The strong demand for rental property, low interest rates, and the potential for robust returns are helping to make real estate an increasingly popular investment. In this article, we’ll take a look at the main types of real estate available for investment, explain common ways to invest in real estate, and discuss why people are attracted to investment real estate.
- There are 4 main categories of real estate: residential, commercial, industrial, and land.
- Ways to invest in real estate include purchasing shares of a REIT, owning a home as a primary residence, and purchasing a single-family rental property.
- Three reasons for investing in real estate are generating rental income, profiting from potential appreciation in property value, and tax benefits.
- Real estate investors conservatively use leverage as a tool to help increase potential returns on investment.
What are the types of investment real estate?
There are 4 main categories of real estate that people invest in:
- Residential real estate, such as single-family rentals (SFRs), condominiums and townhomes, and small multifamily buildings with 4 units or less.
- Commercial real estate like retail shopping centers, office buildings, large apartment buildings, or mixed use properties with both residential and commercial space.
- Industrial property, including cold storage facilities, warehouses, distribution centers, and research and development (R&D) properties.
- Land for future development or use, such as agricultural land used to grow crops or raise livestock, subdivided land in a subdivision, and individual lots to build a home or building on.
Real estate investors may be categorized as active or passive investors. An example of an active real estate investor is someone who self-manages a rental property instead of hiring a professional property manager.
Passive real estate investors are those who delegate the majority of the work involved in owning and managing a property to others, such as owning shares of a REIT, investing money in a crowdfund, or hiring a local property manager to handle the day-to-day details of a single-family rental home.
How to invest in real estate
There are countless ways to invest in real estate, including flipping houses, wholesaling real estate, and purchasing shares of a real estate limited partnership (LP) or limited liability company (LLC).
For real estate investors seeking a balanced blend of potential risk and reward in their portfolios, here are 4 common strategies used to invest in real estate.
Purchase a primary residence
Instead of paying rent to a landlord each month, many people save for a down payment to purchase a primary residence to live in. Historically, property prices tend to rise over time, creating equity for a homeowner.
According to Zillow, the value of a typical middle price tier home has nearly doubled in less than 10 years. That means that a typical home purchased for $187,000 back in 2011 would now be worth approximately $356,000, assuming the property was properly maintained.
Single-family rental homes
Another popular strategy for investing in real estate is to purchase a single-family rental (SFR) home. The right SFR may offer nearly everything an investor is looking for: recurring rental income, appreciation in property value over the long term, and the tax benefits that real estate investors enjoy.
As the most recent Single-Family Rental Investment Trends Report from Arbor reveals, vacant-to-occupied rent growth accelerated by 12.7% over the past year. Annualized monthly rent growth for property already occupied has averaged 8.1% since May 2020, compared to an historical average of 3.3%. Occupancy rates for single-family rental homes at 95.3%, a level not seen since 1994.
Real estate investment trusts and ETFs
Real estate investment trusts (REITs) are companies that purchase, own, and operate different types of real estate, including residential rental homes, student housing, commercial property, and special purpose real estate such as cell phone towers. For example, newly launched Roofstock One is a private placement REIT offering tracking stock tied to SFR portfolios to accredited investors.
Shares of publicly traded REITs can be bought and sold online, similar to the way that any other stock is traded. One of the nice things about investing in a REIT is that they are required to pay out 90% of their income as dividends to their investors. According to Nareit (September 30,2021), residential REITs have an average dividend yield of 2.51% and a total year-to-date return of 36.29%.
Similarly, real estate exchange-traded funds (ETFs) hold baskets of securities in the real estate sector.
Crowdfunds for real estate
Real estate crowdfunding platforms offer investors a way to place small amounts of capital in large real estate projects, such as single-family rental home developments, apartment buildings, office properties, and shopping centers.
