Real estate is a popular investment choice due to its historical appreciation, steady income, and exceptional tax benefits. Investors typically focus on either residential or commercial properties.
The COVID-19 pandemic has affected each category of real estate, which affects investors. For example, the stay-at-home orders have increased remote work from home and reduced out-of-home activity, negatively affecting demand for office buildings and physical retail stores. At the same time, interest in residential properties has expanded as residents pursue larger houses and relocate to suburban and rural areas.
Each category of real estate has unique characteristics, opportunities, and concerns that should be considered before investing.
Residential real estate generally includes single-family homes and one- to four-unit rental residences. Residential properties are typically leased to families and individuals.
Investors in these properties usually play active roles in their administration and maintenance or contract management companies to care for their properties.
Residential property appeals to investors because of its:
There are myriad ways to profit from residential property ownership depending on an investor’s interest, capability, and available time. The strategies include:
Principals identify houses in need of minor repairs or cosmetic refurbishments selling below market costs. Their objective is to spend as little money as possible – up to $5,000 – and resell the property as quickly as possible (45 to 50 days after purchase). While the profit is limited on each transaction, the gain of multiple transactions adds up fast. Several good books explain the strategy, its nuances, and pitfalls necessary to begin “flipping.”
Selection and accurate estimates of the improvements are essential. Plenty of people have lost money on fixer-uppers by failing to consider the work, expense, and resale value of the property they are buying.
Investors who seek regular income look to lease properties for a steady income in addition to amortizing the underlying mortgage. Owners or their agents are responsible for attracting and keeping suitable tenants, collecting rents, and maintaining the physical property as landlords. Success is dependent on acquitting properties at a cost allowing a positive cash return.
Location is crucial in residential properties. Generally, properties within high-income areas are preferred due to the larger population able to afford higher rents.
Many residential investors buy and hold for specific periods, generally when the tax benefits of accelerated depreciation expire. Some sell after a significant increase in value due to a series of increased rents and cash flows, generating higher market values.
Many real estate investors begin by “house hacking,” buying a duplex, triplex, or fourplex. The investor lives in one unit and rents the remaining units to others. In most cases, they seek a rent high enough to cover the mortgage, insurance, and tax payments, thereby reducing their personal shelter costs or earning a profit.
House hacking is not for everyone. Some real estate markets are too expensive to attract renters. Others dislike living close to neighbors, sharing a wall separating the units, a garage, or front and back yards. Nevertheless, hacking is an easy way to get into real estate investment.
Commercial real estate properties include office, retail, industrial, multifamily (of five units or more), hotel, and special purpose buildings. While residential properties are rented to individuals for months, commercial properties are generally leased to business enterprises for years.
Commercial properties tend to be a higher cost due to scale and financed for shorter periods than residential property. Commercial real estate financing is available from traditional banking and lending sources. In contrast, most residential mortgages are supported by government programs.
Commercial real estate appeals to investors due to its:
Commercial real estate owners employ similar strategies as residential investors with subtle differences and more extended holding periods. For example, buyers often buy distressed commercial properties to rehabilitate, refurbish, and rebrand to attract higher rents. However, due to the valuation techniques – comparables versus ROI – commercial property owners necessarily hold a property for longer periods.
Commercial property owners typically employ a “triple net lease” with qualified tenants. Under the terms, the tenant pays the real estate taxes, insurance, and maintenance on the space in addition to a base lease cost.
The table defines the similarities and differences between the two types of investment real estate. Tax benefits have not been specified, as each is subject to the same tax treatment.
|Market Price Source||Comparables||Rate of Return (ROI)|
|Acquisition Costs||Low to High||High|
|Available Financing||Plentiful, Simple||Restricted, Complex|
|ROI Potential||Medium to High||High|
|Property Management Intensity||Low to Medium||High|
|Lease Length||6 to 12 months||1 to 5 years|
Each property type comes with a different set of opportunities and requirements. Commercial real estate is generally considered more expensive, more complex, and higher risk but with higher returns than residential property investment.
Nevertheless, residential real estate investments provide more diversity and less complex management responsibilities than commercial property. The typical residential property investor usually takes a more active role in the property than commercial property investors. Consequently, residential property is the ideal entry-level for those seeking to invest in real estate. Many begin with the purchase of a single rental property and go on to eventually acquire large commercial properties.
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