Investors looking for the best real estate investments need to realize that it can be a complex undertaking, and both timing and leverage play a crucial part in the success of real estate investing.

Real estate investing can be a great sideline, whether you’re a company employee or self-employed. Some of the great fortunes in real estate investing started out when a homeowner decided to buy the house next door and rent it out by the room.

There are several ways investors can make the best real estate investments without getting involved in costly, money-losing situations.

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Five points to help you profit from the best real estate investments you can find

First, real estate is a business, not just an investment. It requires maintenance, accounting and decision-making on a variety of legal and other topics that can eat up surprisingly large amounts of your time. You can hire people to carry out these chores for you. But you need to find them, negotiate with them, supervise them and replace them as needed. As you buy more real estate, this gets increasingly complex and time-consuming. Errors become increasingly costly.

Second, leverage deserves a lot of credit for your profits, but leverage works two ways. You have to keep paying loan interest and other fixed costs, even when your property is vacant. When times are good, leverage makes your profits rise faster. But when times are bad, leverage cuts profits or turns small losses into big ones.

In addition to possible great fortunes, real estate has also led to spectacular bankruptcies.

Third, timing plays a role in results, just like in the stock market. If you buy when prices are generally rising, you’re likely to make money. However, transaction costs—brokerage commissions, legal fees, land transfer taxes and so on—are higher in real estate than in securities. You need a bigger rise in prices to make money in real estate.

When the real estate market goes into a slump, liquidity can temporarily evaporate. Without deep price cuts, it can take months or years to find a buyer, especially for a unique property or one that needs work.

Fourth, it’s hard to diversify in real estate on a small scale. Because of the work involved, you’ll naturally want to invest mainly in a small area—within your hometown, or even in one neighborhood. This raises your dependence on the local economy, transportation, taxes, regulation and so on. Lack of diversification intensifies any problem.

Fifth, it’s easy to stumble into magical thinking in a real estate boom. Even if you understand all that can go wrong, it’s easy to slip into a feeling that you’re in a charmed period of your life and can safely ignore the risks, if only “just this once.”

Many individuals have grown rich through part-time involvement in real estate investing—probably more than have done so through the stock market. However, that’s mainly because of three key factors that are easy to overlook: leverage, sweat equity and higher risk.

The best real estate investments can provide a great outlook for the future, but they may also introduce extra risk and more work

If you’re a homeowner who bought the house next door and you’re renting it out by the room, you may be just as secure as the long-time follower of our Successful Investor philosophy. But in a real estate boom, many real-estate-as-a-sideline investors let themselves get carried away with confidence and enthusiasm, just like investors in a penny-stock boom.

For instance, they may buy properties with short-term financing, and simply assume they can borrow more money as needed. They may pay too much for properties because they overestimate how much rental income the property can generate. They may hire contractors who disappear after receiving down payments on work that has to be done to make the property rentable. They may buy properties that seem bargain priced, because they are unaware of structural weaknesses, or rising crime, or transportation problems, or prolonged zoning uncertainty, and so on.

They can stay out of trouble so long as the boom continues—that is, so long as prices on the whole seem to keep rising. But if the boom stumbles, these investors can be forced to sell if they fall behind in payments to lenders, or simply because lenders feel they represent too much risk. This falling confidence can spread to other lenders. It can spark property sales by solvent investors who want to avoid having to sell if things get worse.

The outlook for investors who follow our Successful Investor approach is attractive. The outlook for real-estate investors can be attractive as well, but it comes with extra risk and work demands, so it takes more effort to profit from it.

Bonus Tip: The best real estate investments: Real Estate Income Trusts (REITs) are another option

Real estate investment trusts (REITs) invest in income-producing real estate such as office buildings and hotels.

The best REITs have good management and balance sheets strong enough to weather an economic downturn. They also have high-quality tenants, and they carefully match their debt obligations with income from their leases. The best ones still do well despite a weak economy.

We advise against overindulging in REITs. But high quality REITs can make attractive, low-risk additions to your portfolio.

What are the best real estate investments you’ve made, and how did you find these investments originally?

What mistakes have you made with real estate investments that you would warn new investors about?