Categories: Education

The Ultimate Guide to Investing in Rental Properties

Introduction

Many well-heeled investors will come to realize that their investment portfolio is too heavily skewed toward traditional stocks and bonds. Upon this realization, they will begin to look at ways to diversify their portfolios – oftentimes, by adding alternative investments. One of the most popular alternative investments is commercial real estate.

Commercial real estate comes in many shapes, sizes, property types, and forms. There are small, individual rental properties such as single-family rental homes. At the other end of the spectrum, there are 800+ unit apartment buildings, commercial office towers, hotels, and retail strip centers. The diversity of commercial real estate as an asset class is one of the reasons it attracts so many investors. There is virtually a rental property of type to meet the needs and risk tolerance of any given investor.

That said, the sheer breadth of commercial real estate can be overwhelming for those investing in a rental property for the first time. Today, we provide a simple, easy-to-understand guide for those interested in commercial real estate investing. The examples used here skew toward residential investments but can generally be applied to other forms of commercial property as well.

Related: Recession-Proofing Your Real Estate Portfolio

There are many strategies for investing in rental property. The first distinction to make is between active and passive investing.

Active investing is when a person, sponsor, or entity puts up a share of the equity needed to buy or renovate a property, raising the remainder of the equity from passive limited partners. The operator or fund manager will then oversee all day-to-day activities related to that investment property, ranging from acquisition to financing, construction to lease-up, stabilization, and eventually through to disposition. Fund managers/operators often have the most at stake for ensuring a rental property is managed properly and well-maintained.

At a small scale, someone might decide to purchase a two- or three-unit multifamily building. Investments of this scale are usually manageable, even for those with little real estate experience. Larger projects will require the operator or fund manager to be more heavily involved, with the amount of work often equating to a full-time job.

Passive investing is when a person invests in rental property, often with or alongside the operator or fund manager, and then takes a backseat role while the operator manages the project. Passive investing is similar to investing in stocks or bonds, in which the investor has little control (if any) over day-to-day decision-making. Depending on the investment vehicle, a passive investor may have more or less access to the sponsor and the ability to provide input related to business plan execution.

Another form of passive investing is purchasing shares of a REIT or real estate investment trust. REITs are usually (but not always) publicly traded companies that invest in and manage commercial real estate. When investing in a REIT, you are purchasing a share of the company that oversees those investments – you are not buying a real estate asset itself. The benefit to investing in a REIT is that, like buying other stocks and bonds, it is a way for investors to preserve liquidity as shares can be easily purchased and sold with the click of a button.

Related: REITs vs. Real Estate Funds

Other Investing Strategies

Aside from active versus passive investing, there are other real estate investing strategies. One such example is investing for cash flow versus investing for appreciation, or some combination of both. Those who invest for cash flow will often be drawn to Class B and Class C assets that are less expensive to purchase but, when stabilized, offer tremendous cash flow potential. Those who invest for appreciation will often be drawn to Class A or B properties in top-tier markets that are expensive, generate less cash flow initially, but have the potential to increase in value over time significantly.

There are other investment strategies, such as ground-up development and value-add development. Ground-up development, as its name would imply, involves the acquisition of raw land upon which a newly constructed property is built. Ground-up development can be risky. There are a lot of unknowns related to permitting, design and construction. These projects also have a long time horizon. Depending on the scale of the project and market, it could take two or three years to get the project permitted and designed alone. It may take another two years for construction and two more years after that to lease-up and fully stabilize the asset.

Value-add development is when someone purchases an existing property and then invests in property renovations to some degree. A “light” value-add might only require new paint, carpet, and fixtures, whereas a “heavy” value-add may require gutting each unit to the studs and virtually starting from scratch.

Buy-and-hold investing is another strategy for investing in rental property. With this strategy, the investor will purchase a property, usually already in decent condition, and hold it for the long term. Buy-and-hold investors can run the gamut; some will buy already stabilized assets, whereas others will deploy a value-add strategy and then continue to hold the property instead of selling it for a profit. Buy-and-hold investors generally plan to own a property for at least 7 to 10 years or longer – may be intended never to sell.

Ground-up development, as its name would imply, involves the acquisition of raw land upon which a newly constructed property is built. Ground-up development can be risky. There are a lot of unknowns related to permitting, design and construction.

Value-add development is when someone purchases an existing property and then invests in property renovations to some degree. A “light” value-add might only require new paint, carpet, and fixtures, whereas a “heavy” value-add may require gutting each unit to the studs and virtually starting from scratch.

