know what you’re doing.

House flipping involves buying a property when its price is low, then selling it quickly to turn a profit. Investors often focus on foreclosed properties and short sales to do this, but house flipping does come with risks.

For one, a foreclosure may not be livable, which means you’ll have to invest more money into it if you want to turn a profit. Making these types of repairs and improvements is also a lot of work and you can run into trouble if you don’t have the time or experience to handle it.

Real estate investment trusts (REITs)

You could also consider putting money into a real estate investment trust (REIT). These are investment equities run by companies who own and operate real estate properties. These investments tend to produce high dividends but they also come with risks.

REITs are traded on the market, so they have market risk just like any other stock. They are directly affected by the real estate market as well. They tend to have good long-term returns, but they might underperform in the short term.

In most cases, diversifying your investments is key. This could mean investing in one type of real estate in addition to a traditional portfolio of stocks and bonds, or you could try all the above.

2. Choose a good property

Choosing which property to invest in is one of the biggest challenges of being a real estate investor, but there are a few things you can keep in mind that will help you avoid the most common mistakes.

Location, location, location

First, you should only invest in an area that is growing. While it may be tempting to buy up properties on the cheap in places that are struggling, keep in mind that you need people to live in your properties if you want to make any income. Growing areas will have more demand for housing, which means you may be able to charge higher rental prices as well.

You should also start with locations you either already know or have researched thoroughly. Work to understand an area’s vacancy rates and demographics before putting any money down. Investing in a brand new building filled with high-end condos might sound nice, but it won’t make you much money if the people living in the area can’t afford to live there.

Choosing a property within budget

Unless you have an electrician or plumbing license in your back pocket, try to avoid the worst “fixer-upper” properties. It might be a good investment if the walls just need a new paint job, but if the core of the property is compromised, you could lose thousands of dollars trying to make the location livable.

Finally, you should calculate your returns, including your cash-on-cash return rate, before putting any money down. You should be able to project well into the future to determine how your real estate investment fits with your budget and your FIRE objectives.

3. Prepare your finances

Most people have to get their finances in order if they intend to buy a house to live in. Investing in real estate is no different.

Have a good credit score

You’ll need a strong credit score if you intend to get a mortgage or rental property loan with a low interest rate, and you’ll need a low interest rate if you intend to profit off your property investment. By most standards, a score of 700 or more is considered “good.” In order to get the best rates, you should try to achieve an “excellent” credit score of 720 or more.

This can be challenging if you’re still young and you haven’t built up that much credit, as the length of your credit history affects your score. The length of your history is an average of the lengths of your debts, so don’t take out any new debts while you’re trying to improve your score.

Assemble your documents

You’ll also need certain documents to acquire a mortgage:

  • Recent pay stubs (W-2s)
  • Two years’ worth of tax returns
  • Property tax documentation
  • Proof of property insurance
  • Existing mortgage statements
  • Statements from your bank and from your investment and retirement accounts

You’ll also need documents associated with your purchase:

  • A purchase agreement
  • Proof of funds for the purchase
  • Statement of current property taxes

Even if you intend to use other people’s money to finance your purchase, a good credit score and clear documentation will be important for convincing investors you’re a good bet.

Make sure you have savings

You’re going to need to front some cash for your real estate investments, whether that’s on the front end or when repairs and updates come up. Make sure you have an adequate amount stashed away to pay for any unexpected expenses and closing costs on your properties, as well as anything else that may arise, like gaps between tenants.

Finance your investment

There are a few ways to acquire the financing you need to invest in real estate.

Investor capital

One of the most attractive ways is to use investor capital, also known as other people’s money or (OPM). Of course, this isn’t always an option, and succeeding with it often comes down to having the right people in your network.

Traditional loan options

If you don’t have a ton of cash on hand, you can also use traditional loan options like mortgages to fund your real estate purchases. With an investment property, the lender may require more than the standard 20% down payment, however. Banks typically prefer to provide mortgages to people who intend to live in the homes they buy, not to investors.

You’ll also need to rely on your personal financial history to secure a mortgage.

Fix-and-flip or hard money loan

Another option is to get what’s often referred to as a “fix-and-flip loan” or a “hard money loan.” These loans typically have terms of just one year. The money you can get is based on the lender’s determination of how much the property will be worth after you fix it up.

The downside to this route is that these loans are not cheap and you only have a short time to pay them back. They come with high interest rates and the fees associated with obtaining one can eat away at your returns.

HELOC or cash-out refinance loan

You could tap into your own home as a source of equity through a home equity line of credit (HELOC) or cash-out refinance loan. These are risky loans for any borrower, though, as you’re putting up your own home as a source of collateral.

A HELOC will come with a variable interest rate, but you could capitalize on it if you only have to make payments on interest before you’re ready to pay it back. With a cash-out loan, you’d get a fixed interest rate, but it could extend the life of your existing mortgage.

