The Most Important Questions to Ask Before You Invest in Real Estate
For many investors, real estate is coveted, highly attractive — and uncomfortably unfamiliar.
Although it’s widely accepted that a strong real estate investment has the potential to generate considerable wealth, until recently relatively few investors had the chance to acquire first-hand experience with the asset class. And despite its many advantages, real estate can be a complex investment. With today’s wide availability of opportunities, it’s as important as ever to know how to approach all types of real estate investment methods — both active and passive, from rental properties to public REITs to Fundrise.
Shrewd investing starts with knowing how to ask the right questions. That’s where this article can help. No matter which method you plan to use to put your first dollar toward real estate, these are questions you should consider beforehand. By studying the points and potential pitfalls outlined here, you can learn some of the crucial ways to assess an investment before committing your hard-earned cash.
Questions to Ask Before Any Real Estate Investment
Let’s start with questions that every prospective real estate investor should think about, no matter what kind of investment model they’re considering.
Do you have the time and expertise to invest actively, or would it make more sense for you to invest passively?
There are major differences between active and passive real estate investing, and most investors will have a clear inclination for one over the other. However, if you’ve just started to think about real estate generally, you might not have figured out exactly where your preference lies. Once you do, you’ll likely identify which option best suits your situation — or you might recognize that one model is simply not feasible or economical for you. For example, love the idea of being a landlord? Look at active options. Alternatively, simply don’t have the time to deal with properties and tenants first-hand? Consider passive investments. Those decisions can have an immediate impact on the specific investment you pursue, and how much it costs for you to get started.
What’s your investment timeline? How important will liquidity be to you in the future?
Defining a timeline, or investment horizon, is crucial for any investment, though some kinds are particularly illiquid (which isn’t necessarily a bad thing!). That makes identifying a comfortable timeline even more important when it comes to real estate investing. Make sure you know if and when you’ll need liquidity and, if so, whether the investment can support your particular needs.
What are the potential tax benefits?
Both active and passive real estate investments can offer tax advantages, but the exact tax benefits available to investors depend on the investment.
For example, on the passive investing side, thanks to the Tax Cuts and Jobs Act, income earned from pass-through structures, such as REITs, can qualify for a 20% tax deduction.
On the active investing side, a 1031 Exchange offers investors a way to defer capital gains taxes on their initial investment indefinitely. While a 1031 Exchange doesn’t let an investor reduce their capital gains tax liability, it can offer a step-up in basis upon inheritance. This feature has made it a useful tool for estate planning for some active real estate investors.
Each set of tax advantages can help an investor achieve a different goal. That’s why it’s important to determine which tax advantages best help you meet your investment goals.
Read More: A New Tax Code is Now Law and Presents Opportunities For Real Estate Investing Nationwide
How will real estate affect your overall portfolio?
One of real estate’s most renowned benefits is its capability to diversify a portfolio. But not all diversification is equal. Make sure you understand exactly how the addition of a new investment will impact the overall risk and earning potential of your investment situation. For example, whether an investment is in the public or private market can play a huge role in its power to diversify.
Read More: Bringing Portfolio Theory into the Age of the Internet
What makes a particular real estate investment attractive to you? How would you define success?
“Money!” might seem like the obvious answer, but responses can differ as much as people themselves. For some, an adrenaline-pumping fix-and-flip is their first choice real estate scenario, while others want to stay as far away from hands-on work as possible. Knowing what matters most to you in an investment will help you determine a clear view of what success in this investment can look like. It will most likely involve a return goal, but will it include any other aspects, benefits. or responsibilities?
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Before You Invest in Real Estate: Active Investments, Doing It Yourself
Think you might be interested in taking out a mortgage and buying a rental condo in that buzzing new neighborhood across town? Have you seen a coworker fund their summer vacations with a dedicated AirBnB — and now you want to set up your own? In other words, are you ready to become a landlord?
These are the questions to consider before initiating an active real estate investment, on your own, where you’re personally responsible for decisions that will impact the success of the investment.
How much of a down payment and mortgage do you need to get started? How much additional capital will you need in the future?
This is the first and probably most obvious consideration for an active real estate investor. A traditional, active real estate investment involves buying a property directly — land, building, and all — either for rental or resale. For many investors, that’s an expensive prospect. Additionally, investing in real estate is rarely a static enterprise, consisting of simple buy-and-sell transactions. Often you need to do some value-add work in the form of renovations or repairs. And those additional tasks cost money beyond your initial investment. On top of those, you need to consider ongoing costs like property taxes, home insurance, and mortgage insurance. When analyzing the price of an investment, don’t forget to take into account soft costs along with hard costs.
Depending on your risk tolerance, liquidity needs, and desired return, should you choose a debt or equity investment?
This question illustrates how entering an investment on your own can occasionally require much more specialized knowledge. On one hand, deciding between debt and equity implies a considerably advanced level of investment that many people will never encounter directly. But on the other hand, if you consider the full gamut of real estate, there’s the chance you might face these distinctions, and understanding the pros and cons of each of these structures can be crucial for maximizing potential performance and minimizing risk. Making the right choice requires you to have comfortable command over each one and how they work together, such as how the “cap stack” works. Investing in real estate directly can offer obvious upsides — any return earned is yours and yours alone — but it also means you shoulder all responsibility to understand any nuances.
