Real Estate Investing (REI)
There are four major types of real estate investment. Each involves a unique strategy, with different levels of risks and returns. As a general rule of thumb, the higher risk of an investment, the greater the reward.
I. Core (Safe)
Core Investment: Lowest risk and lowest return.
- Generally unlevered, meaning no money is borrowed.
- If leveraged, generally less than 40% of purchase price.
- Predictable cash flows
- Income is the largest source of return
- Not looking for appreciation (an added bonus)
- Capitalization rates are low
- Fully leased properties
- Occupancy rates over 80%
- Vacancy rates under 20%
- Strong area
- Increasing property values
- Top 20 Metropolitan Area (i.e. New York City, San Francisco, etc.)
A good example of a core investment is a fully leased office building in New York City. The tenants are reliable and have strong credit, and income is steady.
II. Core Plus (Moderate)
Core plus investment: Higher risk and return than core investments.
- Enhancing or adding value to core properties
- Needs minor improvements
- Net Operating Income will increase
- Value will increase
- Needs minor improvements
- Target recently expired or upcoming expiring leases
- Investors can enhance property and raise rents
A good example of a core plus investment would be a large, already established apartment building in New York. The investor believes that with a doorman and new kitchen appliances, he can command a higher rent.
III. Value-Add (Risky)
Value-add investment: Higher risk and return than core plus investments.
- Buying, improving, selling a property at a profit
- Risky because they have problems
- High vacancy rates
- Physical issues
- Require moderate improvement
- Bought at discount
- Once improved are sold to core and core plus investors.
A good example of a value-add investment is a rundown multifamily townhouse in Brooklyn. The apartments haven’t been renovated in years. There are minor plumbing and electric issues. The value-add investor would purchase this property at some discount of market value, perform proper improvements, and either rent out or sell off the new apartments.
IV. Opportunistic (Aggressive)
Opportunistic investment: Highest risk and return of all real estate investments
- Requires high level of enhancement/improvement
- Ground-up construction, land, mortgage notes, niche property sectors
- Involve immense amounts of time and pressure to complete
A good example is land in Brooklyn Heights, NY, with views of Manhattan. The neighborhood is steady, although not strong, and a small decrepit warehouse currently occupies the land. The investment plan is to build a 40-story apartment building that will boast incredible views of New York City. But, it will cost a lot of money, time, and there can be many potential problems. If it pays off, returns are astronomical.
The three most common real estate investment strategies are buy and hold, flipping, and wholesaling.
I. Buy and Hold
Buy and hold - buying a property and then ‘holding’, renting it out for prolonged periods of time.
Investors attempt to hold a property until appreciation, reselling at a profit. The cash flow from rents pays the mortgage. When the mortgage decreases, the equity increases.
- Bad Deal - wrong price or unforeseen problems with property
- Delinquent Tenants - tenants cannot or will not pay their rents
- Price Changes - buying at the wrong time
Flipping - buying property at a discount, renovating or enhancing to increase value, and then reselling at a profit.
Profit margins are strong in flipping, but buying a property at a wrong price or underestimating expenses can easily lead to a loss.
- Timeframe - property needs to be bought, renovated, and sold as fast as possible
- Expenses - time frame is important because the property still incurs expenses, which cut into profits
III. Contract Flipping (Wholesaling)
Contract flipping - investor finds a favorable deal, drafts a contract, and then sells the contract to another buyer at a premium.
- Fee - Hundreds or thousands of dollars
- Costs - Low, wholesaler never purchases property.
This strategy, although tough to master, earns an unlevered profit and can lead to astronomical profits.
- Consistency - finding constant deals
- Connections - to gain access, community presence is needed
- Wholesalers need to attract buyers to the deals.
Real estate asset classes and growth methods can be categorized. But there are many categories—where do we start? By understanding the real estate asset classes and their corresponding strategies (described below), try to best match your investment character with the asset.
- Build a house to live
- Build a building to do business
- Can also include residential properties because ‘providing a living environment’ can be a commercial activity
- Reasons to invest in land
- Investing in natural resources (e.g. timberland)
- Hedge against inflation and price fluctuation
- Sell when commodity’s market is favorable
- Maturity of natural resources
- Build a space dedicated for manufacturing, warehousing, and distributing goods
- High demand
- Important role in economy
- Location is the most important
- Construction is secondary
- Importance of distance to facilities, such as a seaport
- Quality of property is important
- Tenant Considerations
- Rent Per Square Foot (RPSF)
- Additional costs arising from distance to important facilities
You can also build a home. There are two types of houses: single family and multifamily. In a more crowded environment, you can build apartments. There are small and large apartments.
