- How to Invest in Real Estate Directly
- Residential Real Estate
- Commercial Real Estate
- Photo Credits
Welcome back! In the first part of this tutorial, Residential and Commercial Real Estate Investing 101 (Part 1), I talked about the attractive aspects of owning investment property, citing the historical rate of appreciation enjoyed by real estate market investors — about 9% per year — as well as the added option to earn an additional income through rent. I also laid out some of the cons of investing in real estate, including the enormous responsibility that comes with owning properties directly, especially for those investors who seek to become landlords. Finally, I suggested some simple and profitable alternatives to directly purchasing multiple investment properties — such as owning a home and/or purchasing shares in REITs or REIT mutual funds — for those folks who would rather take advantage of real estate market returns, without assuming as much of the hassle that goes hand-in-hand with direct ownership. (Don’t worry if you missed Part 1 of this tutorial, as it may be accessed via the handy link at the beginning of this paragraph!)
Now it’s time to take off the kid gloves, so to speak, and get down to the nitty-gritty of investing in residential and commercial properties directly. So, if you think you’ve got what it takes to be a landlord, and if you’re just itching to gobble up your very own investment real estate to own and manage à la Rich “Uncle” Pennybags (the Monopoly guy), then this article is definitely for you! In the following sections, we’ll cover the different types of properties that are available for you to invest in, and give a thorough overview of what to expect from each.
How to Invest in Real Estate Directly
Once you have decided to take the plunge and purchase investment real estate, you will quickly catch on that buying opportunities in this sector are anything but scarce. Generally speaking, you will have the option to choose from among three different property classifications to begin amassing your fortune — residential housing, commercial real estate, and undeveloped land. Investing in residential real estate is the least complicated of the three, while commercial real estate investing can get a little tricky. Investing in land is best left to those with more experience, as I will discuss later.
Residential Real Estate
If you own a home, then you already know much of what you need to know in order to profit from investing in this type of property. Many of the skills used to seek out and acquire residential real estate investments are similar to the skills employed when buying a home (e.g., preparing for transaction costs, saving for a down payment, scouting out neighborhoods, securing financing, attending to routine maintenance issues). Moreover, just as is the case when buying a home, you should typically approach a residential real estate investment with the intent to hold onto the property for the foreseeable future.
True, some real estate investors take a completely different approach! Known as “flippers,” these folks purchase residential properties in need of significant repairs at a discount, fix them up, and then immediately place their properties back on the market at a higher price. One drawback of this method is that “flipped” properties are subject to (higher) short-term capital gains taxes in many cases. At any rate, this tutorial focuses on more conservative — i.e., long-term — real estate investment strategies, where profits are earned through appreciation and rental income over many years.
Owning and managing residential property is comparatively easier than owning commercial real estate. Common options for investors include single-occupant dwellings (can refer to an entire family) — like single-family homes, townhouses, or condo units — and even multi-unit apartment buildings that house many tenants. As you might expect, single-unit properties are less complicated with regard to tenant relations (not to mention logistics), and those new to real estate should probably avoid taking on a multi-unit investment before gaining experience.
However, if you feel up to the challenge, one obvious advantage to managing a multi-unit property is the potential for increased rental income. Single-unit properties can struggle to turn a profit for investors in the early years of ownership, due to the time that is usually required to recover from transaction costs, the double expense of buying a residential unit and the land that it sits on, as well as higher mortgage interest and points due up front. But the increased rent from a multi-unit means that these properties can be more profitable in the beginning. (An exception to this rule is if you are able to afford a higher down payment for your single-unit, such as 25% – 30%. In that case, you may have an easier time of turning a profit on your rental property in the early years.) Plus, you have some breathing room if a tenant decides to move out — assuming, of course, that the remaining units are occupied.
Contrarily, if you own a single-unit property and your tenant decides to move on to greener pastures, you are stuck with a cash drain on your bank account for as long as it takes to find a replacement! If you happen to lose your renter(s) during a period of low interest rates (on mortgages), you could have difficulty filling the unit for some time. This could be disastrous in the early years — if you are unable to carry the weight of your vacant rental financially, you could end up losing your property altogether.
Single-unit properties still have multi-unit properties beat in terms of maintenance and upkeep, though, as it is comparatively simpler to maintain one unit (with one tenant), as opposed to many units (with many tenants) simultaneously. Even if you delegate your duties as a multi-unit landlord to a property manager, you will still have to authorize and pay for major repairs (in addition to paying the property manager for telling you which major repairs you need to pay for). The alternative — of handling every problem that arises by yourself — is easier said than done when managing a multi-unit rental property.
Condos are usually least expensive as far as maintenance costs go. The reason being that many condominium associations will deal with upkeep and major (external) repairs for you — e.g., landscaping, roofing, heating and cooling — though you will still be responsible for interior repairs within your unit. However, some condominium communities don’t allow rentals, and unless your unit lies in a highly desirous urban area, chances for long-term appreciation are usually small for condos.
