Real estate investments can offer additional wealth to fund retirement, increase an emergency fund, pay off debts, and increase an investor’s asset portfolio.
Real estate investment can be a great way to generate passive income through rental income and increased property value. Understanding the basics of owning income-producing property helps potential investors develop an investment strategy that works for their financial goals.
What Is an Income-Producing Asset?
Income-producing assets are assets that generate cash flow. An individual pays money to own or invest in these assets with the expectation that they will earn income from the asset in the future. Some income-generating assets require little financial investment to get started, while others demand a significant amount of capital.
Purchasing or investing in income-producing assets should involve careful strategy. Investors may be interested in diversifying their portfolio of income-producing assets between several types. This approach can benefit investors in the long run by protecting them from loss if one or more other income streams fail.
Income-producing assets include stocks, bonds, savings accounts and certificates of deposit. Real estate investments can be a profitable type of income-producing asset, as they can yield high returns for low risk. A property can generate income for an investor through rent earnings.
Types of Income-Producing Real Estate Investments
Real estate investments can be an effective way to generate passive income. Many investors are drawn to real estate investment because it provides multiple avenues for return, such as rental income and potential appreciation of the property. Real estate properties can also offer tax advantages through 1031 exchanges, which allow investors to buy and sell like-kind properties while deferring capital gains taxes.
Whether renting out an apartment complex or investing in a real estate investment trust (REIT), real estate provides several opportunities for generating income.
1. Single-Family Homes
Investing in single-family homes gives investors the option to rent a property to a single tenant. Obtaining financing to purchase a single-family home is typically as straightforward as getting preapproved for a mortgage and calculating the potential return. Single-family homes can be an ideal income-producing asset for investors new to real estate or who have the time to manage properties themselves.
Advantages of investing in single-family homes include:
- Long-term appreciation: A single-family home often appreciates over time, leading to greater returns.
- Consistent demand: Despite rising prices, sales of single-family homes have also increased over the last three years. Single-family homes are usually in high demand, making this type of property relatively simple to rent and resell, depending on location and market conditions.
- Affordable property taxes: Property taxes on a single-family home are generally less than on multi-family homes or commercial properties.
This type of real estate investment can also carry some disadvantages:
- Fewer rental opportunities: A single-family home only provides one income stream, limiting the potential return on investment.
- Dependence on tenants: Investors must first attract the right tenants to the location.
2. Multi-Family Homes
Multi-family homes include homes with multiple units, such as duplexes, triplexes, and fourplexes. Obtaining financing for multi-family homes requires a commercial mortgage. Lenders examine the income the property is expected to produce and may require a specific credit score or net worth amount. Investors who are new to multi-family homes may choose to partner with veteran investors when getting started.
The pros of investing in multi-family homes include:
- Multiple cash flow opportunities: Multi-family homes allow investors to generate income through numerous tenants. Having multiple tenants can also lower the investor’s risk profile.
- The economy of scale: As investors purchase more properties, they may benefit from a few efficiencies. For example, replacing roofing or exterior paint for a multi-family home could be less expensive per unit than the same repair for a single-family home because the investor can spread the cost over multiple units.
Investing in multi-family homes can come with some cons:
- More challenging to obtain financing: Lenders may require a more thorough process for providing funding for a multi-family housing property because it functions more like a business.
- Larger upfront cost: Purchasing a multi-family home generally requires a more significant financial investment than buying a single-family property. There are also more units to manage, leading to a potentially higher maintenance cost.
3. Turnkey Properties
Turnkey properties are housing units that require minor or no renovation before investors can rent them out. New and experienced investors are drawn to turnkey properties because they require less work and are more convenient. Many turnkey properties are renovated, sold, and managed by turnkey real estate companies. This arrangement takes the pressure of managing the property off investors. Financing is generally easier for this type of real estate, especially if the property already has a tenant.
Investing in turnkey properties can provide advantages such as:
- Lower improvement cost: Investors in turnkey properties can save significant money on improvements and even maintenance.
- Immediate rental income: Because turnkey properties don’t require any improvements, investors can begin renting them right away.
