The Pros and Cons of Different Real Estate Investments

May 11, 2015

Which property types are right for you?

 

 

Real Estate

Real estate investors can choose among many types of properties to generate attractive returns. Each property type has its own risk/reward profile, and it’s a great idea to select the types that best meet your criteria. Questions you have to ask yourself are whether you want to be an active manager or a passive investor, how much you want to invest, your required rate of return to compensate you for the stated risk, whether you are looking to develop and sell/rent a property or simply collect rent from an existing one, and your time horizon for payback. Let's review the pros and cons of the most popular real estate investments.

Single-Family Home

You can buy or build the property, or pick it up on a short sale or foreclosure. You may want to buy a fixer upper and flip it, or rent it out for income. Investments can be rather modest compared to those for larger properties and are generally 15%-35% of the total value of the home with a personal guaranty on the loan.

Pros:

  • After-repair value may greatly exceed purchase price
  • Longer tenant leases can yield a higher annual ROI
  • Holds its resale value if the community is thriving and the home is well-maintained
  • Property taxes are often lower than those for multi-family units and commercial real estate
  • Can have lower management costs, especially if responsible tenants take good care of the property
  • Only one tenant can mean fewer demands
  • Quicker to sell on short notice

Cons:

  • Less diversified rental income cash flow compared to multi-family properties. If the one tenant moves out, you have no cash flow from the property until re-rented.
  • Property costs may be higher due to homeowner association fees
  • Potential renters may want more land than is available on the property
  • Fix-up costs may be high and you may have to renovate the property before renting it out or selling it. The high cost may limit your access to additional credit.

Duplex/Multifamily

Usually two to four units, this is a popular investment for those just starting out. Owner occupancy is possible and is generally 15%-35% of the total value of the home with a personal guaranty on the loan.

Pros:

  • Less risk of zero income
  • Always in demand
  • Spreads costs of improvements and repairs over multiple units
  • If four units or less, doesn't require special financing
  • Convenient to manage rather than having multiple single family homes geographically disbursed
  • Can choose to passively invest in a professionally managed property

Cons:

  • Possibility of higher repair costs: i.e. an overflowing bathtub on a high floor may require repairs to several units
  • Higher turnover rate - turnover is costly because property must be cleaned and repaired, plus the legal and other costs
  • Vacancies take a proportionally larger bite from your income

Apartment Complexes

Large properties with at least five residential units. You may choose to occupy one of the apartments yourself.

Pros:

  • Larger, less risky cash flows and good ROI
  • Always in demand, even when the economy is poor
  • Professional management costs spread over multiple units
  • Possibility of additional value from remodeling, condo conversions and rezoning
  • One geographical location provides economies of scale
  • Shorter depreciation period than that for commercial real estate
  • Occasional vacancies have minimal impact

Cons:

  • Requires more secure financing when more than four units, including higher down payment and reserves
  • Management fees eat into profits
  • Vulnerable to a downturn in the community, since all units are in a single place
  • Relatively illiquid investment, costly to dispose of
  • Possibility of deadbeat tenants
  • Frequent turnover

Mixed Use

Some combination of commercial and residential property, usually located in urban areas. Examples include buildings with ground floor stores and apartments above, or large skyscrapers divided between commercial and residential tenants.

Pros:

  • Can spur community development that increases rents
  • Commercial portions may accommodate longer leases
  • May command higher rents if commercial section is attractive, such as retail stores, a deli, a tavern, etc.
  • Two income streams: residential and commercial
  • May qualify for tax breaks and local concessions
  • Professional management

Cons:

  • May be more speculative and thus harder to finance
  • Higher construction costs
  • Vulnerable to economic downturns
  • Higher legal and administrative costs
  • May be less efficient to manage due to operational conflicts between residential and commercial tenants
  • Possible safety issues

Office

Can have a single or multiple tenants, involving different companies.

Pros:

  • Office tenants may pay premium rents
  • Easier than mixed-use to finance

Cons:

  • Require large investments, especially for downtown locations
  • Even one vacancy can be very costly
  • Tied directly to economy, vulnerable to downturns
  • May have high maintenance costs, including landscaping

Retail

Can involve single or multiple tenants, such as a mall. Giant tenants like box stores can provide substantial rents but require large investments.

Pros:

  • Can select from a wide variety of investments and store sizes
  • Can have multiple tenants
  • Retail leases can have longer durations

Cons:

  • Tied directly to economy, vulnerable to downturns
  • Bankrupt retailers may never pay past-due rent

Industrial

Usually limited to a single tenant.

Pros:

  • Choice of property types, including warehouses, distribution centers, depots, etc.
  • May require a smaller investment than that needed for a retail building or an office
  • Can have long and more lucrative leases

Cons:

  • Properties can be highly specialized and thus harder to rent
  • Costly to convert from one use to another
  • May be only a single tenant - rental income is all or none

Land

Pros:

  • Can hold the land for long-term appreciation and then sell to developer
  • Can have the land rezoned and then sell to developer
  • Can rent the land, perhaps for farming or parking
  • Can develop the land yourself
  • May be completely passive investment with few additional costs other than mowing the lawn

Cons:

  • Zoning rules may not support your plans for the land
  • No guarantee the land will appreciate
  • May discover features that decrease the land's value, such as restrictive covenants or polluted streams
  • Property taxes must be paid even if the land is unused

 

Of course, acquisition costs for all types of real estate investments are typically high. This is one of the advantages of investing through a real estate crowdfunding platform such as PeerRealty. Since acquisition costs are wrapped up in the overall transaction, investors do not need to come up with additional out-of-pocket costs. In addition, crowdfunding real estate investments do not require investors to actively manage the properties, and the deal sponsor has already performed due diligence on deals listed on the platform. While risk is an inherent part of investing, crowdfunding helps minimize risk through diversification while allowing investors to enjoy the benefits of real estate investing.

 

Daniel Kelly

Daniel Kelly

Daniel Kelly is the Head of Marketing at PeerRealty.

 

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