From a FIRE perspective, taking on additional high-interest debt is almost always a risk to your goals. If you’re stuck with high monthly costs, you’ll have a hard time setting money aside for retirement. You’ll need to do the calculations beforehand to determine if these types of loans are worth it for you.

Common mistakes when investing in real estate

Real estate investment can be a great avenue for achieving your FIRE goals, but it involves risk, just like any other investment. It’s important to avoid some of the common traps real estate investors fall into, including:

1. Failing to get educated

You may be a guru when it comes to managing your personal finances, but managing real estate investments is a different animal altogether. Learn as much as you can before deciding to invest in real estate, especially if you want to make it a part of your FIRE strategy.

2. Failing to plan beforehand

A plan-as-you-go strategy never works in real estate investing. There are just too many variables to consider with a physical asset, and if you don’t calculate your expenses, returns and interest beforehand, you could find yourself with real estate assets that are costing you money rather than making you money.

It’s important to find a property that fits your plan, not force your plan to fit a property. You should also have contingencies in place in case something goes wrong. After all, while the rental market can affect the profitability of your real estate assets, so can hurricanes.

3. Paying too much for a property

“Buy low and sell high” is one cliché that almost always applies to real estate investments. Once you purchase a property, you’ve already sealed in how much profit you can make from it. Search for bargain properties that fit your plan, but focus on those properties that won’t require too much investment to get up and running as well.

4. Miscalculating maintenance costs

Investing in a physical asset like a property always involves costs for maintenance and upkeep, especially if you’re investing in a rental property. If you fail to fix the problems from general wear and tear while people are living in your property, they could turn into expensive problems down the road.

You’ll need to have enough cash flow to cover repairs and keep your property livable during an emergency, such as a natural disaster, a burst pipe or a long-term power outage.

Advice from one FIRE enthusiast to another

It can be tricky to figure out how to make the FIRE movement work for your specific needs, especially when it comes to real estate investing, as every market is different and requires a unique approach from investors. Still, even with the potential investing difficulties, the young investors who have found success with the FIRE method swear by it and have plenty of advice for young would-be FIRE enthusiasts.

“For young investors that are a part of the FIRE movement, my best piece of advice is to invest aggressively. The fastest and most profitable way to invest in real estate is to leverage the properties as much as you can,” Kevin Vandenboss, Broker at Vandenboss Commercial, said. “In most cases, you will get a higher return on your cash by spreading it out among several properties than it will by owning a single piece of real estate free and clear. The cash flow per property will be less, but the cash flow from four with a mortgage will be more than from one property without one. As you build equity in your investment properties you can either leverage the equity to buy more or use a 1031 exchange to trade up to a larger investment. It’s a game of monopoly. You have to stack up properties if you want to win.”

Caleb Liu, owner of HouseSimplySold.com, said you should “get educated in real estate first. You’re buying a house, not a share of Tesla stock. Mistakes hurt. Real estate, as great as it is, is generally not ‘retire early.’ There’s one exception: the young hustlers who put in eighty to one hundred hours looking everywhere to find great deals. Never buy based on quoted returns. Everything looks great on paper. But there are some shady people in real estate.”

Jared Hauf, a FIRE blogger for 30sum.com, said investors do their homework beforehand.

“Run your numbers multiple times and then run them some more. You can wipe out a lot of progress by purchasing the wrong property. If it doesn’t meet your exact goals, walk away,” Hauf said. “There are always more opportunities; picking the wrong one can sink your ship. To best achieve FIRE using real estate, the investor needs to have a firm understanding of what they’re trying to achieve. It’s easy to say we want to achieve making more money, but you must understand how, and have a plan in place to deal with all aspects of the business.”

Brian Davis, Director of Education at SparkRental, also has some very specific suggestions for FIRE real estate investors.

“My best advice for new real estate investors pursuing FIRE is to focus on just three fundamentals before anything else because there are so many micro-skills and moving parts involved in real estate investing…,” Davis said.

“First, focus on learning how to find good deals. As an investor said to me once, ‘There’s no deal tree that you can walk up to and pluck deals from; you need to learn how to go out and find them.’

“Second, learn how to accurately forecast rental cash flow. Financial independence requires income, so generally FIRE-oriented real estate investing means rental investing. Get very familiar with forecasting expenses, in particular, and get comfortable with running the numbers in a rental cash flow calculator. The last place you want to find yourself is buying a property that costs you money each year, rather than earning you money.

“Finally, learn how to screen tenants thoroughly. It sounds simple, and it is, yet so many new landlords gloss over this step. The quality of your returns directly correlates with the quality of your tenants, and bad tenants can cost you tens of thousands of dollars.”

The bottom line

FIRE is achievable even on a middling income if you make the right financial moves, according to practitioners and enthusiasts. If you intend to invest in real estate to achieve FIRE, you’ll need to avoid all of the most common pitfalls in the business and choose investments that will provide you with the best opportunity for steady income.

The post How to Invest in Real Estate to Achieve FIRE appeared first on The Simple Dollar.



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