- Easier to expand a portfolio: Turnkey rental properties allow investors to expand their real estate portfolio outside their home state or immediate vicinity if managed by a third party.
Turnkey property investment can also come with some disadvantages:
- Less control over the interior: Since these properties are already finished, investors have less control over the design and layout without incurring more costs.
- Little to no control in the management company: Owners of turnkey properties may not be included in the tenant screening process, as these tenants typically already have approval from the management company.
- Varying level of renovation: Investors interested in turnkey properties should investigate what work was done on the property, as definitions of turnkey can vary. If possible, investors should find out who performed the work. If it wasn’t done properly, investors can face bigger financial problems in the future.
4. Short-Term Rentals
Short-term rentals like those listed on Airbnb and VRBO are properties people rent for a short period, from a few days to several weeks. These properties might be multi-family homes, condos, or accessory dwelling units (ADUs). Those interested in investing in short-term rentals can obtain financing as quickly as for similar properties. Short-term rentals are often appealing to investors who want less commitment to tenants.
Investors in short-term rentals can benefit from pros such as:
- Flexibility for tenants: Short-term rentals offer tenants greater flexibility, as leases may run for a few days or up to six months.
- Tax advantages: Investors in short-term rentals might benefit from deductions and other tax advantages.
- Increased earnings potential: Rent for short-term rentals are generally higher than for long-term rentals.
Investing in short-term rental properties might also bring some cons, such as:
- Additional regulations and fees: Some states and municipalities have different rules about short-term rentals depending on the type of dwelling. Investors may also be required to obtain specific licenses and pay occupancy taxes.
- Potentially higher management costs: Owners of short-term rentals might see increased maintenance costs and longer vacancy periods than other real estate types.
- Lack of predictable income: Investors can be stuck paying the mortgage themselves if they cannot continuously fill the property and cover expenses with the rental income.
5. Apartment Buildings
Investing in an apartment building can bring in significantly more rental income than other types of residential properties. Investors interested in apartment buildings generally need a significant sum of money upfront and approval for a commercial mortgage. They usually have to meet stricter qualifications as well.
Investing in apartment buildings can provide pros such as:
- Higher returns: Since apartment buildings have several units, owners can typically expect higher rental income than for single-family or smaller multi-family properties.
- Vacancy carries lower risk: A single vacancy in an apartment building is less of a financial liability than a vacancy in a single-family home.
Investors in apartment buildings might also experience cons, including:
- Higher cost: Investing in apartment buildings costs more upfront and in maintenance fees over time than smaller properties.
- More involved maintenance: Apartment buildings require more maintenance than other real estate types. Some investors choose to outsource management to another company.
- Difficulties in attracting and keeping good tenants: It can be challenging to attract and retain good tenants to keep all the units occupied.
6. Commercial Real Estate
When comparing commercial and residential real estate, investors may prefer the lower tenant turnover and other benefits that commercial properties can provide. Commercial real estate comes in several types, including office buildings, manufacturing facilities, and self-storage facilities.
Investing in commercial real estate often requires significant expertise, time, and funds, making this type of property ideal for experienced investors. Investors must typically qualify for specific loans and invest more heavily in property management.
Advantages of investing in commercial real estate include:
- Consistent returns: Commercial real estate owners can generate revenue through monthly rent and property appreciation. In addition, commercial real estate usually has a lower tenant turnover than residential properties, which means more consistent cash flow.
- Escalation clause: Many commercial real estate owners include an escalation clause in the lease. This clause allows the property owner to increase rent directly or increase the common area maintenance fees tenants pay.
Potential disadvantages of commercial real estate investment include:
- Higher upfront investment: Commercial properties generally cost more than smaller residential properties.
- More complicated property management: Maintenance, repairs, and rent collection might be more complex with businesses as tenants.
7. Fix-and-Flip Real Estate
Fix-and-flip real estate properties require more intense improvement or development than other properties. Investors can usually acquire fix-and-flip properties at a discounted price because of their condition, improve them, and sell or rent them for a significant profit. Fixing and flipping properties can be profitable if investors know how to pick properties with potential.
