Making a real estate investment can be a good way to amass wealth, prepare for retirement and add extra income to your bottom line. In most cases, real estate can be an excellent investment opportunity. It is one of the only business opportunities that banks will finance as long as you have access to steady income, some savings to fund a down payment and an acceptable credit score as determined by bank underwriters.
If you need money to start or fund, say a startup business, many banks would be unwilling to take this risk. Financing real estate presents less of a risk to the bank because they can collateralize the loan with the property being financed. This way, if you default on your loan for any reason, the bank can take your property and resell it to pay back the loan.
For this reason, many people choose to start building wealth with real estate. Though real estate can be one of the easier investments to start with, it can be daunting learning the ins and outs of the industry. There are as many real estate investment strategies as there are investing personalities.
Some investing approaches are very hands-on, while others are much more passive. Certain types of properties could be subject to more regulation, while others are not. Then, there are properties that could require massive renovation, yet produce massive returns and cash flow, while others may be more “turnkey” with slightly less risk and return-on-investment (ROI) as a result.
With all the options, what real estate investing approach do you start with to ensure that you’re investing according to your means, available resources and desired level of involvement? There are many answers to this question, but we can start by looking at the pros and cons of three common types of investment properties: vacation, single family residence (SFR) and multi-unit dwellings.
Vacation Rental Properties
Vacation rental properties can be a fun way to enter the world of real estate investing. You may already have or desire to own a vacation home near a beach, lake or some other destination that is popular for vacationing.
If this is the case, then it may not be a bad idea to turn your excess capacity into income. If you won’t use your vacation rental year-round, then why not rent it out while you are not using it? It sounds like a great idea, but before you buy your dream lake house, consider some of the pros and cons to this approach.
People tend to pay premiums for short-term housing. As a result, you will be able to charge far more for a vacation rental than a long-term rental. You may even be able to charge substantially more during vacation “high seasons.” If you’ve financed the property at a reasonable rate, this could mean that you are able to clear a profit a.k.a “having a cash flowing asset.”
The advent of the internet makes it much easier to market The internets make it much easier to locate and market short-term rentals. There are plenty of platforms like AirBnb, VRBO and HomeAway, that make it incredibly easy to find renters for your vacation property.
As a landlord, you can get tax deductions for expenses like interest, depreciation and other costs associated with keeping your rental afloat. Though these deductions apply to every property type we’ll review here, there’s more potential for more deductions due to the higher expenses you could incur with a vacation rental.
More Scrutiny of Temporary Rental Models
With home rentals becoming quite common due to platforms like AirBnb making it easier to rent even a spare room in your home, this business model has been under more scrutiny in places where housing costs are high. In some of these areas, there’s been an effort to promote more affordable housing stock, which have caused reactions by cities like San Francisco to limit the rental inventory of absent tenants.
Vacation rentals, by nature of the short-term use aspect, will have higher turnover. You’ll spend more on cleaning, maintenance and supplies. Plus, there’s more potential for wear and tear that will require more maintenance and replacement. For example, you may need to paint or replace carpet and some appliances more often in a short-term rental situation.
Don’t forget, you may have to hire a property manager to deal with the property when you are not in town. As you run your numbers, be sure not to overlook this important cost.
Vacation rentals acan have ebbs and flows in income due to high and low vacation season. If you are not carefully managing your cash flow, this could be a problem. You’ll want to make sure that you keep sufficient reserves around in case your rental income doesn’t cover expenses like your mortgage or maintenance expenses during slower times.
Single Family Residence Rental Properties
Single family residences can be a good start to real estate investing. Why? Well, because most people will start their own personal homeownership journey with a SFR. If you are considering this type of investment here are some ideas to pour over.
Financing & Affordability
As mentioned above, an SFR is one of the easier types of property to finances. They can be purchased at a reasonable price with relative ease due to the abundance of bank financing available for these types of properties. As long as you meet certain requirements around debt-to-income ratio, credit profile and income, you should be able to purchase a SFR.