What asset type and strategy are right for you in your given market?
The most obvious real estate assets for direct investment are residential — houses or condos. But are there any other variables that might make another asset type a more promising option? Retail or office space? Maybe there’s been a new influx of young professionals, thanks to a change in local laws, and office buildings are increasing in value. But, with a change in real estate class, there’s also a change in expertise required. Assess the options and make sure your money is doing the most it can in any obvious circumstances.
How well do you understand the specific city where you’re planning to invest? What are the local opportunities and risks?
“Location, location, location” is a saying as accurate as it is cliché. A warehouse in Brooklyn might have an altogether different outlook from an identical structure in Akron. How can you expect the area you’re eyeing to develop? You need to make sure you account for as many location-specific variables as possible, ranging from natural disaster risks to noise pollution, all of which can make it difficult to secure tenants. For example, maybe the building next door is a school. That can have a major effect on how you’re able to develop and use the property. Be honest with the fidelity of your expertise — try to know what you don’t know and fill in the gaps.
How much time do you have available to devote to your real estate investment?
For some investors, time is a more scarce commodity than dollars. Likewise, some investment models inherently apply far more of a time strain than others. If your investment requires a landlord, can you spare the hours? If not, can you afford to hire a property manager? Unlike other investments, which require attention only trading hours, an investment property requires constant administration as long as you own the investment.
Before you Invest in Real Estate: Passive Investments, Through a Fund, Service, and/or Platform
Purchasing real estate directly might be the most widely-known way to invest in the asset class, but it’s far from the only method. Today, there’s a wealth of options for accessing the market, for investors of all kinds. With “hands-off,” passive investment methods, the acquisition and management of real estate is left to dedicated and experienced professionals. Public REITs and online platforms can considerably streamline the investment process. However, these models also come with their own list of crucial questions, equally important to review if you decide this is the approach that’s right for you.
Do you qualify?
Again, we recommend leading off with one of the most basic but relevant questions. Before spending too much time envisioning your future with a particular service, be sure to check and confirm which kinds of investors it admits. For example, some funds provided by famous private equity real estate companies, like Blackstone, have a history of only admitting investors that meet certain salary thresholds, while newer platforms, like Fundrise, allow anyone to invest.
What is the investment manager’s historical performance?
You should always remember that past performance doesn’t and can’t guarantee future results — but looking at a service’s track record is one way to develop an idea of the organization’s expertise and character. How has the manager that you’re considering fared in prior years? Have they shown responsible custodianship over investors’ funds in the past? Each of these factors can help you determine what your investment experience will be like with a particular service.
How will the service behave if the market enters a downturn?
Does an advisor give an indication of how they’ll behave if the market changes its behavior from how it looks right now? Successful, knowledgeable investors will cite the fact that the market is fundamentally unpredictable – which is absolutely true — but that doesn’t diminish the importance of preparation. Be sure you know that your advisor has a plan for the next financial crisis, no matter how likely it is to come around the corner today, tomorrow, or in five years.
Do the expenses and fees make sense?
A real estate investment has a number of built-in expenses, whether it’s done actively or passively. These are a simple, inescapable byproduct of the asset type itself: in order to generate dividends, for instance, a property requires a certain amount of ongoing costs. The bottom line is to make sure you understand a service’s fee structure and confirm that it makes sense, given the value that the investment manager is creating for you using your capital.
How well can you track and manage the investment through the service?
One of the big advantages of investing in real estate directly is that you never have any doubt what your money is up to or how to track it. On the other hand, when you invest using a service, you can only track those things into which the service gives you visibility. What does that access look like? Is the information easy to access and understand? Now that most services are online, there are expectations for dynamic reporting and easy management. Be sure you understand how you’ll interact with your investment after your capital is handed over to the investment manager.
Would a public market fund or private market fund better serve your portfolio?
One of the biggest reasons people turn to real estate is to improve their portfolios’ overall diversification. Often, something like public REITs will appear satisfactory, as they can expose you to up to a hundred distinct properties, seemingly providing broad diversification. In reality, however, the public trading of these funds can seriously compromise how well they diversify beyond other public market assets, like the stock market — a publicly traded fund will often correlate closely to other public investments in your portfolio. On the other hand, platforms that invest in private real estate can provide exposure to dozens of properties in the private market, which, in total, can represent significantly deeper diversification.
What’s next if you want to invest?
In many cases, nobody but you can answer these questions, based on your financial circumstances, your personal preferences, your experience, and the particular opportunities to which you have access. But don’t let an abundance of options intimidate you into not choosing anything at all — there’s a great chance that real estate can benefit your investment portfolio in many ways.
Depending on whether you decide to invest in real estate, and the investment model you think is best for you, you might find that Fundrise represents a truly revolutionary opportunity: accessible to everyone, investments of virtually any size, truly passive, and with minimal fees.