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Making Money In Real Estate

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Learn how wealth is created through real estate. This article focuses on the basic ways that money is made through real estate. These haven’t changed in centuries, no matter how you spin it the basics have remained the same.

Appreciation
The most common source for real estate profit is the appreciation – the increase in the value – of the property in question. This is achieved in different ways for different types of real estate. And, most importantly, it is only realized through selling or refinancing. (For related information, be sure to check out Avoiding A Big Tax Bill On Real Estate Gains.)

Raw Land
The most obvious source of appreciation for undeveloped land is, of course, developing it. As cities expand, land outside the limits becomes more and more valuable because of the potential for it to be purchased by developers. Then developers build houses that raise that value even further.

Appreciation in land can also come from discoveries of valuable minerals or materials, provided that the buyer holds the rights. An extreme example of this would be striking oil, but appreciation can also come from gravel deposits, trees and so on.

Residential Property
When looking at residential properties, location is often the biggest factor in appreciation. As the neighborhood around a home evolves, adding transit routes, schools, shopping centers, playgrounds and so on, the value climbs. Of course, this trend can also work in reverse, with home values falling as a neighborhood decays.

Home improvements can also spur appreciation, and this is something a property owner can directly control. Putting in a new bathroom, upgrading to a heated garage and remodeling to an open concept kitchen are just some of the ways a property owner may try to increase the value of a home. Many of these techniques have been refined to high-return fixes by property flippers who specialize in adding value to a home in a short time.

Commercial Property
Commercial property gains value for the exact same reasons as the previous two types: location, development and improvements. The best commercial properties are in demand, and that drives the price up on them. (For related reading, see 7 Steps To A Hot Commercial Real Estate Deal.)

The Role of Inflation in Appreciation
Of course, there is one major factor we skipped in our summary – the economic impact of inflation. A 10% inflation of the dollar means that your dollar can only buy about 90% of the same good the following year, and that includes property. If a piece of land was worth $100,000 in 1970, and it sat dormant, undeveloped and unloved, it would still be worth many times more today. Because of runaway inflation throughout the ’70s and a steady pace since, it would likely take over $560,000 to purchase that land today – assuming $100,000 was fair market value at the time and all other factors remained constant.

So, inflation alone can cause appreciation in real estate, but it is a bit of a Pyrrhic victory. Even though you may get five times the money due to inflation, many other goods cost five times as much to buy now. (Learn more in 5 Tales Of Out-Of-Control Inflation.)

Income

Generally referred to as rent, income – or regular payments – from real estate can come in many forms.

Raw Land Income
Depending on your rights to the land, companies may pay royalties for any discoveries or regular payments for any structures they add. These include pump jacks, pipelines, gravel pits, access roads, cell towers and so on. Raw land can also be rented for production, typically agricultural production.

Residential Property Income
Although it’s possible to earn income from the installation of a cell tower or other structure, the vast majority of residential property income comes from basic rent. Your tenants pay a fixed amount per month – and this will go up with inflation and demand – and you take out your costs from it and claim the remaining portion as rental income. While it’s true you will get an insurance payout if your tenants burn down the place, the payout only covers the cost of replacing what is lost and is not income in a real sense.

Commercial Property Income
Commercial properties can produce income from the aforementioned sources – with basic rent being the most common – but it can also add one more in the form of option income. Many commercial tenants will pay fees for contractual options like the right of first refusal on the office next door. These are essentially options that tenants pay a premium to hold, whether they exercise them or not. Options income is sometimes used for raw land and even residential property, but they are not common.

What About REITs or MICs?
Real estate investment trusts (REIT) and Mortgage Investment Corporations (MIC) are typically considered to be great ways of earning income from real estate. This is true, but only in the sense that real estate is the underlying security. With a REIT, the owner of multiple commercial properties sells shares to investors – usually to fund the purchase of more properties – and then passes on the rental income in the form of distribution. The REIT is the landlord for the tenants (who pay rent), but the owners of the REIT get the income once the expenses of running the buildings and the REIT are taken out.

MICs are even further removed, as they invest in private mortgages rather than the underlying properties. MICs are different from MBSs in that they hold entire mortgages and pass on the interest from payments to investors, rather than securitizing the interest streams independent of the original mortgage. Still, they are not so much real estate investments as they are debt investments, and thus outside of our area of interest. (Learn more in How To Assess A REIT.)

