What is Real Estate Investing?
This one seems obvious: Real estate investing is when we buy real estate, hold it, or improve it, and sell it for a profit. End of article, right? Not so fast.
In our first article in the Loyal Homes Guide to Real Estate Investing, we discussed Real Estate Investing for Beginners, where we took a look at some of the mental roadblocks that stop us from becoming an investor. In other words, we tore down some of our previous notions about real estate investing as it related to ourselves. In this article we’re going to start build up new notions, that will act as the foundation of our future success.
The Definition of Real Estate Investing
According to Investopedia: “Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit. You can invest in endeavors, such as using money to start a business, or in assets, such as purchasing real estate in hopes of reselling it later at a higher price.”
Let’s dive deeper into that quote. A real estate investor will allocate money to purchase an asset (real estate) in the hopes of generating income or profit, that’s true. A highly successful real estate investor will take money and start a business, and that business is a real estate investment company.
What do I mean by that? I mean that to have sustainable success, you must think about your real estate investment as a business, and by doing so you’ll develop the mindset to make good business decisions over a long period of time. It starts by knowing your numbers and having proper financial statements. What is my revenue? What are my expenses? How can I get my expenses down? Could I make higher revenue by selling a current property and buying a different property?
What is Revenue in Real Estate Investing
Real estate investors earn revenue in one of two different ways: (1) They earn ongoing income through rent, leases, or fees; and/or (2) They earn income by buying a property and then selling it for a profit. It’s important to note that the two revenue streams may have different tax implications, and so you’ll want to discuss your real estate investment business’ strategy with your tax professional.
Rents are a consistent source of repeatable (usually monthly) revenue, while the positive gain earned on the sale of a property that has appreciated is generally one lump sum. The two revenue models have far reaching consequences on the cash flow of your businesses.
Return on Investment & Risk
Return on Investment (ROI) will be a financial calculation that will act as a Key Performance Indicator for your real estate investment business. ROI is a measure of the profitability of an investment used to compare it to other investment options.
Before we get into how to calculate and use ROI, I want to discuss risk, as the two are linked. The act of investing by its very nature carries risk. The biggest mistake new investors make is not truly accepting the fact that investment is risky. The biggest mistake all investors make is not properly, or correctly, analyzing the risk of a particular investment.
One of the fundamentally most important things I was ever taught in business school was the link between interest rates and risk. Traditionally we think of investments in terms of interest rates. A high interest rate is a “good investment”, while a low interest rate is a “bad investment”. This is simply not true. The correct way to look at interest rates is that a low interest rate represents a lower risk investment, while a high interest rate represents a higher risk investment.
This way of thinking carries over to our Return on Investment in real estate investing. If we hope to make very large profits, in relation to the original investment, it will mean taking a higher level of risk. For example, buying a duplex in a market will low vacancy rates, with the intent of collecting profit through rental income, is a relatively low risk investment, which should correspond to solid, but modest, profits. Buying a dilapidated house on a large lot, with the intention of rezoning and subdividing, is much higher risk, and should result in higher level of profits. However, because rezoning, subdividing and development is never a sure thing there is a correspondingly higher risk to the initial investment.
As I mentioned ROI will be a Key Performance Indicator for your real estate investment business. To calculate it the profit of the investment is divided by the original cost of the investment. The result is expressed as a percentage or ratio. By calculating ROI on all your investments, and updating the calculations regularly, you’ll be collecting information that will help you make better ongoing decisions.
Now that you understand what real estate investing is on a somewhat deeper level, your next step is to start applying this knowledge to begin developing a business plan. This business plan can start out simple, but it should analyze how you intend to make profit, what expenses you expect to incur, and most importantly include an honest risk assessment.
About the Author
Chris Fenton knows real estate investment. He has been an investor in real estate since 2001. He holds a Bachelor of Commerce from the University of Victoria in which he studied finance and investing. Chris is the owner and CEO of both Royal LePage Pacific Rim Realty – The Fenton Group, and Royal LePage Port Alberni – Pacific Rim Realty. As a top 1% real estate agent in Canada he has guided countless people from all walks of life through the process of building wealth through real estate investment. In these articles, he will personally guide you.