Real estate investing can be a lucrative and rewarding opportunity for those who understand the market. With any investment, though, it is important to understand both the potential benefits and perils before making an investment decision.
This article will take a first look at some of the risks and rewards of real estate investing.
Vacancy - One of the biggest concerns with real estate investing is vacancy. Whether you own a rental home or a strip mall, your investment is at risk without a paying tenant in place. Periods of vacancy mean periods of reduced income, which can cause major cash flow issues and in many cases can jeopardize the whole endeavor.
Most real estate investments have mortgage payments to make. Periods of vacancy can limit your ability to make mortgage payments, risking foreclosure in extreme cases.
A good real estate investment will budget for periods of vacancy to ensure that the financials allow some “cushion” for the periods with no revenue. Larger investments like multi-family apartment complexes have the advantage of lowering the impact of one unit being vacant - compare this to a single family home rental that experiences 100% vacancy whenever the tenant moves out.
Before investing, get to know the vacancy rates in the areas you are considering and make sure you understand how that rate of vacancy would impact your investment.
Market Volatility - Changes in supply and demand affect every type of investment, including real estate. In real estate, this applies to both the sale price of the property and to the amount of rent you can charge your tenants.
Ideally, you would buy at a low price and sell at a higher one. Demand, supply, and interest rates will all play a role in determining the sale price of your investment, and you should be careful to understand the likelihood of appreciation in both property value and rent rates before investing.
Time Horizon - Real estate, unlike stocks and other investments, is illiquid. Due to sale transaction costs and complexity, getting into and out of a real estate investment takes both time and money. It is important to do your homework and understand the investment thoroughly before buying because you cannot quickly get your money back if the investment does not pan out the way you thought it would.
Many real estate investors plan for a 7-10 year hold period. While there are many strategies for real estate investing, you should be aware that most involve holding the investment for an extended period of time.
Maintenance & Management - Don’t buy a job! Maintenance concerns can include burst pipes, repairs and restoration after tenants move out, clogged toilets and drains, and more. Finding and placing a tenant, performing background checks, collecting rent, and managing evictions can take time and cause stress.
Smart real estate investors don’t try to manage it all themselves, but plan to hire a property manager to coordinate their maintenance and address their tenants’ concerns.
Appreciation - One of the main reasons investors buy real estate is appreciation. Historically, real estate has demonstrated an overall trend of appreciating in value. This is especially true in areas of high demand with a lot of economic activity. As demand for housing and commercial space increases, so does the value of real estate in the area. This can result in substantial gains for investors who are able to purchase properties at a lower price and sell them at a higher price later on.
Additionally, real estate can be a more stable investment than other options, such as stocks and bonds, as the value of real estate is not solely dependent on market conditions.
Depreciation - Real estate investing also offers the potential for tax benefits, such as deductions for mortgage interest and depreciation. In some cases, the depreciation on the building can be enough to reduce your taxable income from rent to $0, and real estate professionals can even qualify to apply passive loss depreciation to their active income, putting more dollars in your pocket today.
There are tax implications to this strategy, and you should seek advice from a qualified tax professional on how this might apply to your particular situation.
Cash Flow - After all operating expenses and debt service is paid, the remaining cash left over is yours to keep. This cash flow will often come to you monthly, and is an added benefit afforded by real estate investing that is not as common in stocks, bonds, and other non-cash-flowing investments which must be sold to realize a gain.
Many investors will take the free cash flow from one investment to buy a second, then use the free cash flow from both to buy a third. This “snowball method” allows the investor to accelerate the rate at which they are buying new properties.
Leverage - Most real estate is purchased using a loan. Even after paying the interest on the debt, most real estate investments gain a huge financial advantage by using this approach. Each mortgage payment reduces the total outstanding liability on the property, meaning you have less to re-pay when the property is sold. This represents an increase in your equity in the property, and at sale, this is money that you get to keep.
Moreover, buying with leverage means you have to put less of your money in to buy the property at the outset. A smaller amount of money down means the returns you are getting are a larger return on investment (ROI).
Few other appreciating investments allow you to buy with leverage.
Inflation Hedged - Another reward of real estate investing is the potential for higher rental rates. As demand for rental properties increases, landlords are able to command higher rents for their properties. This can result in higher cash flow and improved returns for real estate investors.
Consumer demand will have a positive impact on the value of single family homes, and increased rent rates will have a positive impact on the value of multi-family investment properties. So as prices rise, most real estate investments keep pace. This means your real estate investing is hedged against inflation.
Conclusion
All investment carries risk. Real estate is no different. A good real estate investment can be an appreciating asset that provides you with free cash flow every month, and a portfolio of real estate holdings can make for a great retirement. It's important, though, to weigh the potential risks and be aware of market conditions. Market professionals, such as property managers and asset managers can help guide you through the process and to make informed investment decisions.
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Liberty Capital Consulting is an asset management and syndication firm based in Sioux Falls, South Dakota. We own, manage, and maintain over $500M worth of real estate in 2 states, and our mission is to make your real estate investing easy and profitable through exceptional asset management.