Similar to securities with real estate underlying the investment, most alternativesare merely a layer on top of these two basic steams of income.

For example, there are informal residential real estate options where you pay a fee to have the right to buy a house at a given time, say after a month, for an agreed upon price. Then, you find investors who will pay more than your option price for the property. In this case, the premium you get is essentially a finder’s fee for matching a person looking for an investment with a person looking to sell – no different than a real estate agent. Although this is income, it doesn’t come from buying (i.e. holding the deed to) a piece of real estate.

Similarly, no money down or OPM deals are simply the financing aspect of the deal – it doesn’t change how the buyer is planning to make money in the long run.

The Summary
If someone is trying to sell you a new way to make money from real estate other than buying low and selling high or collecting rent, they’re probably trying to sell you on the process of real estate investing rather than a new mechanism for making profits. Whether the process is worth it or not is up to you, but know that it doesn’t change how money will be made (or lost).

Learn the basics of commercial real estate

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The Basics of Commercial Real Estate

Commercial real estate is property that is used solely for business purposes. Examples of commercial real estate include malls, office parks, restaurants, gas stations, convenience stores and office towers. Commercial real estate is one of the three primary types of real estate; the other types are residential real estate and industrial real estate.

Commercial Real Estate – Summarized
Commercial real estate includes various types of real estate from gas stations to shopping centers. As its name implies, commercial real estate is used in commerce. Residential real estate is used for living purposes, while industrial real estate is used for the manufacture and production of goods. While residential real estate may be quoted in total price or rent per month, commercial real estate is customarily quoted in dollars per square foot through lease agreements, as businesses that occupy commercial real estate usually lease their spaces. An investor usually owns the building and collects rent from each business that operates there.

Types of Commercial Real Estate Leases

There are four primary types of commercial real estate leases, each requiring different levels of responsibility from the landlord and the tenant. In addition to rent, a single net lease makes the tenant responsible for paying property taxes. A double-net (NN) lease makes the tenant responsible for paying property taxes and insurance. A triple-net (NNN) lease makes the tenant responsible for paying property taxes, insurance and maintenance. Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance and maintenance.

Commercial Real Estate Classifications

Commercial real estate can be a shopping center with multiple retail tenants or a skyscraper with dozens of tenants. Commercial real estate is categorized into different classes. Office space, for example, is divided into one of three classes: class A, class B or class C. Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure and location. Class B buildings are usually older and not as good-looking as Class A buildings. These buildings are often targeted by investors for restoration. Class C buildings are the oldest, usually over 20 years of age, located in less attractive areas and in need of maintenance.

Investing in Commercial Real Estate

Investing in commercial real estate often requires a considerable amount of startup capital and extensive knowledge of the legal, financial and regulatory aspects of owning this type of property. Investors who don’t want to deal with these hassles directly can gain exposure to commercial real estate through real estate investment trusts (REITs). Commercial real estate REITs are publicly traded on stock exchanges, so they are easy to buy and sell, providing liquidity to investors who otherwise would not have it by owning commercial real estate properties directly. Commercial real estate REITs can provide income to investors as well as capital appreciation.

Real estate is property comprised of land and the buildings on it as well as the natural resources of the land including uncultivated flora and fauna, farmed crops and livestock, water and minerals. Although media often refers to the “real estate market” from the perspective of residential living, real estate can be grouped into three broad categories based on its use: residential, commercial and industrial. Examples of residential real estate include undeveloped land, houses, condominiums and townhomes; examples of commercial real estate are office buildings, warehouses and retail store buildings; and examples of industrial real estate are factories, mines and farms.

Commercial Real Estate Loan

A mortgage loan secured by a lien on commercial, rather than residential, property. Commercial real estate (CRE) refers to any income-producing real estate that is used solely for business purposes, such as retail centers, office complexes, hotels and apartments. Typically, an investor (often a business entity) purchases commercial property, leases out space, and collects rent from the businesses that operate within the property. Financing, including the acquisition, development and construction of these properties, is typically accomplished through commercial real estate loans. Commercial real estate loans are typically made to business entities formed for the specific purpose of owning commercial real estate. Entity types include corporations, developers, partnerships, funds, trusts, and Real Estate Investment Trusts, or REITs.