In my article Buying Your First Home: an Investment in the Future, in the section entitled Analyzing the Potential for Real Estate Appreciation in an Area, I talked about many of the factors that influence a property’s potential for appreciation — from the perspective of a homeowner. Most of these hold true from the perspective of an investor, as well. One difference, though, is in the case where a property under consideration happens to be located within an area that is considered to be “the best” available (e.g., great schools, little-to-no crime, outstanding amenities). Speaking strictly from a financial point-of-view, a property located within a premium area will most likely already be selling at a premium, and your chances for seeing long-term appreciation may be lower than if you were to purchase an undervalued property in an area that could stand to see some improvement.
For example, every real estate agent and their mother (if their mother also happens to be a real estate agent) will tell you that it is always a good idea to purchase property in an area where the schools boast higher test scores. The logic here is that high test scores indicate excellent schools, which tend to have a positive effect on property values. But, the problem with this conventional wisdom — from an investor’s point-of-view — is that property values in a marquee area have nowhere to go but down if something affects the surrounding community adversely:
What if your state cuts funding to education (which isn’t exactly unheard of in our country), and one or more of the schools in your area has to close? Or, say the economy takes a turn for the worse, and a major employer in the region goes belly-up — what then? Worse still, what if both happen at the same time?
I’ll get into some more investor-specific criteria that you can use to evaluate the appreciation potential of a property and the surrounding area in Part 3 of this tutorial. For now, just remember that less-than-perfect communities, that have shown an overall upward trend in recent years, may actually prove more profitable for investors in the long-term than “the best” areas. Similarly, look for properties with superficial flaws that may be easily fixed by applying a little elbow grease. A new coat of paint, landscaping attention, or even a good cleaning can sometimes make all the difference! (Touch-ups like these increase a property’s market value, which in turn raises your rental rate.)
Commercial Real Estate
In addition to checking how vacancy and rental rates have changed in recent years, analyze the local unemployment rate over the same period. Realize that although residential and commercial real estate prices are both susceptible to economic fluctuations, each area will have different benchmarks for indicating whether the local economy is strong or weak (to a certain extent). For instance, there are over two hundred Starbucks coffee houses located in Manhattan, NY.1 Therefore, opening up one more will probably not have a dramatic effect on the area. However, a Starbucks grand opening in Muskogee, OK, could have a significantly greater impact on the local economy.
Investing in commercial real estate is considered to be more complicated than investing in residential real estate for a few reasons. First of all, tenant turnover rates are higher for commercial properties. This makes sense if you think about it, considering that eight out of every ten new businesses fail each year in the U.S.2 Additionally, you might have to renovate between tenants to suit the professional needs of your new occupants, as not every business will make the same use of your space. Franchises, in particular are contractually obligated to adhere to certain guidelines. Needless to say, this can prove to be quite a challenge (and quite a hassle), but you have to be prepared to make the necessary changes if you don’t want potential renters to look elsewhere.
However, investing in commercial real estate might make sense for you if you also run a small business. If you can use some of your commercial property for your own purposes, while simultaneously renting out your unused units to other entrepreneurs, you stand to earn in two ways from your investment. At the very least, if you buy at a good time (see below) and hold onto your commercial real estate for the long haul, chances are that you can save more than you would by renting — as long as you employ a little common sense. (Re: It is generally a bad idea to purchase the equivalent of a shopping mall in commercial real estate for your small business, if you require less space than a Banana Republic!)
To determine whether or not it is a good time to purchase commercial real estate, you will want to look at local economic trends. Specifically, check to see if the supply of commercial real estate available seems to be increasing much more quickly than the demand. If so, rental rates will drop faster than your pants after two bran muffins and a cup of coffee!
At some point early on, most real estate investors will inevitably experience a moment where the metaphorical light bulb clicks on above their heads, and they will come to the following conclusion:
Why not just buy land on the cheap in an area that’s ripe for development, and then sell it at the perfect moment for a huge profit?
They reason that it is better to eliminate the hassle of dealing with tenants and maintenance altogether, and approach real estate investing with a buy low and sell high philosophy — just like those fat-cats on Wall Street do every day with other financial securities, like stocks and commodities. This is usually a bad idea, though.
For starters, unless you’re Lex Luthor it is very difficult to predict with certainty where, and at what time, a boom in residential and/or commercial development will take place. You can look at overall trends of expansion in an urban area, then try to pick a swath of unused land that seems to be in the way of progress, and still end up waiting a lifetime for some big-time developer to swoop in and make you an absurdly lucrative offer. Even if you time your speculation perfectly, it is more likely that construction will just proceed around your property — unless you are able to purchase a great deal of unused land.
Also, mortgage lenders charge higher interest rates for undeveloped land, as it is considered to be a riskier investment. Don’t forget, too, that you will still have to pay property taxes — and since land isn’t depreciable, you won’t be able to claim that annual deduction like you would with developed real estate. Most importantly, the carrying costs associated with owning land are entirely one-sided (i.e., you don’t have any rental income to offset expenses).