Investing in fix-and-flip real estate could come with a few advantages:
- Lower upfront cost: Investors may be able to purchase and renovate fix-and-flip properties for less than the cost of buying an updated property. If they understand contracting work, they can reduce costs even further by performing some of the work themselves.
- More control over improvements: Investors in fix-and-flip properties have more input in the renovation process.
Fix-and-flip real estate could also bring disadvantages:
- Trouble estimating profit: Generating profit on a fix-and-flip property depends on several factors, including location and market state.
- More involvement: Investors in fix-and-flip real estate also have to spend more time on improvements.
- Difficulty assessing property value: If an investor assesses a property incorrectly, it could cause them to lose money rather than generate profit.
8. Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) are companies that own a portfolio of real estate income-producing assets. Investors can buy private or publicly-traded shares in a REIT and take their share of rental income as dividends. Investing in REITs can be a good choice for investors who want a hands-off approach to real estate investment. A broker can help investors find a REIT that fits their financial goals.
Investment in REITs might bring advantages such as:
- Less involvement: REIT investors can benefit from real estate investing without committing time and energy to managing their properties.
- Excellent for diversifying: REITs allow investors to diversify their portfolios by asset type.
REITs could also carry some disadvantages, including:
- High taxes and fees: REITs may charge investors high fees, usually 9% to 10% of the investment. In addition, investors only receive a portion of the rental income for each property.
- Little control: Because shareholders don’t directly own properties in a REIT, they have little input in their management.
9. Delaware Statutory Trusts (DSTs)
Delaware Statutory Trusts (DSTs) are legal entities created under Delaware Statutory Law in which investors earn a pro rata interest in the trust. DST investors can also receive distributions from the trust through rental income or the sale of properties the trust owns. DSTs free investors from the responsibility of property management and enable fractional investments in larger properties that might be too costly for one investor to purchase on their own.
There are several best practices and things to avoid when considering an investment in DSTs. Investing in a DST could bring advantages such as:
- No need for unanimous approval: Investors in a DST don’t need unanimous approval to deal with unexpected developments and mitigate losses. The signatory trustee is also empowered to reduce losses, such as by selling properties or renegotiating leases.
- Lower minimum investments: DSTs can have up to several hundred investors, significantly reducing minimum investment amounts.
DSTs could also carry disadvantages, including:
- Reliance on the trustee: Investors ultimately rely upon the trustee for the success of the DST. Trustees continually survey the market for opportunities, although they may work with property managers who oversee the properties and other professionals who help carry out the DST’s goals.
- Real estate risk: All types of real estate investments carry risk. Market volatilities could cause DSTs not to perform as expected, so forecasted cash flow isn’t guaranteed.
Which Income-Producing Real Estate Investment Is Right for You?
With so many choices regarding income-producing real estate investment, it can be challenging for potential investors to know where to start. Investors looking into income-producing real estate will likely face a few challenges, including:
- Rising interest rates: The U.S. Federal Reserve announced it would raise interest rates by historic levels to help curb inflation. With mortgage rates rising as well, experts are predicting that the demand for housing will begin to taper off.
- Illiquidity: Any real estate transaction can take months to close, making it difficult to turn an asset into immediate cash.
- Inexperienced management: Whether an investor manages a property themselves or outsources these tasks, ineffective management can quickly become expensive.
Despite these challenges, experts consider real estate a sound investment because of a historical upward trend. Investors may find it helpful to remember these tips when choosing an income-producing real estate investment:
- Understand your financials: A close look at your budget can help you determine what you can afford and which loans could suit your situation.
- Look at the market: Study the real estate market to determine the right time to buy and how much you’re likely to make when you sell.
- Consider property appreciation: In today’s economy, buying properties that will increase in value can be a beneficial move.
- Get legal advice: Having reliable legal advice can be a significant advantage in real estate investment.
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Real estate investment carries some risks, although it can also bring potentially high returns. Researching the real estate market thoroughly is essential to making informed investment decisions.
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