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People need places to live, and people need places to work. It doesn't get much more basic than that. When you buy a piece of property, you need to be convinced that people — whether prospective tenants or prospective buyers — will find such value in it that it will be profitable for you, first and foremost as a stream of passive income, and later, if you choose to sell it, as a windfall of capital gain. Of course, there are real estate investments that don't make money for you as a passive income stream, such as vacant land or a house flip, and while those kinds of real estate investments can be very profitable, they should be reserved for another time as they are much more risky.
🔤 Real Estate: The Basics
- Ease of Entry: Medium. You can’t just wake up one day, decide you want to buy a piece of property, go online, and buy one like you can with stocks. There are many moving parts to a real estate purchase (finding a deal, obtaining financing, inspecting the property, etc.). Notable exceptions to this rule are the recent real estate crowdfunding sites that have become very popular in the past few years.
- Money Requirement: Medium – High. You can have $100 to buy a stock, but to buy real estate, you generally need some capital reserves for a down payment. There are ways to creatively finance a real estate purchase so that you do not have to come out of pocket so much, but that is beyond the scope of this discussion.
- Time Requirement: Low – Medium, depending on if you pay a property manager or not.
- Potential Payoff (cash flow): Low – Medium
- Potential Payoff (appreciation): Medium – High
There are many different kinds of real estate investments you can make, but today I am just going to cover the most common kinds of passive income-producing real estate investments.
🏠 Single-Family Residences
Single-family residences (or “SFRs”) are residential properties having only one dwelling unit.
- Availability of good deals: it’s a lot easier to find a deal (say, buying a property for way below market value or finding a seller who will consent to seller financing) on a single family residence than on other property types since the majority of owners of this property type are Average Joe’s and Jane’s, so to speak, which is to say that they are typically far less sophisticated than, say, an owner of a multi-family or commercial property. And the less sophisticated someone is financially, the more prone they are to get in over their heads, and when people get in over their heads and find themselves in a bind, they’re often willing to part with their assets at far less than market values because they need to sell fast.
- Exit strategy: about 14,000 single-family residences are sold in the United States every day. There are far more people in the market to buy single-family residences than other types of property.
- Inefficient: if you plan on building your real estate empire on single-family residences, keep in mind that you’re going to have to manage different tenants in different buildings around town, which may make property management difficult once you start owning more than a few houses. Also, major repairs will add up quickly. It’s typically less expensive to hire a roofer to replace one 20-square roof than two 10-square roofs. This concept is even more relevant when dealing with foundation issues.
🏘️ Multi-Family Residences
Multi-family residences are residential properties having more than one unit. This could be a two-unit duplex or a 500-unit apartment complex.
- Economies of scale: two tenants in the same place, under the same roof, are easier to manage than two tenants who live on the opposite sides of town in two different buildings. And the bigger you go, the more economies of scale you achieve.
- More bang for your buck: generally, a duplex will cost less than two single-family homes in the same area and of the same quality.
- Low down payment options: by purchasing a 2-4 unit property with FHA financing, you can jumpstart your real estate investing career even if you don't have much money saved up. I devoted a full article to this strategy here.
- Price: they may cost less per unit, but still, on an absolute basis, two units will cost more than one unit of similar quality and geography, so you obviously need access to more capital to buy a multiple-unit building in a given area than a single-family residence in a given area.
- Savvy sellers: unless they’re very small (say, 2-4 units), multi-family properties are typically owned by a wealthy investor or, more commonly, by a group of wealthy investors. Moreover, many of these owners aren’t even individuals at all, but rather corporations or pension funds with smart attorneys and advisors on their side, so it’s a lot more difficult to negotiate a good deal out of these sophisticated investors for their 100-unit complex on 456 2nd Street than it would be to negotiate with Average Joe for his 3-bed, 2-bath on 789 Sycamore Drive.
🌴 Vacation/Short-Term Rentals
These are properties that you rent out for short periods of time, typically less than a month. So it's sort of like running a hotel/motel/inn on a miniature scale.
- Rent: you can charge a lot more for short-term rentals than you can for long-term leases. For example, a single-family residence may be able to be leased to a long-term tenant for $1,000/month, but this same single-family residence may be able to fetch $100/night on a short-term basis. Assuming you’re able to fill 20 nights out of the month, that’s $2,000/month renting to short-term tenants rather than $1,000/month renting to a long-term tenant.
- Ease of marketing: sites like Airbnb have basically taken over this space and centralized most all non-hotel short-term rentals on one website, and they make it very easy to post your property.
- More time-intensive property management: multiple people are coming in and out of your living space every month, and after each one leaves, you have to clean the place and get it ready for the next tenant.
- Legislation: some cities are currently attempting to stop short-term rentals or heavily tax them.
- Location: while location is key to any piece of property, it matters even more for short-term rentals than for long-term rentals. While a short-term rental will probably have no problem in a downtown or touristy area, you may be hard-pressed to find a steady stream of tenants for a short-term rental in suburbia or on the outskirts of town and may be better off renting to long-term tenants in these locations. Sure, $100/night sounds better than $1,000/month on paper, but if you can only fill five nights out of the month, that $100/night has become $500/month with more hassle than simply renting to a long-term tenant for $1,000/month.
- Competition: yes, Airbnb and its competitors have made marketing easier, but of course that is true for everybody. You have to work hard to distinguish yourself.
🏢 Commercial Buildings
These are properties occupied by businesses. This covers everything from strip malls to skyscrapers.
- Costs: it is customary in many markets and for many types of commercial properties for the tenants to pay things like maintenance, insurance, and even property taxes (Google “NNN” for elaboration).
- Longer leases: while it’s rare for a residential lease to be longer than 12 months, it is not uncommon to write a commercial lease for five, ten, or twenty years. This provides stability (as long as the tenant doesn’t go broke!).
- Savvy sellers: the same thing that could be said of multi-family properties with regard to owner sophistication can be said about commercial properties as well.
- Complexity: from the variations in lease provisions to the financing to tenant evaluation, investing in commercial properties is more complicated and less intuitive than investing in residential properties.
- Vacancies: vacancies in commercial units are typically longer than in residential units, especially for smaller mom-and-pop type oddball properties. People always need a place to live, in good times and bad. But in bad times, lots of businesses go under.
- Liquidity: although real estate in general is not a liquid asset, you may have to wait even longer to unload a commercial property than a residential property since there are fewer potential buyers of commercial properties.
🤔 But Is Real Estate Truly Passive?
Yes, real estate can be a truly passive investment if you’re willing to pay for it. And by “willing to pay for it”, I mean willing to pay a property manager 8 – 10% of your gross rents to take care of the everyday operations of the property for you.
But if you aren’t willing to pay somebody to do this, you will certainly have to invest your own time into keeping your properties running smoothly. For example, my first real estate investment was a 4-unit property in which I lived in one unit and rented out the other three. Here is a list of things I had to attend to — all in the first six weeks!
- fix ceiling fan in Unit 2
- fix bathroom faucet in Unit 2
- replace entire roof for Unit 1
- replace flat portion of roof for Unit 3
- treat soil near front door of Unit 4 for termites
- put down metal flashing behind add-on portion of Unit 4 to prevent seepage during rain
- replace stove in Unit 4
- convert stove in Unit 4 from natural gas to propane
So real estate can be an amazing wealth-building tool and source of passive income, but keep in mind that passivity in real estate comes at a price! 🙂
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