Single Family House (SFH)
- Free-standing home
- Traditional ‘home’
- Strong potential for capital growth
- Emotional factors contribute to value
- Low level of cash flow
- High acquisition costs
- High maintenance expenses
- Vacancy is a threat (Only one tenant)
- Lot size can be smaller
- Not as restricted by geographic location
- More sensitive to increases and decreases in property value
Multifamily House (MH)
- Multiple units in one building
- Weak potential for capital growth
- High level of cash flow
- Many tenants paying rent
- Vacancy not a threat
- Same lending standards as SFH for less than 4 units
- Less scrutiny
- Larger amounts of income
Residential/Commercial - Apartments
- Barriers to investment are greater
- Commercial lending standards
- Tougher to get financing
- High cash flow
- Small apartments
- Less than 50 units
- Too large for starters, too small for institutions
- Value based on income generated
- Higher income, higher value
- Increase rent or decrease Operating Expenses means increase in value
- Large apartments
- Greater than 50 units
- Managed by companies
- Financed by a group of investors
- Large-scale luxury condos, prime real estate markets
Properties built for doing business are known as commercial real estate. So far, we’ve only spoken about residential purposes. Exceptions are properties whose business is to provide or sell residence; these are considered commercial asset class with residential uses. The following asset classes are most commonly office, retail and hospitality spaces.
Commercial properties are more closely related to economic fluctuations than their residential counterparts. Although houses and apartments’ values fluctuate over time, the need for living does not disappear because of an economic recession. Before delving into commercial real estate, we must discuss Real Estate Investment Trusts (REITs).
- Built for the sale and purchase of goods
- Shopping malls, restaurants, street stores
- Customer base of retail = pedestrians
- Walking street access important
- Directly related to the state of the economy
- Consumer spending has a strong influence
- Landlord and tenant interests aligned
- Tenant’s sales have an immediate impact on value of landlord’s real estate
- Lease structure is percentage of tenant’s sale plus fixed
- Lease term long
- Tenant establishment
- Landlord risk of low rent growth
- Landlords link rent with Consumer Price index to match the market.
Commercial - Office
- Most common commercial property
- Directly related to unemployment rate
- More employees= higher demand for office space
- Modern office environment demand strong because each person occupies a larger unit of space
- Occupants include accountants, bankers, architects, lawyers, real estate agents, doctors, dentists
- Main occupation is their business, not real estate management
- Real estate is a raw material used to deliver services to clients
- Purchasing an office makes this both a raw material and an asset
- They rarely purchase property
- Main occupation is their business, not real estate management
Commercial - Hospitality
- Hotels lease space for users and receive payments
- Length of tenancy
- ‘Average daily rate (ADR)’
- Revenue Per Available Room (RevPAR), which is ADR multiplied by occupancy rate (Measures economic efficiency in hotels)
- Length of tenancy
- Heavy emphasis on service to tenants
- Significant income from restaurants and other amenities
- Landlord usually hires hotel company to manage property
- Hilton, Marriott, Starwood, etc.
Real Estate Investment Trusts (REITs)
- Publicly traded corporations that make real estate investments
- Distribute 90% of its taxable income as dividend. (Otherwise, taxed at corporate rate.)
- Invest in a wide range of markets
- You invest in the REITs, not the property that the REITs own
Each type of real estate has its own unique characteristics that make it suitable for various types of investment strategies, which will be discussed in other ENDVEST articles. Knowing different investment vehicles enables you to find the real estate right for you. Continue to read the other articles prepared by ENDVEST and let your investment genius lead your financial life.
- Recovery from 2008 financial crisis
- Supply of capital greater than availability of deals
- Lower lending standards
- Increased deal flow in real estate
- Overall capital growth
- International Money
- Anbang Insurance - Waldorf Astoria New York: $1.95B
- Largest source of capital into U.S.
- Exceeded $30B from 2011 to 2014
- Germany, Japan, Switzerland, Israel, Hong Kong, Korea
- International Money
After devastation, U.S. real estate is poised for economic prosperity.
- Also has deployable real estate capital
- Impressive price growth
- Still suffers from 2008 crash
- Capital increase low
- Increase in prices not based on economic improvement
- Oversupply of capital
- Wealth and Pension Funds
- Expanding into real estate
- $8T assets under management
- Increase real estate portfolio allocation from 8.5% to 9.39% ( $80B )
- Also has deployable capital
- Change in demographics
- Higher desired returns
- Actively pursues investments
- Transaction volume has plummeted
- Investing in the West
- Too many funds for domestic investment
- Insurance and pension companies are major investors
- Australia and Japan will follow suit.
- Looking toward opportunistic and new development investments
- Secondary Markets
- Dusseldorf, Paris, Chicago, Houston, Atlanta
- Secondary Markets
What's a SDIRA?
