Hello dear reader and welcome back to InvestPhilly.com. We’re continuing our ongoing series on the subject of real estate investment in Philadelphia. Today, we’ll discuss how one can go about investing in real estate, as well as the associated risks and benefits of each method discussed.
To begin, let's clarify that most investments fall under one of the following categories:
Simple Rental Properties
This is the most common type of investment. If you have ever rented an apartment or office space, you're probably familiar with this method. An investor purchases a property with the intention of subdividing it and attracting tenants. Another scenario is that a developer purchases land and builds an apartment or commercial complex with the same goal. In both cases the owner/landlord receives regular monthly income from tenants. The owner/landlord is responsible for maintenance and upkeep of the property. These tasks can be preformed by the landlord or, if they lack the time or inclination, a property management company can be hired for the service.
An obvious risk in this scenario is an inability to find tenants or the taking on of non-paying tenants. In this case, there is no rent money coming in but mortgages and property taxes are still expected to be paid, resulting in a negative cash flow.
A shrewd investor using this method would find an area of low vacancy rates and carefully vet rental applicants to minimize this risk.
Real Estate Investment Groups
This method takes the previously mentioned method of a simple rental and spreads the risk, as well as rewards, across a pool of investors. A company purchases an rental property. This property is often larger than a simple rental property to accommodate investors that would then join the group by buying one or several units in that property. The investor would own the lease to the unit they purchase with a portion of all rents being set aside to help compensate other investors should their unit go vacant.
The company is responsible for maintenance and management of all the units and, consequently, takes a percentage of rent for it’s efforts.
The benefit is that property management is done (literally) in house, to minimize expense, and risk of vacancy is mitigated by pooling of all investments. The downside is that the company does take a portion of rents and the reduced return might not make it a worthwhile investment for some investors.
Real Estate Trading (Flipping)
Popularized by such shows as Masters of Flip, Chicago Flippers , Flipping Boston, real estate trading is the purchase of a property with the intention of reselling it within a few months at a profit. This is contingent on property values increasing in the short term. Flippers will often research upcoming development in an area with the intent of benefiting from the increased desirability of the neighborhood. Examples of such development include the building of a supermarket or a major road.
A pure flipper would take a "buy and hold" approach whereby they simply purchase and expect the value to rise due to external factors. Some flippers, on the other hand, take the time and expense to update or otherwise improve the property to increase marketability (and profit) at sale. Improvements range from minor cosmetic upgrades, to full scale additions and rehabilitations.
The risk in this example is that, if the expected property values do not materialize, the flipper could be left with a wash transaction, in which there is no net gain. Or, worse still, if values fall unexpectedly, the flipper could be left in the red and facing.
Essential Elements: Use of Leverage
Anyone who has heard of or taken out a mortgage is familiar with the concept of leverage. Similar to the use margin in other financial transactions, this is essentially the borrowing of money to purchase a more expensive property. The reasoning is that the greater expectated returns justify the added risk.
This is common in real estate, with some mortgages having as high as a 95% Loan to Value ratio.
The benefits of using leverage are obvious, in that one can net larger returns for a similar investment of money. This is a common tool to especially astute investors using timing and researched
We hope that you’ve found this week’s installment of the #investmentseries informative and entertaining. As always, if you have an suggestions or topics you’d like to learn more about, feel free to drop us a line at firstname.lastname@example.org.
With prudent investments in real estate, you too could be sleeping on a pile of cash!