Commercial Real Estate Loan – Summarized
Like residential loans, banks and independent lenders are actively involved in making loans on commercial real estate. In addition, insurance companies, pension funds, private investors and other capital sources, including the U.S. Small Business Administration’s 504 Loan Program, make loans for commercial real estate. And, like residential lenders, various commercial lenders have different levels of risk that they will undertake. As a result, lenders have different terms they are willing to offer to borrowers.

Private Equity Real Estate

Private Equity Real Estate is an investable asset class that consists of debt and equity investments in the property markets allowing multiple investors to pool their funds. Private Equity Real Estate funds became prominent in the 1990s as an alternative way to capitalize commercial real estate to real estate syndications.

Private Equity Real Estate
Investing in Private Equity Real Estate traditionally requires a longer-term consideration, an active management strategy, and significant upfront capital commitment to a fund that seeks potential investment opportunities in the space. Little flexibility is offered to investors since the capital commitment typically requires several years. However, given real estate’s popularity as an asset class, it provides high potential levels of income with strong price appreciation in the future.

Commercial Property

Real estate property that is used for business activities. Commercial properties fall into many categories and include including industrial properties, shopping centers, farms, offices, or even vacant land.

Commercial Property – Summarized
Common examples of commercial property include the grocery store you regularly visit and the office buildings found near major urban centers. It is possible to monitor the trend in nationwide commercial property prices by following the Moody’s Real Commercial Property Index.

Commercial real estate 101

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Commercial real estate — comprised of office space, hotels, retail space, industrial property, land and multi-family homes — is one of the three main types of real estate, along with residential and industrial. Owners of commercial real estate, say a gas station or strip mall, make money through appreciation when they sell, but they can also pull in revenue via rent they collect from tenants.

Lease Lowdown
Leases can run from one year to 10 years or more. Leases on multi-family homes usually run a year, while leases on industrial space average about five years. Office and retail space can range from five to 10 years. “Larger tenants tend to have longer leases,” said Brian McAuliffe, an executive managing director in CBRE Group’s (CBG) Capital Markets division. “Shorter-term leases provide more flexibility to adjust lease rents while longer leases provide more security, especially with credit tenants.”

There are several types of leases commercial property owners use. Under a gross lease, they collect only rent and are responsible for expenses such as property taxes, insurance and maintenance. With a single-net lease, owners generally collect property taxes on top of rent. With a double-net lease, they collect rent, property taxes, and insurance from tenants; with a triple-net lease, tenants pay property taxes, insurance and maintenance.

A commercial real estate firm advises on how to best negotiate lease agreements that will attract and keep tenants — property owners need to strike a balance between maximizing rents and minimizing vacancies and tenant turnover. Turnover in can be costly for owners because a space must be adapted to meet the specific needs of different tenants, like if a restaurant is moving into a property once occupied by a yoga studio.

There are many firms in the commercial real estate space. CBRE is the largest in the world. Other big players include Jones Lang LaSalle (JLL), Cushman & Wakefield, Inc., Newmark Grubb Knight Frank, and DTZ. These companies help source commercial real estate, appraise value, broker purchases and sales, manage upkeep, find and retain tenants, negotiate leases, and navigate financing options. “A full-service company satisfies all of a client’s real estate needs, whether they be individuals, limited partnerships or institutions,” said McAuliffe.

The specialized knowledge of a commercial real estate company is helpful as the rules and regulations governing such property vary by state, county, municipality and industry and size. The rewards can be substantial, though.

Lucrative Holdings
The U.S. commercial property market took a hit during the 2008-2009 recession, but it has experienced annual gains since 2010 and has since recovered almost all recession-era losses.

Washington-based Urban Land Institute recently released a forecast of real estate trends that predicts commercial real estate prices will continue to sharply rise through at least 2017. The Real Estate Consensus Forecast surveyed 46 industry economists and analysts. It sees commercial property increasing an average of 7.6% annually through 2017, which is up from historical long-term increases of 5.3% annually.

The rents collected from commercial property is also on the rise. Commercial lease rates are usually quoted in annual dollars per square foot. Newmark Grubb Knight Frank recently reported that the national average for office space rent was $27.76 a square foot in the first quarter of 2015, up 4% from a year earlier, while the price asked for industrial space was $5.70 a square foot, up 7%.

The Bottom Line
As one of the three major sectors of real estate, the commercial property market is on fire. Prices are expected to appreciate sharply over the next few years. Whether owners are making money via selling or renting properties, there should be plenty of cash on hand to buy lots of hair products.