[ The Money Side of Lifeā„¢ ]

Playing The Trump Card: Getting started in real estate

By Alex Brandt, Jens Odegaard on October 31st, 2010 •

You don't have to be Donald Trump Jr. to start investing in real estate. Investments range from the electronic market transaction of a share in a real estate investment trust (REIT) to the hands-on remodel of a starter home. Here's how to get started in the real estate game.

REIT

REITs are a simple, liquid way to invest in real estate. Instead of having to take all the complicated steps of purchasing physical property, simply buy shares in the trust. REITs invest in all kinds of real estate with some specializing in particular sectors. They're required to pay out 90% of taxable profits in dividends, which means that as long as they're making money you'll see a steady return on investment. Plus, share prices can also appreciate, or gain value, just like regular stocks. In the decade from 1999 to 2009, REITs averaged an 11.27% annual return. In comparison, the stock market -- as measured by the S&P 500 -- only averaged a return of 3.02% annually over the same period.

There are three types of REITs.

  • Equity REITs buy and invest in properties. Their primary source of revenue is rent.
  • Mortgage REITs loan money to buyers or purchase mortgages and mortgage-backed securities. Revenue is generated from the interest earned on the loans.
  • Hybrid REITs are a combination of equity and mortgage REITs, so revenue is generated by both rent and earned interest.

Though REITs offer easy access to the real estate market, REIT performance depends on which sector of real estate the REIT is invested in (residential, commercial or both) and on macroeconomic forces (think the housing crash and ensuing financial crisis). For example, in 2007 and 2008 the average annual REIT return was -17.83% and -37.34% respectively -- yes, those are negatives. In 2009, it was up 27.45% from 2008. REITs can be risky, but they have potential. Learn more about REITs at forbes.com and fool.com.

First house reality

The most obvious way to start investing in real estate is by buying your first house. It's going to cost you though. The average price for homes in the U.S. was $199,125 in September 2010. Making a 20% down payment is the ideal situation -- you'll avoid paying private mortgage insurance (PMI) and receive a lower interest rate. That means you're looking at an investment of $39,825 right off the bat, not to mention monthly mortgage payments (likely higher than the rent you pay now), homeowner's insurance, property taxes and upkeep. As the median yearly income for 16- to 24-year-olds is $22,360, according to bls.gov, saving up almost $40,000 just for the down payment seems pretty daunting.

Here's the reality. The median 16- to 24-year-old's monthly earnings are only $1,772. If you save 15% per month for a house, it will take a little over 12 years to save up for that $39,825 down payment (not factoring interest you may earn on that money while saving).

So... now what?

Don't give up just yet. For the 25--34 age range, the median annual salary jumps up to $35,100. In other words, as you get older it's highly likely that you'll make more, so it won't take 12 years to save for a down payment. Plus, while a 20% or more down payment is optimal, it's actually quite common for people to buy a house with less. In fact, around 30% of new mortgages are from the Federal Housing Administration (hud.gov), which offers mortgages with down payments as low as 3.5%. For the average home, that works out to $6,969.

Besides giving you the option of a low down payment, FHA loans have other benefits.

  • Loans can be used for properties with 1-4 units. Buy a duplex and live in one side while renting out the other half.
  • There is an FHA loan that enables you to buy a fixer-upper and include all the costs of a remodel in one loan. Buy a fixer-upper, remodel it and then sell for a profit (hopefully).
  • FHA loan down payments can come from gift or grant money. Consider asking a trusty relative for help with the down payment.

FHA loans also have a couple of drawbacks.

  • FHA loans charge mortgage insurance of 0.5% of the total loan amount per year.
  • There is an upfront mortgage insurance premium of 1.5% on the total loan amount.

The other downside to making a smaller down payment (whether with an FHA loan or not) is that you'll have to take out a bigger loan and interest rates will be higher, which means you'll be making higher payments for the typical 15- or 30-year life of the loan.

Investing prep

When starting out in real estate investing, realize that you aren't looking to start with a dream home. Instead look for something affordable with potential resale or rental value -- a diamond in the rough. Steer away from buying a McMansion, or any home, if you can't afford it -- you'll end up losing your investment by defaulting on the loan. See what's affordable by using the mortgage calculator at bankrate.com.

Keep in mind that you'll need good credit to get approved for any loan. The average credit score for an FHA borrower is 690. Other mortgages usually require a score of 730 or more. Check your free credit score from creditkarma.com or get your FICO credit score (the industry standard) from myfico.com.

If your credit score is okay and you can get approved for a mortgage, shop around for a bargain. There are more than four million houses on the market. Look at long-term stability and consider the appeal of the neighborhood before buying.

When it comes to investing wisely, real estate is no different than other forms of investing. Weigh the potential losses and gains, research the market, and make an informed purchase. Remember that the goal is to sell or rent the home down the road and turn a profit.
 

The Bottom Line

The easiest way to start investing in real estate is through REITs, but buying a house gives you a tangible investment. With mortgage rates hovering near all-time lows, now could be the time to invest. Just don't get in over your head or you'll end up like the millions of Americans who currently owe more on their mortgages than their homes are worth.

Sources: investopedia.com; irs.gov; reit.com; moneychimp.com; realestateabc.com; bls.gov; usnews.com ; hud.gov ; bankrate.com; fha.com; freddiemac.com ; nytimes.com; realtor.com