Buy-and-hold investing is another strategy for investing in rental property. With this strategy, the investor will purchase a property, usually already in decent condition, and hold it for the long term. Buy-and-hold investors can run the gamut; some will buy already stabilized assets, whereas others will deploy a value-add strategy and then continue to hold the property instead of selling it for a profit. Plan to own a property for at least 7 to 10 years.

How to Determine a Good Rental Property

Determining a “good” rental property is largely dependent upon any individual’s investment preferences, goals, and risk tolerance. Those looking to actively own and manage rental property may want to look for properties that have already been renovated (referred to as “turn-key”); this will reduce the management burden. Investing in stable communities with good schools, access to employers, and in close proximity to goods and services is another way to ensure you will find good tenants. It also increases the likelihood that the property appreciates in value over time.

Someone who prioritizes cash flow may instead look for properties located in fringe neighborhoods. These properties are generally more affordable but can still produce strong rents. In exchange for the increased cash flow, though, an investor is taking on more risk since these are not as well-located as properties located in highly sought-after neighborhoods. Investors pursuing this approach will want to consider whether a neighborhood is up-and-coming, stable, or on the decline. It is always smart to invest in stable or up-and-coming neighborhoods; the latter, in particular, can offer a great combination of immediate cash flow and long-term appreciation.

Many investors are told to use the “1% rule” when evaluating properties. This guideline suggests that investors estimate a property’s monthly net operating income and then divide it by the purchase price. If that number is in the 1% range, then it is potentially a “good” rental property. Although this is a good guide, some markets do not provide 1% opportunities.

An alternative is to look at cash-on-cash returns. The cash-on-cash return is calculated by taking the annual before-tax cash flow and dividing it by the total cash invested in the deal. Cash-on-cash returns are therefore higher when an investor uses leverage (a mortgage) since their personal investment is lower. An investor can then look at the cash-on-cash return and determine if they could be investing that same amount of cash elsewhere to generate a higher return on investment. For example, if they assume they will make 6% in the stock market, and a deal presents itself with the potential to generate a 9% cash-on-cash return, then this might be a good investment – regardless of whether it meets the “1% rule” described above.

Related: Real Estate Syndication: What Is It?

Buying a Rental Property

There are many costs to consider when buying a rental property. In addition to the actual purchase price, an investor must also factor in closing costs, taxes, and insurance, utilities, the cost of routine repairs and maintenance, property management, legal fees, leasing broker fees, and more. Many first-time investors underestimate the costs associated with buying a rental property. One of the biggest mistakes, for example, is overlooking a major capital expenditure such as a new HVAC system or major roof repair. Several investors will also forget to factor in vacancy; few properties are ever 100% occupied. At a minimum, an investor will want to carry a 5% vacancy to account for the time it takes to turn over units between tenants.

Unless someone feels highly confident with the costs associated with buying and managing a rental property, it is usually best to passively invest with a sponsor or developer who understands the nuances of commercial real estate investing. The individual returns might be lower than if you were to purchase and own the property outright, but it provides a buffer and third party to help mitigate the risk for those who have never owned rental property before.

Financing a Rental Property

Most investors will finance the purchase and renovation of rental property. Unlike buying a primary residence, buyers will usually need to put down at least 20 to 25% in equity when purchasing a rental property. The more equity someone invests, the better terms they will get on the mortgage. In general, the rates associated with investment property are already about 50 to 100 basis points higher than someone might get on a primary residence.

It is important to understand how lenders evaluate rental properties. In addition to looking at the borrower’s personal credit score and liquidity, the bank will look at whether that borrower has experience owning and operating the rental property. They will place a large emphasis on the property itself, beyond just looking at comps in the marketplace as they might do with single-family owner-occupied properties.

With rental properties, the lender will also look at the property’s current and potential cash flow. Many lenders will underwrite a deal based on the cash flow (or cash flow potential) even in circumstances when the borrower has little experience or a poor credit score. The lender wants to know that if they need to take back the property for any reason, it will have the income needed to justify the cost of holding the property.

Although most people will use a traditional bank loan to finance a rental property, there are other tools, such as hard money loans, that some investors will consider if they are unable to finance a property through traditional means. Online crowdfunding (both debt and equity) has also become increasingly popular in recent years.

Related: What Are Illiquid Investments?

Why Invest in Rental Properties?

