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 article provides an overview of factors relevant to evaluating residential real estate properties.
Residential properties are often an easy entry point for real estate investing because they are plentiful, require a comparatively modest amount of initial capital, and the experience of renting an apartment is familiar to many. So how do you choose where to start? Do you look for a property you would want to live in yourself?
There are considerations like neighborhood, proximity to transit, and amenities that are always going to be important when you purchase a residential property, no matter who is going to live there. However, when evaluate a residential property for investment, there are additional criteria you should consider beyond those that impact 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 or vacation home.
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 afford a new place to live without your sale proceeds for a down payment or security deposit, and you can collect sufficient rent for your existing property—enough to cover your current mortgage, taxes, insurance, and other recurring “carrying” expenses (such as homeowners’ association charges), and you live in an area where population is stable or growing, you may be better off holding your original property for investment and leasing it.
These same underwriting 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.
As with any real estate investment, location is the most important consideration when evaluating a rental 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. When considering the market, you will want to learn about any new residential developments under construction or in the planning stages, as they may impact your future rental stream. Geographic factors that can affect the long-term viability of your property include, among other things:
Many large-scale multifamily investors use tools such as walk scores, traffic counts, and services that analyze foot traffic to help them understand the neighborhood. In addition, traditional tools such as the MLS and apartment rental websites can give you a sense of the current rental rates in different neighborhoods as well as specific buildings.
Demographics play an important role in determining current and prospective future rents and prospective demand for specific property types. 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. For example, if an area attracts young couples and families with children, you may do better with a townhouse or single-family home as a rental than a studio apartment. If the demographics reflect a high concentration of seniors, a rental without stairs may generate stronger demand.
Real estate taxes are another important consideration, as well as any local ordinances that affect the rent you can charge (i.e., rent control or affordability restrictions) or the terms of a prospective tenant’s lease (i.e., restrictions on short-term rentals, landlord obligations to provide certain utilities). You should understand the property tax rate, as well as the process to appeal the assessment. Additionally, if you purchase property in a state that has an income tax, you will be responsible for tax on your earnings even if you live in another state.
Once you find a property, you will need to evaluate the condition of its structural elements and fixtures as well as cosmetic aspects. 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. Design trends, including paint colors, window treatments, and even floorplans, can make your property look either fresh or dated. Features like private workspace that can function as a home office or kids’ study area have become increasingly important post-pandemic. Understanding the likely desires of your potential tenant base will help you assess how your residential property compares to alternatives available in the market.
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 and price points (i.e., an individual condominium unit, rental home, or small apartment building versus a larger multi-unit 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 of your income stream. Further, agency lenders such as Fannie Mae and Freddie Mac provide financing exclusively for residential properties, giving you options for leverage that may not be available for other asset classes.
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 to keep up with market rents 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 (or accept a lower occupancy to maintain your existing rental rates).
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, pet areas, outdoor space, in-unit laundry, parking, 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 average household 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. You can begin with free US census data, and then narrow your diligence with the aid of online tools.
Another advantage of residential real estate is that leasing terms are fairly straightforward. In addition to the duration of the rental and terms for 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) and, if applicable, in the whole apartment complex. Residential leases do not usually have complex contingencies, such as rent concessions triggered by nearby vacancies, that are more common in some types of commercial leases.
While many people get started by investing in single-family rentals, 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, parking lots, etc.) that are outside of any tenant’s specific premises, but which require upkeep. Structural elements of the property, such as the roof, are also maintained by the landlord, and repairs and replacements can prove costly.
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 or restrictions on short-term rentals. 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. 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 level 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 tenants are rarely responsible for performing any property maintenance, and you will need to be prepared to address unit repairs and potential emergencies as needed, 24/7. Additionally, because residential leases tend to have terms of only one to two years, you will need to find new tenants or negotiate extensions with existing renters frequently. More turnover equates to more need for repairs to restore a lived-in unit to a turnkey condition for a new tenant. 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. If your investment property is not located relatively close to you, having a trusted and experienced manager is essential to a successful investment.
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 primary 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. The funds necessary to make improvements must either be taken from your cash reserves that could otherwise be invested, or borrowed from a lender. 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 that includes a cushion for delays.
Renovation projects also require the market research necessary for an existing, occupied 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 generate a sufficient profit if you sell at a price comparable 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.
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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on October 11, 2016 and previously updated on September 16, 2019]
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Tracy Treger is Principal at Syndicated Equities. Tracy 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 of…