Owner-Occupant Financing & Investment Potential
There are even more favorable financing programs available for owner-occupants. Many people begin investing in SFRs as owner-occupants, then move on to other properties while renting out their former home. They simply repeat the process until they amass their desired number of properties.
If you’re looking for more stable predictable income, a SFR investment may what you’re looking for. Evan Roberts is a real estate agent with Dependable Homebuyers who notes, “Unlike multi-units which have frequent turnover, single family tenants are more likely to treat the home as their own and stay for many years. This creates a more stable and predictable income since vacancies are less common.”
Depending on your acquisition method, (i.e. using the owner-occupancy strategy outlined above,) you may find that it takes a longer time to accumulate properties. This could make scaling your real-estate investment business.
A single family home may not bring in as much income as vacation rentals and multi-units. A two unit building with similar square footage will bring in more in rental income than the SFR. Also, vacation rentals tend to be higher priced and will seem to have more income relative to this property type.
Should your SFR experience vacancy without sufficient cash reserves, you could be hard-pressed to make monthly mortgage payments. You can check local vacancy rates to give you an idea of the percentage of time you can expect your property to be vacant.
Purchasing a multifamily rental can be a great boost to your net worth and property portfolio.. However, there are several things to consider when investing in multi-unit property for passive income.
If you decide to purchase up to a four-unit property and live in it, you are eligible for conventional bank financing. You could even use FHA financing to put around 3.5% down on the property as long as you will occupy it for at least one year.
With a multi-unit property, you can service many tenants at one time. Whether you are managing the property yourself or hiring someone, it can be easier to have a single location to manage, yet with multiple sources of rental income.
Of course, this income is relative to your expenses, but if you can imagine yourself owning a 50-unit apartment complex, your monthly or annual income per unit is multiplied by 50! With more income you have the potential to build equity faster, too. Of course, this kind of income potential will not come easily, but it’s exciting to consider this as a possibility when you are investing in real estate.
If you decide to purchase a multi-unit with more than four units, you will be required to put a down payment of 20%-30% for financing received as an investor as opposed to an owner-occupant. If you do not have this much cash available for a down payment, this could prevent you from acquiring this property type.
Multi-unit buildings can be considerably more expensive than their SFR counterparts. The higher purchase price of a three or four-unit building can be a big deterrent for many would-be investors. However, to find out if this property is “too expensive” for you, you should calculate potential returns relative to the purchase price.
Cash Reserves & CapEx
Though the bank will consider the rental income when you apply for financing on a multi-unit property, they may also have requirements around liquidity, cash reserves and other financial criteria. They may ask you to have enough money available to cover capital expenditures (CapEx) or a certain amount of mortgage payments in the bank to reduce the risk of defaulting on the loan.
Recent Tax Law Changes
Finally, it might be helpful to know how recent tax law changes will affect real estate investments. For example if you decide to purchase your property in an entity, like an LLC, there could be more benefits. Jason Reed of the Duplex Doctors, says, “Passthrough entities will now be able to deduct 20% of their business income (and not pay state or federal income tax on it).”
Evan Roberts gives an example of how this might affect your real estate investment strategy, “With the new tax reforms in place a vacation home is a less desirable investment because the deduction (combined with your state income tax and primary residence) is capped at $10k. Single family rentals held in an LLC however are benefited by the new tax reform as they are treated as a pass-through business.”
Do Your Own Research
Of course, all of these recommendations are sweeping generalizations. Many of these statements and assumptions can be proved or disproved based on location and market conditions. At the end of the day, you’ll have to do your own research in the market where you’ll be purchasing to find out the real story along with the numbers that support it.
Once you research is complete, purchase the property type or types that appeals to you the most. There’s always the risk of making a bad decision in investing, but the good news is that you can get better at real estate investing with experience.
Thank you for reading all the way!
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