Investing in Rental Properties for Beginners
Rental properties have many things going for them as an investment asset. They can provide a regular source of cash flow, property appreciation, a counter-cyclical resistance to economic contractions, and significant tax advantages. However, there is one positive quality that is often incorrectly attributed to the sector- the status of rental property investments as a form of passive income. This vision can be particularly compelling for high net worth and high-income individuals, like physicians, who have an abundance of capital, but not much free time to actively invest.
To be clear, there are ways to generate passive returns through investing in multifamily and residential real estate- but the perception of rental properties as a "set it and forget it" investment is wildly off the mark. Leasing residential property to tenants involves a significant amount of work, from researching and acquiring properties to rehabilitations and renovations to ongoing operations like collecting rent, maintenance, finding tenants, etc. Luckily, there are several ways to obtain the ROI and tax advantages offered by residential real estate without direct investment or management on the part of the asset holder.
When most people think of investing in rental properties, they are thinking of the direct ownership model. Investors purchase a real estate asset like a multifamily building or single-family home and rent out units to tenants on short-term leases. In this model, investor-owners are responsible for:
Finding Investment Opportunities
Independent RE investors are responsible for finding potential acquisitions. This process involves working with an agent or a broker to find suitable commercial properties, or locating them via web platforms like LoopNet, Berkshire Hathaway, or 21st Century Commercial. Prior to and during this search, investors should do a deep-dive relating to the property markets in which they choose to invest, and the property type. For example, if an investor is worried about an economic slowdown in the near term, a multifamily property might be a better fit for their portfolio, compared to a high-end single-family home.
Evaluating Potential Acquisitions
Upon locating a possible acquisition, direct investors are required to perform due diligence on the property market, sector, the underlying business fundamentals of said property and the physical condition of the property itself. This process includes researching market metrics like the unemployment rate, population growth, educational attainment, demand for the property type in question, and other factors that can determine the success or failure of a residential investment.
Evaluating the financials of the business that underpins the property is also essential. Properly undertaken due diligence will include a detailed review of financial statements like property income, fixed and variable costs, vendor payments and relationships, as well as a physical inspection of the property and all systems contained within, like HVAC, boilers, pools, gyms, and other amenities and property features.
Most rental property investors use lender financing to acquire properties. The use of borrowed capital lets them purchase larger properties or a multitude of properties within a real estate portfolio. In addition, financing acquisitions can substantially reduce personal financial risk to the investor. Obtaining a commercial property loan is substantially different than the residential mortgage process most people are familiar with- in addition to the property itself, lenders want to look at the financial underpinnings of the subject property to ensure their investment is protected.
After securing financing, the next step is to purchase the property. For novice investors, it is highly recommended to work with a team to complete the transaction. This may include the services of agents, brokers, real estate attorneys, title agents, appraisers, loan officers, and other real estate professionals. Investors must work with a team until learning the ins and outs of commercial property transactions- one little mistake can end up costing big down the line. Eventually, direct property investors should try and reduce the number of professionals they work with on a particular deal, as everyone has to get paid, which affects the eventual return on investment for that asset.
For investors who do not have the time to invest directly, or for those who want to benefit from the scale and diversity benefits of a larger capital pool, there are a few ways to passively/indirectly invest in rental properties.
Many REITs, or real estate investment trusts, acquire and operate apartment communities or hold other residential properties within their portfolio. Most REITs are publicly traded and accessible via any broker like Charles Schwab, Robinhood, Citi Financial, etc. Popular rental property REITs include Mid-America Apartment Communities MAA, Equity Residential EQR, and Essex Property Trust ESS. Most REITs do not offer the same average returns as real estate funds, but their ease of access makes them a popular choice, especially among retail investors who want exposure to the property market without a large capital investment.
Private Equity Real Estate
This asset class is made up of private and public pooled investment in property markets. Their investment path is the same as an individual investor, just scaled-up. Private equity real estate funds purchase, finance, and own/operate properties, as well as generate returns through property appreciation.
Crowdfunded Real Estate
This form of real estate investing has grown in popularity, primarily due to lessened government regulations on crowdsourced real estate investments, and the rise of digital platforms that connect developers and investors for real estate deals. Investors can purchase fractional shares of properties which pay an expected return. Like REITs and private equity funds, the investor is responsible for coming up with capital and collecting returns- the rest of the work is up to the manager of the fund.
Investing in rental properties can be a phenomenal way to generate returns, as well as preserve capital over time. Despite the hype, directly investing in rental properties requires a substantial amount of work to create desirable returns, and protect investment portfolios against losses. For physicians and other working professionals, taking an indirect approach to investing, either through a REIT, private equity real estate fund or crowdfunding platform may be preferable, due primarily to the time-savings, in addition to the benefits that come from pooled capital and professional asset management.