My clients often ask me, “What type of real estate is ‘best’ to invest in?” I always respond with another question: “What are your investment goals and your tolerance for risk?” While location and financing will impact the success of any real estate investment, be aware that some benefits and challenges will vary based on the asset type. This column provides an overview of factors relevant to evaluating residential real estate properties.
When you select a residential property for investment, your criteria will be different than when you decide where you want to live personally. This is because investors care about cash flow and tax benefits, such as depreciation deductions, that do not apply to a primary residence.
To illustrate the difference, consider a scenario where you own your residence but plan to move. Should you sell your current property, or hold on to it and rent it out?
The short answer is that if you can collect sufficient rent for your property—enough to cover your existing mortgage, taxes, insurance and other recurring “carrying” expenses (such as condominium assessments), you may be better off holding your original property for investment and leasing it.
As with any real estate investment, location is the most important consideration when selecting a property. It is prudent to consider that a neighborhood or the demand for housing in a given area may change significantly in a relatively short period of time. Geographic factors that can impact the long-term viability of your property include, among other things:
Demographics play a role as well. The size of the population, the median age and family composition (i.e., young singles, families with children, elderly), as well as socioeconomic status and household income in the neighborhood will impact an area’s housing needs.
Once you find a property, you will need to evaluate the condition of its structural elements as well as the cosmetic ones. Appliances and building systems must be maintained and kept up to date. Keep in mind that amenities desirable to you personally may not be attractive, or worth a premium, to a renter. There are generational differences, among others, that influence what a prospective tenant may be looking for. Understanding the demographic trends and desires of your potential tenant base will help you assess how your residential property compares to alternatives available in the market.
These same considerations come into play when you are looking to purchase a rental property outright. You will want to evaluate both the current and prospective rental stream, and what factors may affect it in the future.
Strong familiarity with the neighborhood can help you make educated decisions about the relative risk of a particular location; many investors wisely get started by buying rental property close to home.
Residential real estate offers the advantage of a broad range of choices at a range of price points (i.e., an individual condominium unit or small apartment building versus a larger apartment complex) in a wide variety of neighborhoods. Everyone needs to live somewhere, so you will see a strong supply of prospective tenants compared with other asset classes. There may also be government subsidies available for types of affordable housing to guarantee some income stream.
Importantly, as a typical residential lease is for a term of one year, you will have the opportunity to increase your rental income on an annual basis as leases are renewed or replaced. However, if the economy in your location declines, or becomes subject to additional competition or supply, you may find you must actually decrease your rental rate in order to maintain occupancy.
Market data about sale prices and rental rates for comparable properties is readily available, especially if you work with a residential broker. You may also consider how the interior finishes of your unit (i.e., countertops, appliances, flooring) and property amenities such as a fitness room and security measures compare to similar apartments in the neighborhood. This type of information is often specified in property listings, making it easier to do your homework.
Demographic data can provide guidance on the size, age, and income of your potential rental pool. This information can be useful in projecting your current and future income stream in the absence of a long-term lease.
Additionally, residential leasing terms are fairly straightforward. In addition to the lease term and payment of rent, utilities and other expenses and security deposit, there will be provisions about what the tenant can or cannot do in the unit (e.g., pets, smoking, use of balconies) and, if applicable, in the whole apartment complex. Residential leases do not usually have contingencies, such as rent abatements triggered by nearby vacancies, that are more common in some types of commercial leases.
It is also possible to buy an entire apartment complex or large multi-unit building. These larger projects are considered to be commercial properties, notwithstanding their residential nature. Multi-unit buildings offer the opportunity to establish economies of scale for property management, maintenance and expenses.
Perhaps the biggest drawback to residential real estate investments is the degree of property management required—both in terms of maintenance and collecting rent from individuals. Most residential leases make the landlord responsible for property maintenance and repairs, and many multi-unit properties share common areas (lobbies, lawns and parking lots, etc.) that are outside of any tenant’s specific premises, but which require upkeep.
Further, with shorter lease terms than commercial properties, residential units are more likely to incur turnover costs, which can include cleaning and painting, brokerage commissions and periods of vacancy without rental income between tenancies. In the event of a default, a residential tenant is less likely to have the financial resources of a commercial tenant, making collection more challenging.
If you buy individual units in a multi-tenant building, you may be affected by the actions or inactions of neighboring owners, as well as any policies the building may implement, such as rules about pets. As with any investment property, you will need to evaluate the credit of your tenant(s) and any lease guarantors, and allow for the possibility of vacancy or delinquent rent in your financial forecasts.
Pricing to acquire a residential property may be competitive, as you must bid against prospective residents as well as prospective investors.
If you are purchasing an apartment building, you should keep in mind that residential renters’ appetites for amenities change more quickly than do commercial tenants, and residents are unlikely to pay for any capital improvements to the property (although tenants may be willing to pay higher rent for a higher degree of unit finishes or amenities). It is wise to carefully evaluate the costs of new improvements in terms of initial outlay and future maintenance, as well as how quickly those costs can be recovered through increased rent. For example, a dog wash area may attract pet owners, but pets can also cause additional wear and tear on the units themselves.
Residential leases tend to be shorter in term than commercial leases, and the tenants are rarely responsible for performing any property maintenance. You will need to find new tenants or negotiate extensions with existing renters frequently, and you will need to be prepared to address unit repairs and potential emergencies as needed, 24/7. An overarching question to consider, therefore, is, “How much hands-on management responsibility do you want?”
Some investors choose to hire professional property managers, while others undertake these duties themselves to capitalize on their own sweat equity. This decision is important economically as well as practically, as income from active property ownership may have different tax implications than a purely passive investment. An experienced property manager will have the expertise and availability to address problems as they arise. A good property manager will also proactively and preventatively avoid problems for you before they ever arise.
Another way to invest in residential real estate is to buy a “fixer-upper”, make substantial improvements, and then sell the property for a gain, as featured on a growing number of television shows. This type of investment is about return on investment, measured by an internal rate of return (IRR) or equity multiple, rather than the percentage annual cash-on-cash return that is a goal in an operating rental property.
The risk profile for rehabbing and reselling a vacant residential property is substantially greater than owning rental real estate as described above. There is no cash flow available to you during the course of renovations, while the funds necessary to make improvements must either be borrowed from a construction lender or taken from cash reserves that could otherwise be invested. You will need to have a sufficient, and flexible, construction budget to make the improvements you intend, as well as to address any issues that you discover during the renovation process. If you are not doing the work yourself, you will need to have reliable contractors and an accurate budget for materials.
Renovation projects also require the market research necessary for a more straightforward rental property. You should familiarize yourself with the types of finishes and amenities in the neighborhood, and note which ones fetch the biggest resale price or rent increases for the cost. Additionally, you will want to make sure your improved property will sell at a target price compatible with other homes in the area.
As seen on TV, this type of project can be exciting and lucrative, but there is no guaranty that you will be able to sell the renovated property quickly upon completion, or at your target asking price.
As noted above, these are only a handful of factors to consider when evaluating a prospective residential real estate investment. Starting off with something close to home and enlisting the assistance of an experienced property manager can help you to make a profitable investment.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Investing in Residential & Multi-Family Real Estate and Due Diligence in Real Estate Deals. This is an updated version of an article originally published on October 11, 2016.]
Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…
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