A lot of people have read the book Rich Dad, Poor Dad, and if not I would recommend it, as a good high level start to property investing. Although not sure it has enough detailed explanation in it.
I am a believer of property as an investment class, and did move a large portion of my total investment into it a few years ago. As I believe it is important for long term wealth. Obvious thing with property it is not easy to buy due to the need for a cash deposit (normally) and cash for fees etc. So I borrowed the money for my first deposit, and then took out the rest as a loan. So might not be something you can do right now, although you could pool funds.
I have spoken to at least seven (maybe more) friends (very smart people) to pool funds. Only ONE agreed, and the rest pretty much said they might as well do it themselves. Out of the rest ONE did, and he went for best rental return, when I said go capital growth. He bought five properties over a period of a few years and after about four years sold them and broke even (no profit).
I recently got an honours student, Justin, to do a thesis comparing the returns on housing vs stocks (passive market tracker) over a 15 year period. Results are they were not very different when risk adjusted, however the "risk" as measured by finance is effectively standard deviation and apparently property is much more risky that stock, which shows the obviously flaws in risk measurement in finance. So much for the saying "safe as houses".
So going to point out some key things and then after that a little example to show you it works ;-)
First thing with property is - Location, location, location
So what is a good location? When I am looking at property the primary and most important factor is capital growth (Not rental). Rental is the second key point. It took me a while to realize this, but the real value in property is the capital growth.
So a good location is one that is going to have capital appreciation (house value will go up).
Second - The bonus of leverage
Lets say the property capital appreciation is 3% a year. You might say 3% a year is low compared to the market, why would you buy property (especially given is more "risky")? Well the big difference between a share and a house is with a house you normally have leverage. So if you put is 10% you leverage is basically 9x on your capital appreciation, if you put 20% then 5x. Is a 3% return time x 9 is a 27% return, and 3% at 5x is 15%. Now 27% is pretty hard to beat, and 15% pretty respectable!
Third - Free savings
This brings me to that short excerpt. Lets say I earn my 1000. So you want to buy an asset (the house). However you don't have lots of money and you need your money to live, eat etc, but you know saving (and compounding those savings) is key to wealth generation. So how you going to save money and spend it. "Can't have your cake and eat it".
This is where investment property gets round the issue. When you buy an investment property and let it out. The tenant is effectively buying the asset for you, as you pay 10% of the price and they pay the rest, and after a while that pay the asset and start paying you money as well.
Lets take an example: Of a house the cost 100 000. Lets say the rent is 5% and the cost of the loan is 6% and you put in a 10% deposit. Housing growth is lets say 3% a year. So your initial investment is 10 000.
End of year 1:
House value 103 000
Capital appreciation 3000
Rent 5 000
Interest 5400
Realized loss 400
Unrealized net gain in wealth (3000-400) 2600
Return on investment 2600/10000=26%
Bonus you can deduct the 400 loss from tax and don't pay on the gain, so return is actually higher. If you assume tax rate is 30% (2600+400*0.3)/10000= 27.2%
How about you get a property with rental of 7% but no capital growth:
End of year 1:
House value 100 000
Rent 7 000
Interest 5 400
Realised gain 1600/10000 = 16%
Now here you have a realised profit so pay tax on the income so you return is actually less. Assuming 30% tax (1600*0.7)/10000 = 11.2%
Now the above it is important to note often the gain is not realised (can't go spend your 2600). Now this is the best part, because you can't take it out, you are forced to compound your profits. In year two you get a 3% return on 103 000!
So if you bought this property above effectively you would get you 12 000 for the year, have to pay in 400 for the loss, and someone else will contribute 5000 to your asset. That 5000 is effectively you investing in an asset. You are "saving" 5000 (although someone else is paying), and you are effectively saving a further 3000 (capital growth) you are reinvesting.
Now for me the goal is never to really make a profit on my properties for the next 10-15 years. After which you will now own 100% of your assets which you paid 10% for and get an annuity for the rest of your life.
Fees
Trading property is also not free and transaction costs are quite high, so you are likely to pay an additional 3-5% (Sometimes more) of the purchase price. So need to consider that as a cash investment upfront with the deposit. So this would decrease the return slightly but the overall concept is still the same.
Now with anything there is risk! Never forget risk.
- Tenants not paying, unfortunately there is always a risk, and the best you can do is have a thorough background check done, and have multiple properties which does diversify the risk a little (after a couple of years).
- Can't find a tenant. Often I feel I should get a higher rental, and that is when I remind myself it is not about the rental, so rather have a tenant at a lower rental than not have a tenant for 1 or 2 months.
- Property values going down. Always a possibility in the short term (property is cyclical), however you are looking at the long term, so might go down now, but in the long term unlikely will go down. Also important you look at the location carefully!
Can't get rid of all the risk, however I am not sure it is more risky that shares!