On the other hand, if you are looking to try your luck as a developer, consider the following criteria before committing yourself financially:
- Scouting Assessment – I’ll get into the specific resources and criteria used to assess the economic health of an area in Part 3 of this tutorial, but for now, just remember that you are looking for property located in an area where businesses are expanding rapidly that have a shortage in housing.
- Zoning – Never purchase land if you don’t know exactly what you can and can’t build on it! Also, keep in mind that the zoning status of a piece of land can change, restricting your options, and reducing market value. You will want to take the temperature of the surrounding communities, as well as the folks at the local planning department, before potentially buying into an area with a strong anti-development streak. Otherwise, you could end up on the 6 o’clock news after some impassioned college students chain themselves to a tree in front of your bulldozers!
- Estimated Development Costs – Make sure that you get a solid estimate on how much developing the land is going to cost you (e.g., installing water and sewage, running power lines, building roads). Understand that this will inevitably turn out to be a low-ball figure, and plan accordingly. As a developer, you will be assuming responsibility for every stage of the construction process, and not just the finished result.
- Be Honest With Yourself – Can you really afford the proposed enterprise? If you’re going to have to over-extend yourself to the point where you could lose everything if the venture collapses, then the answer is no. Remember that you are not only taking on all of the expense, but you are also consigning yourself to a perpetual cash drain for as long as your project is in the works.
Development is anything but cheap. Just as mortgage rates are higher for land, so too are the costs associated with securing financing for building on that land. It is not uncommon to get turned down by a few lenders before finding someone who is willing to take a chance on your architectural vision, especially for more ambitious undertakings.
But before you commit yourself to this course of action, give careful thought to the Atlantean burden that you will have to shoulder while walking the developer’s path. There are plenty of completed properties available for you to invest in (i.e., where someone else has already taken on the burden of development), so why re-invent the wheel? Investment real estate development usually makes the most sense for those who have already built their fortune, and who are now looking to build an empire.
Allow me to conclude this installment of Residential and Commercial Real Estate Investing 101 with a personal anecdote:
Years ago, I was acquainted with a successful developer in my hometown, named Tom. He owned several local businesses, and was also regularly featured in the city newspaper. He drove nice cars, lived in an expensive mansion, and commanded respect. I really wanted to successful like Tom when I grew up!
But trouble came when he negotiated a big contract — with a famous Hollywood production company, no less — to bring a theme park to our mid-sized hamlet. He got in over his head, and leveraged himself so extensively that when the deal fell through he couldn’t recover. The last time I saw Tom, he was broke and in the process of losing that big mansion I so admired.
So, what’s the moral of this story?
Quite simply: know you’re limits, and don’t bite off more than you can chew! Otherwise, you could end up like my friend Tom.
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- Blogger Vows To Visit Every Starbucks In Manhattan [Internet]. New York, NY: CBS New York; 2013 Jan 8 [cited 2014 Feb 13]. Available from:http://newyork.cbslocal.com/2013/01/08/blogger-vows-to-visit-every-starbucks-in-manhattan/
- Wagner, Eric T Five Reasons 8 Out Of 10 Businesses Fail [Internet]. New York, NY: Forbes; 2013 Sep 12 [cited 2014 Feb 13]. Available from: http://www.forbes.com/sites/ericwagner/2013/09/12/five-reasons-8-out-of-10-businesses-fail/
- ‘Downtown Dallas From the Trinity River.’ Source: nthomas76207, CC-BY 2.0, via Wikimedia Commons. 2009 Mar 29 [cited 2014 Feb 13]. Available from: http://en.wikipedia.org/wiki/File:Downtown_Dallas_from_the_Trinity_River.jpg
- ‘North of Santa Monica, CA4.’ Source: Sunsetwatcher, CC-BY-SA 3.0, via Wikimedia Commons. 2012 May 9 [cited 2014 Feb 13]. Available from: http://commons.wikimedia.org/wiki/File:North_of_Montana_Santa_Monica_CA4.JPG
- ‘My Condo Building (Mixed-Use Residential & Retail), Looking to the SW Oceanside CA.’ Source: Joe Wolf, CC-BY-ND 2.0, via Flickr. 2010 Jul 7 [cited 2014 Feb 13]. Available from: http://www.flickr.com/photos/joebehr/4772904111/
- ‘College Pants 5(1).’ Source: Maria Morri, CC-BY-SA 2.0, via Flickr. 2010 Mar 26 [cited 2014 Feb 13]. Available from: http://www.flickr.com/photos/idhren/4464613569/
- ‘Cowboy Show – Dragged By a Horse.’ Source: Gabriel Villena Fernández, CC-BY-SA 2.0 (see link at No. 4), via Wikimedia Commons. 2008 Jun 5 [cited 2014 Feb 13]. Available from: http://commons.wikimedia.org/wiki/File:Cowboy_show_-_dragged_by_a_horse.jpg