However, unlike publicly traded REITs, money invested in a crowdfund may be locked up for several years, and in most cases crowdfund shares are illiquid and difficult to trade. Another potential drawback to crowdfunds for real estate is that some opportunities are restricted to accredited investors with a net worth of at least $1 million (excluding a primary residence) or with an annual individual income of $200,000 or more.
Why invest in real estate?
People invest in real estate for several reasons, including generating rental income, profiting from the potential appreciation in property value over the long term, and reducing taxable net income.
One of the unique things about real estate as an investment asset class is that it may be possible to achieve all three of these things – income, long-term profit, and tax savings – at the same time while using other people’s money.
Use leverage to invest in real estate
People who invest in real estate directly by owning property such as a single-family rental (SFR) home often use leverage – also known as other people’s money – to finance the property purchase.
To illustrate how leverage works, assume an investor purchases a SFR for $120,000. One option is to pay cash for the property, while another option is to leverage the property purchase by making a 25% down payment of $30,000 and financing the rest.
Now assume that after 5 years, the home is worth $176,000. If an investor had paid all cash, the profit would be $56,000 and the cash on cash return would be 47% ($56,000 profit/$120,000 purchase price cash invested).
However, if an investor had used leverage to purchase the home, the profit would still be $56,000 but the cash on cash return would be 187% ($56,000 profit/$30,000 down payment cash invested). In other words, by wisely using leverage by making a conservative down payment, an investor nearly doubled the cash on cash return in this example.
Another reason people invest in real estate is to generate monthly cash flow.
Depending on the type of real estate owned, an investor may earn income from dividend distributions from a REIT or crowdfund, or an annual cash return by directly owning a property.
Profit from long-term appreciation
Housing prices historically increase in value when held for the long term, although there may also be times when home prices decline.
According to the Federal Reserve, the median sales price of houses sold in the U.S. has increased by more than 25% since the 2nd quarter of 2020, and by over 94% since the end of the Global Financial Crisis (GFC) of 2007-2009.
However, the median sales price of houses sold during the GFC declined by about 20%. During this 2-year period, millions of people lost their homes through foreclosure, allowing some buyers to purchase inexpensive homes and wait for the real estate market to rebound.
Save money on taxes
The IRS offers real estate investors numerous tax deductions to reduce taxable net income. For example, rental property owners can deduct ordinary expenses from rental income collected, including:
- Property management fees
- Leasing commissions
- Repairs and maintenance
- Mortgage interest
- Property taxes
- HOA fees
Depreciation is another way that real estate investors lower pre-tax income.
Residential real estate can be depreciated over a period of 27.5 years, excluding the land value. If an investor owns a home worth $120,000 net of the land value, the annual depreciation expense used to reduce a taxpayer’s taxable income would be $4,367.
Tips for choosing a single-family rental
While investing in a single-family rental may offer the opportunity for recurring returns, directly owning rental real estate requires work and planning as well. Here are tips investors may wish to consider before purchasing a single-family rental home:
- Pay off high-interest personal debt so that extra cash is available if and when it is needed.
- Save or raise money for a down payment, normally 25% of the purchase price for an investment property loan.
- Find a location where the population and job market are growing and the demand for rental property is strong.
- Crunch the numbers by analyzing current and future rental income, operating expenses, and anticipated return on investment.
- Contribute to a capital expense account so that funds are available for major repairs and updating.
- Learn how to be a landlord by knowing the state landlord-tenant and fair housing laws, or hire a professional property manager.
- Purchase a landlord insurance policy and consider requiring the tenant to obtain a renters insurance policy if the local laws allow.
There are a number of ways to invest in real estate, including purchasing shares of a REIT, putting money into a crowdfund, and purchasing a single-family rental home. Directly investing in real estate by buying rental property offers the potential for both short-term return from rental income, long-term returns from property value appreciation, and tax benefits used to reduce the amount of taxable income. As with any other investment, prudent investors take the time to analyze the potential risks and rewards before investing in any type of real estate.