Many new real estate investors start with dreams of becoming the next real estate tycoon. Becoming a tycoon is a lofty goal – and as with most other big ideas, the reality is that most investors need to start with the basics and work their way up to tycoon status.
As an investor, you may find you have a knack for finding and buying specific types of properties, those with significant cash flow that will generate reliable income and appreciation over time. But strong instincts and knowledge don't develop overnight, and all investors have to start somewhere.
As you get started, it's worth learning about different types of investment property, the pros and cons of each, and think about which type might be best for a first investment opportunity.
Different Types of Investment Property
While not an all-encompassing list, here's an overview of different options for the first-time real estate investor to consider.
Residential Real Estate - This blanket term applies to many property types, including single-family homes, duplexes, triplexes, and condos. Multi-family properties with three or fewer units fall under the residential umbrella. Buildings with four or more units are considered a commercial property. They are subject to different standards for lending and insurance standards – even if the units are residential and not used for office space.
Commercial Real Estate - Refers to hotels, office buildings, apartment complexes with four or more units, industrial buildings, warehouses, and retail space.
Land and Development - A few real estate types fall outside of residential and commercial categories because they are either undeveloped land, farmland, or ranch land. Land like this often holds great value as a site for a business facility or future development opportunity.
Why Choose Residential Real Estate?
Residential real estate can be a straightforward investment that earns consistent cash flow. When managed correctly, residential properties can yield attractive profits. You gain several tax advantages and receive steady cash flow and benefit from the properties' appreciation.
Advantages of Commercial Real Estate
Commercial real estate offers potential for higher profits and greater cash flow than you might see with residential property. Although they typically represent a larger initial investment, commercial properties have higher income potential, longer leases, and lower vacancy rates than other forms of real estate investing. Investors may have less competition when searching and bidding on a commercial property because such transactions take longer and are more complex than a residential home purchase. With commercial real estate, you earn steady cash flow and benefit from the building's appreciation and several tax benefits.
Pros of A Land Investment
A land investment, whether only vacant ground or a tract zoned for future development, can diversify an investor's portfolio. With a land purchase, you are, in effect, speculating on the likelihood of future expansion to increase the land's value.
Be prepared to complete extensive market research to understand development plans and probable timing – successful land investors often hold a property for years before significant appreciation kicks in to support a profitable sale.
The Downside of Residential Real Estate
When you invest in real estate, your money is tied up for as long as you own it. It is a non-liquid asset. The only way to access your cash is to sell or take out an equity loan, which may or may not be desirable. Managing the property as a rental is time-intensive – showing the property, signing new tenants, cleaning and maintenance, and handling tenant issues can be both demanding and unpredictable. You need to go in with a mindset that accepts the time burden or hire a property management company to handle the daily operations. With tenants, you do have the risk of property damage and need to carry adequate insurance – for your protection.
The Downside of Commercial Real Estate
Vacancies are more common in commercial buildings than in residential rentals. While it's important to have stringent lease requirements, it might mean you wait six months or more for a suitable tenant. Plus, commercial real estate lease agreements are complex – you may need to work with a lawyer to finalize a version that protects you and your tenants.
Commercial loans require a more significant upfront investment than you would need for a residential property. Lenders consider a commercial property to be a higher risk and require a 30 - 40% downpayment.
Poor economic conditions hit commercial properties harder (and sooner) than the residential market. If your business tenant has to move to smaller, less expensive space, or if the business fails, it could take months to replace the tenant, and you might need to do it at a lower lease rate.
The Downside of Investing in Land
Land on its own does not produce cash flow, and you still pay taxes on parcel. It's also more difficult to find a lender to help you purchase vacant land. You gain fewer tax breaks on land investment, as you have no mortgage interest to deduct. And unless you bring in sewer and water improvements, you won't have any structural items to depreciate. If the market changes and it looks like your parcel is no longer a development prospect, you may be sitting on that land until you decide to build on it yourself or sell it as is.
The choices you make to invest in real estate, and your investment goals and risk tolerance should drive the type of property that suits you as an investor. Most seasoned investors will tell you that the first couple of purchases will be nerve-wracking, and you are bound to make a few mistakes along the way.
Your financial situation, long-term and short-term investment goals, and real estate knowledge are the most critical factors to your success. Real estate is a long-term play; it can be extremely lucrative if you continue to build experience in your chosen markets and pursue different opportunities to increase cash flow. Real estate is an investment that can grow with you as you do your homework and learn it.
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