Author: Luke Babich is a real estate investor in St. Louis, MO owning over 24 units and specializing in multifamily units. His first investment was a house hack with Clever Real Estate’s cofounder, Ben Mizes.
What Type of Real Estate Property Should You Invest In?
Are you tired of the volatility in the stock market, watching the value of your portfolio swing from one extreme to the other? In a single month (February 19 to March 23) in 2020, the S&P 500 index lost one-third of its value from a high of 3386.15 to a low of 2237.40.
During the same period, the Dow Jones Index—a collection of America’s strongest companies—declined from 29.348.03 to 18,591.93, a drop of almost 37%. Even those with strong stomachs experienced sleepless nights, tortured by questions of “What if, “If only,” and “How did I miss the signals to sell (or buy)?”
Exhausted by the emotional turmoil accompanying stock investments, many investors are turning to real estate to replace or supplement their security portfolios.
Reasons to invest in real estate
Owning real estate appeals to investors for many reasons, including:
Real estate prices historically are more stable than security prices, especially common stocks. Values change in narrower ranges over more extended periods, driven by a property’s utility, condition, and location. Most physical risks—loss by fire, floods, or violent storms—can be easily transferred through insurance arrangements.
The use of borrowed capital–margin debt in securities, mortgages in real estate—enables a buyer to control higher values of an asset, thus amplifying its financial return potential and increasing the risk of loss.
Regulation T of the Federal Reserve sets a maximum loan value equal to 50% of the market price. For example, an investor could buy one share of a stock selling at $100 with $50 in cash and $50 in borrowed funds. In contrast, a real estate buyer may legally buy a real estate property with 100% borrowed money.
Finally, the mortgage industry is robust, competitive, and ubiquitous, providing easy access to buyers seeking loans for their purchases.
Real estate property owners may deduct depreciation of their property, the interest paid on a mortgage, and operating expenses such as third-party fees for the purchase, sale, or maintenance of the asset. In many cases, paper losses can be used to shelter other income from tax. The regulations even provide a process to sell an investment property and defer capital gains or excess depreciation recapture. By comparison, the tax benefits of security investments are relatively meager.
Most investment real estate properties generate regular income through rent payments. An oft-used investment rule of thumb is the 2% rule, i.e., monthly rent should equal at least 2% of market value. A single-family home selling at $200,000 could generate a rental payment of $1,8,000 to $2,200 monthly. Approximately 85% of the S&P 500 companies pay dividends to their shareholders; the dividend yield for the entire index was 2.9%. The current income received by the average shareholder seems paltry compared with a real estate rental property.
Concerns about owning real estate investment properties
Before investing in a real estate property, consider the following characteristics of a real estate investment:
Delayed purchase process
An adult of sound mind can walk into any brokerage firm with cash, open an account with minimal legal documents, place an order to buy a stock, and have ownership of the purchase two days later. Buying and selling real estate typically has an extended settlement period between the transaction agreement and possession of the property. Signatures on multiple, often complex documents are required, with numerous third parties providing services.
Higher transaction costs
Stockbrokers typically charge little or no commissions on stock transactions but charge their clients an annual maintenance fee for account administration and interest on their margin accounts. These fees, though individually small, are ongoing. While real estate investors pay real estate broker commissions and a negotiated portion of closing costs, the charges only occur when the property is bought and sold.
While there are ways to mitigate closing costs, such as selling on the flat fee MLS, getting lender credits to cover closing fees, and buyer rebates, there’s no denying real estate takes more upfront capital.
A security, once purchased, can be left in a brokerage account or safety deposit box for minimal expense indefinitely. Real estate is generally taxed by state and local authorities annually, mortgages must be amortized, and the property must be maintained, even improved to sustain acceptable rent levels and occupancy.
Investment real estate may not be appropriate for everyone, depending on their specific goals, risk profile, length of the investment period, and capital.
Real estate investment strategies
Real estate investors typically employ one of two strategies for profits:
A long-term strategy, the investor buys a property to rent to others. In the best circumstances, rents exceed expenses of management, maintenance, and debt amortization, delivering a steady income to the investor. In addition to tax benefits that might shelter other income, the investor’s equity grows through a combination of increased market value and pay down of the underlying mortgage debt.
An investor acquires a property below its current market value and sells it as soon as possible for a profit. A variation of this strategy is to purchase a property and subsequently invest in rehabilitation and additional amenities to create a market value higher than the investor’s cost.
Investors may employ each strategy depending on market conditions. For example, an investor who is intent on appreciation might decide to keep the property to capture the increased rents justified by the improvements. Conversely, a buy-and-hold owner could sell a property if its market valuation is excessive compared to similar properties.
Types of real estate investments
Just as an investor in the stock market has choices in the industries and companies, potential real estate investors can choose the types and locations of properties that best fit their investment objectives. The major types of investment real estate are:
The acquisition of a single-family home for a rental is often the first acquisition of a new real estate investor; the house is generally located within easy driving distance of the investor’s residence. Rental strategies may be long-term (a year or more with deposits and cleaning fees), month-to-month, or short-term in the new Airbnb market. Property owners may transfer the expense of utilities and maintenance to the residents of the property.
Multi-family real estate
Commonly referred to as “apartment buildings,” the category applies to buildings with multiple rental units under one roof. Owners of multi-family buildings typically collect higher gross rents and rent-per-foot than is available for most single-family structures. The dollar outlay for acquisition generally is more than required for a single home purchase, but financing to rent the property is more flexible. Property management—tenant relations, solicitation, selection, collections—is more intense in addition to increased maintenance costs. Due to increased management responsibility, many multi-family property owners employ independent property managers.
Condos and townhouses
Buildings with several privately-owned living spaces under a single roof with common exterior walls are especially notable in metropolitan areas. Financing for their purchase may be limited to specialized lenders, often with more stringent requirements than for other properties. Most condominium buildings are directed by a Homeowners’ Association (HOA) that can conflict with the condo owner’s interest.
Some experts claim that condos and townhouses appreciate at a lesser rate than other investment properties. Conversely, an investor looking for rental income might buy a condo in a popular area for considerably less than a single-family house in the area but enjoy similar levels of rent.
Acquisition of real estate investments
Properties sold by a mortgage company to recover its defaulted loan principal and expense can present unique opportunities for investors. The profit opportunity is the difference between the mortgage company’s investment and the fair market value of the property as-is. Those who are capable and willing to thoroughly investigate the condition of the forfeited property and the costs of rehabilitation might find a diamond in the rough.
Residential properties that need rehabilitation, repairs, or updating to meet current market demands represent a significant portion of the residential real estate market. Houses in this category attract do-it-yourself types as well as professional construction companies anxious to make a quick profit. The financing of fixer-uppers is uniquely flexible, including combinations of first and second mortgages, construction, and personal loans.
The breadth of real estate investment types and their availability in communities across the United States can be overwhelming for first-time investors. Instead of being an obstacle, real estate’s diversity is an opportunity. With a little effort, anyone can find a property that fits their objectives perfectly.
If you’re new to real estate investing, a talented real estate agent can help you identify the types of property that are best suited for your investing needs (and some will do it for a 1% commission, rather than the typical 3%).
For reliable financing on rental properties or fix-and-flip projects that you are looking to add to your REI portfolio, contact LendingHome and they can help you get the job done.
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Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. All information shown here is for illustrative purpose only. All views and opinions expressed in this post belong to the author. You should contact an attorney or tax professional to obtain advice with respect to any particular legal or tax matter. NMLS ID: 1125207 Terms, Privacy, and Disclosures. Copyright LendingHome Corporation 2020.