Since 2009, the retirement investment market has soared more than 80% to $25 trillion. One of the largest parts of the market is the Individual Retirement Accounts (IRAs).
IRA is the only individually managed account; others are managed by the government, or by companies. In 1997, the Taxpayer Relief Act was passed and a new form of IRA began: the Roth IRA.
Eligible IncomeTaxWithdrawal AgeContribution Limit
Traditional IRAsAny IncomeTaxed upon withdrawalMust withdraw portion after age 70.5$5,500; $6,500 for age 50 or older
Roth IRAsSpecific Income BracketTaxed upon contributionNo minimum withdrawal ageSee above
In an IRA, a custodian executes transactions. Although the custodian handles the legalese, the client instructs the custodian on which investments he wants. Traditional IRA custodians are large financial institutions, and only offer limited investments, like public securities, mutual funds, and CDs.
But, if an IRA holder wants alternative investments like precious metals and real estate, the Self-Directed IRA is the answer. The investor is more active; traditional IRA holders only provide investors with choice of desired risk. Currently, 2% of IRAs are self-directed, which is about $150 billion. Regular IRAs and Self-Directed IRAs both have traditional and Roth variants.
With great power comes great responsibility. Individuals are responsible for researching and monitoring their investments. This can be time-consuming, but the potential higher return from Self-Directed IRA investing can also be used to counterbalance losses from taxation in other IRAs.
You can start a self-directed IRA by choosing a custodian, depositing funds, and executing investments as you see fit. Transferring money from an IRA to another without getting taxed is outlined below:
Funding MethodsTransferred WealthTransfer Route
Cash TransferCashIRA to IRA
In-Kind TransferAssets In-KindIRA to IRA
In-Kind Direct RolloverAssets In-Kindnon-IRA plan to IRA
Cash Direct RolloverCashnon-IRA plan to IRA
60-Day Cash Direct RolloverCash / Assets In-KindIRA to IRA / non-IRA plan to IRA
Starting 2015, you may only perform one rollover in a 12-month period. There are exceptions:
- Traditional IRA to Roth IRA
- IRA to qualified plans and vice versa
- Qualified plan to qualified plan
Failure to comply with the above will result in taxation of the transferred wealth on top of 10% early withdrawal tax.
Invest with SDIRA
What exactly is a SDIRA?
A Self-Directed IRA or SDIRA is essentially just a traditional IRA, with the exception that you as the individual owner of the account have a greater selection of investment options available to you. Regular IRA’s restrict you to investing in safer but lower return investments such as bonds, mutual funds, and CDs. However, with a SDIRA, you can invest in a much wider range of investments such as real estate, foreign exchange, precious metals, and tax liens.
How can a SDIRA benefit you?
An SDIRA is very beneficial because you get all of the benefits that an IRA provides, such as the tax deductions, tax-free/deferred profits and asset protection, in conjunction with the freedom to invest and truly diversify into different asset classes such as real estate.
How do I setup my SDIRA?
In order to setup your SDIRA, you have to go to your custodial firm that holds self-directed accounts. There are various resources online that you can use in order to find the best custodian for you. It is important to do research on potential custodians because some custodians will not hold certain investments; for example, there are many custodians who do not hold real estate investments. Additionally, the various custodians have different fee structures ranging from one time setup fees along with a flat annual payment or a percentage of your total account. It is important to make sure you find the perfect custodian for your individual situation.
How can I invest using my SDIRA?
You can go about investing from your SDIRA in two ways. First, you can contact your custodian whenever you find an investment opportunity. Your custodian will then write you a check to release the money from your account to fund your investment, and when your investment is eventually sold, the gains and losses are realized when your money goes directly back into your SDIRA.
The second method, to avoid paperwork, potential title issues, and processing delays, many SDIRA holders choose to use a LLC IRA structure. The LLC acts as a pass-through entity for tax purposes, but is considered a corporation for limited liability reasons. The tax benefits are still realized in this scenario, but there is overhead involved in order to pay for the accounting for the LLC you are employing.
Both methods have their benefits, but in general, if you are looking to participate in a lot of transactions annually, it may be in your best interest to use an LLC IRA structure to avoid a lot of paperwork and processing delays.
Is a SDIRA right for me?
An SDIRA is the most ideal for a person who…
- Is interested in diversifying his investments that make up his retirement portfolio
- Prefers to have an input on the investments he makes
- Is more financially independent
- Does not want a manager in full control of his financial safety net
- Wants the option to take a higher risk for higher potential returns
- Wants to be able to put money into standard investments but also wants to try to invest in alternative investments for a portion of his portfolio