I know the title here sounds quite fundamental, but you’d be surprised how we hear from clients who are confused or even intimidated by the different forms of real estate investment that might make sense for their situation.
In this blog, I’d like to focus on a few of the most common types of investment real estate properties and which type of investor these types may be appropriate for, and which not.
Single Family Home (SFH)
It is quite common for individual investors to start with buying and renting a single-family residence. This is pretty straight forward and enables investors to dip their toes into the landlord business. Notice I said “business; please never forget from day one this is a business. Far too often we find new investment property owners are excited about their new investment and tenants and forget this is a business endeavor for which you have a sizable portion of your hard-earned,hard-saved capital at work and at risk.
This new investment starts with the purchase and then the hunt for, and approval of, tenants; if there are not already tenants in place.
If the purchase was researched properly and proper market and rent analysis have been completed, a SFH can be an excellent long-term investment. Depending on the location of the SFH, there will most likely be nice appreciation over time. If the yield, or cap rate, has been calculated prior to purchase to ensure proper rents are applied then there should be significant positive monthly cash flow as well.
The most common mistakes we see in these situations, especially with new landlords, is they do not adequately screen tenants or protect themselves with a sufficient amount of rent and security deposit. I recently spoke with one owner who didn’t charge enough for a security deposit and when the tenants moved out there was over $4,000 in damage to the home. This is not the time to try to be nice and put yourself at risk. This is why I constantly remind people that being a landlord, even for just one SFH, is a business.
The other common risk here is the lack of diversification. Here, in the San Francisco Bay Area, a SFH can easily cost over $1 Million; that is going to require a great deal of capital for down payment, mortgage payments, maintenance and taxes. If an investor is going to be heading down the path of putting all their real estate investment eggs in one proverbial basket, then I want them to be sure they are doing a lot of research before committing.
Most often when people think of commercial property they think of large buildings that house retail stores, but it is important to remember “commercial” covers a vast number of businesses that may rent such properties. Yes, retail, but also personal/professional services (hair, massage, medical, financial services) auto shops, storage, logistics companies, manufacturing and the list goes on and on.
In many cases there are multiple tenants in one property. ; ideally there is more than one unit in your commercial building. If so, you are now reducing your risk with diversification.
Better yet, your multiple tenants are also in different industries. Multiple tenants in multiple industries or fields of practice, will help offset any downturn that may occur in any one segment of the economy affecting some of your tenants. We’ve seen this a lot recently where the hospitality industry has suffered greatly during the COVID-19 pandemic while others have continued to get by, and others are thriving.
The most common mistake here is having too high a percentage of your investable assets in one large investment, as these properties tend to be very expensive and may even require you to have a partner.
In finance, we call this a highly concentrated position. Remember, we like to see diversification within an asset class, i.e.real estate, but also across asset classes, i.e. stocks, bonds, real estate, cash, alternatives.
The last property type I’d like to bring up for discussion is multi-family.
Generally, multi-family is considered to be anything over four units in a building. One-to-four-unit buildings are still considered not to be multi-family, but for our purposes anything over one unit is considered multi-family.
Perception is that these are large apartment complexes; and while they can be, it is more likely for individual investors to invest in multi-family properties with less than ten units. Additionally, we have several clients who own duplexes; somelive on one side, while renting the other.
This starts to become much more complicated when dealing with multiple units and multiple tenants. In some cases, clients have no idea what they have gotten themselves into and have a nightmare on their hands.
This is where many hire property management companies to handle all of this. If you’ve heard me speak or have read me much, you will know that in our firm we call this the Terrible T’s. You’re going to be dealing with a lot of Tenants, Toilets and Trash. A metaphor for the hassles and problems that come with being a landlord, especially in regards tomultiple units or properties.
Some investors are well suited for this and have the infrastructure and resources to handle this and handle it professionally.
I highly recommend using a management company if you have not done something like this before.
But first, calculate your CAP rate.
Of course, it is possible to have a combination of the property types above. It may be helpful for stability of the investment by having diversification within on property.
In any event, please calculate your CAP rate and benchmark it to the marketplace and alternatives to what you are considering.
At a minimum, here is what we want our clients to achieve with CAP rates*:
Managing themselves: 7%-9%
Management Company: 5%-7%
*Net income before income taxes.
Real estate is a wonderful investment and an important asset class for investors to participate in for the long term. Property type, location and diversification of property and tenants are extremely important to reduce risk and increase likelihood of success.
Treat it like a business from day one: entity, bank accounts, liability insurance, retirement plans should not be overlooked.
If you are tired of managing property and want to learn how to convert to passive investment with experienced commercial real estate developers and managers, please contact us and we will help you understand your options and the opportunities and risks with those options.
Bruce Frankel© 2021