Let’s get back to basics. All future and current real estate investors should understand this fundamental question: how does real estate investing actually make money?

Appreciation

 The simplest bet real estate investors make is very similar to the one investors in most traditional equities make: at some later date, you can sell your stuff for a higher price than you paid when you bought it.

This is called appreciation and it’s always important to keep in mind. All else equal, investors acquire assets in markets, geographies, or categories they believe have growth potential, and hope to see a return on their investment when they eventually sell.

The hope is that prices increase over time because demand increases over time.

One way that happens in the real estate space is a force called cap rate compression. A cap rate measures the ratio between a property’s net operating income (total revenue minus expenses per year) and the property’s market value (what you’d pay to buy it or ask for to sell it). 

For a lot of economic and market reasons that go beyond the scope of this article, cap rates tend to decrease over time — especially for hotly-demanded markets. This means that property owners can often expect to see the market value of their assets increase while they hold them — even if the property’s net income doesn’t change. This is one of the primary reasons real estate investments perform well: the price almost always goes up, even if investors sit on a property without making capital-intensive improvements, which almost assures profit at sale.

Rental Income

A more distinctive feature of real estate investments is that many are profitable rental properties. Whether it’s for residential, office, retail, or other uses, property owners can increase their returns by renting out their property.

The dynamics of rental income get complicated fast, but there’s two important things to note for new investors.

First, especially for properties with shorter leases (1-3 years, as opposed to a decade), property owners can adjust rents to account for changing economic circumstances. Recession hits and the ‘expense’ side of the balance sheet starts to hurt? Investors who own stocks can’t do much. But real estate investors can adjust their rents to compensate for increased expenses. Same goes for economic booms. As tenants’ budgets increase, owners of rental properties can charge higher rents to capture economic growth.

Additionally, if the property was purchased via leverage — which just means financed in part via a loan — the ability to dynamically adjust rents as the economy changes creates an opportunity to expand returns. How? Mortgage payments stay the same, while rents rise forever. Over the life of the investment, this can continually increase returns.

Leverage

In general, real estate is one of the easiest asset classes in which to increase returns with the power of leverage.

The math can get more complicated than we want to dive into in this post (click here for a more detailed explanation!), but the basic idea is simple.

Apartment buildings, office complexes, hotels, etc.  are expensive. Often it’s so expensive that purchasing just a handful of assets could consume a given fund’s entire acquisitions budget — if they paid cash.

By using debt to finance acquisitions, investors can secure more assets and diversify their holdings. This is particularly easy to do in the real estate space because mortgage financing is typically low-cost and readily obtainable — especially for established, reputable players who know their market well.

But here’s the important part: even though investors might only finance 20% of the acquisition price in cash, they get to earn returns off the whole building. As long as net operating income (again, that’s effectively rents minus expenses like maintenance) exceeds the cost of the mortgage payment, investors are earning returns off someone else’s money.

That advantage adds up quickly, and it’s another of the most important reasons real estate investments often house traditional equities like the S&P 500 (for an interesting paper on why this is, click here).

Concluding thoughts

Of course, a short blog post barely scratches the surface of real estate investments’ potential. And we get pretty nerdy about this stuff in other spaces (click here for more of our Insights). One of our favorite things about real estate investment is the opportunity to access deep value-realization opportunities via careful strategy.

But the basic value proposition is as old as recorded history, which is why investors keep coming back to real estate. Pound for pound, it’s one of the best asset classes for risk-adjusted returns, which makes it a critical part of anyone’s portfolio.