Leverage

As noted above, most people purchase a rental property using leverage (i.e., a mortgage). This would allow someone to, for example, purchase a $500,000 rental property by only putting in $125,000 of their own money. Over time, the owner pays down the mortgage using the rents collected from tenants. Even in a situation in which the property does not appreciate in value, the owner will eventually own the property outright. Now, that $125,000 is worth the full $500,000 in equity. 

Rental property can provide
stable and predictable rental income

Let us say someone has $250,000 to invest. They could buy two separate rental properties, each worth $500,000. Over time, as those loans are paid down, they will own $1 million in rental property.

If that same investor was to invest in stocks or bonds, they would only be able to invest $250,000 to get $250,000 in value. The equities might increase or decrease in value over time, but either way, the investor does not get the benefit from the leverage that they would by investing in rental property.

Ability to Control Returns

Another benefit to investing in rental property is the ability to control returns. For example, a property may stand to generate a 12% cash-on-cash return if the investor simply buys and holds the property as-is. However, that same owner has the ability to make improvements (often via sweat equity) to increase the value and cash flow potential of the property. In this way, an investor has a much better chance of controlling returns than they would if investing in stocks, bonds, or other traditional equities where returns are more subject to overarching market dynamics.

People Need a Place to Live

Residential real estate, single-family rentals to large apartment communities, are a particularly attractive form of rental property investing because ultimately, everyone needs a place to live. Whether we are in a good market or a down market, people always need housing. In fact, in a down market, residential rentals perform exceptionally well. People who would otherwise own their own homes end up renting for longer periods of time while the economy recovers.

Stable and Predictable

Rental property can provide very stable and predictable rental income. On the commercial side, tenants will often sign 5 to 10-year leases. Some will even sign 30+ year leases (think: Walmart and other major companies). Residential leases tend to turn over on an annual basis, but nevertheless, when effectively managed, these units can be released quickly to ensure consistent, stable cash flow. This proves to be the case even during economic downturns. During the most recent, COVID-induced downturn, the federal government spent billions of dollars to bolster the economy. Most households received stimulus checks that helped them pay their rent, and in turn, landlords’ cash flows remained strong.

Great Varieties

Rental properties come in so many varieties. There are many property types, including multifamily, office, retail, hospitality, industrial, self-storage, and more. There are opportunities to buy turn-key properties, value-add properties, and ground-up development deals. Properties can cost less than $100,000 – or several hundreds of times more. The variety of rental properties is what makes it so appealing to investors of all kinds.

Simple and Straightforward

Depending on the type of rental property you buy, owning and managing the property can be relatively simple and straightforward. Those who buy turn-key investments will find the heavy lifting has already been done. These properties have been renovated and are often already leased; the investor can simply collect the cash flow. This is especially true when the owner hires an adept property manager to oversee the investment on their behalf.

On the other hand, large ground-up development deals can be extremely complicated – and, therefore, are best left to experienced sponsors who can manage the day-to-day. These investments can be attractive to passive investors, though, who leave the complexities to the sponsor to figure out.

Various Ways to Profit

There are many ways to profit from a rental property. As noted above, many investors will buy rental profit for some combination of cash flow and appreciation. Depending on the nature of the investment, profits may skew more towards cash flow than appreciation or vice versa. The degree of cash flow and appreciation is often well within the investors’ control, depending on their strategic property improvements and overarching business plan strategy.

There are also many tax benefits to owning rental property, such as depreciation, a tax write-off that investors can take even when a property is technically appreciating in value.

Final Thoughts on Investing in Rental Properties

Many investors will find that there are only so many ways to “earn” money without being physically present. Rental property is one such avenue. Owning rental property, as either an active or a passive investor, is a way to generate income without having to be physically present. Of course, operators/fund managers will need to play a hands-on role from time to time, but this is not necessarily an everyday responsibility. Some investors might only visit their rental property once a year—maybe less if they have a property manager working on their behalf.

“While rental properties are not without their risk, they can be more
or less de-risked through thoughtful management.”

Anyone looking to maximize their income without taking on another full-time job will certainly want to consider real estate investing. While rental properties are not without their risk, they can be more or less de-risked through thoughtful management and execution.

At Smartland, we have unique deals for active and passive investors alike. Those who want to try their hands at active investing might consider investing in one of our single-family rental homes. We have a portfolio of turn-key properties where all the heavy lifting has already been done. Those looking for a truly passive way to invest in real estate might instead consider one of our funds. Through our funds, you will gain access to significantly larger value-add and ground-up development deals that we manage on behalf of our investor partners. We understand that investors have different priorities and, as such, have different options to meet those needs.

Interested in learning more about how to invest with Smartland? Contact us today!


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