Investors looking for an alternative to stocks and bonds often turn to investment property. People are drawn to shows such as Fixer Upper or books such as Rich Dad, Poor Dad that tout the cash flow benefits and the capital gains that can be obtained by flipping homes.
Stories of $100,000 properties that now go for $1 million inspire some buyers. A number of former stock investors who gave up on equities after prices crashed have also purchased an investment property.
However, the investment property market has also seen its share of perils. Homes in markets such as Las Vegas or Sarasota, Florida lost over 50% of their value after the financial crisis.
Tenants who skip rent payments or damage properties also create problems. Real estate investing can bring lucrative profits or massive losses. Buyers should evaluate the economy, their local housing market, interest rates and, especially, their investing thesis before making such a purchase.
Investment Property: Consider the Economy and the Local Market
Ironically, our stronger economy works against new real estate investors. We have reached the mid-to-late stages of the growth cycle. As a result, finding investment property becomes more difficult at this stage. Those who bought homes in 2010 and still own their rental properties have benefited from large capital gains and rising rents. However, those same increases make it harder to make a profit from renting investment property.
An understanding of the local housing market is also important. In San Jose, California, the average home costs over $1.1 million. As a result, finding a profitable rental property is close to impossible.
However, in Oklahoma City the price of an average home is about $126,000. With the town’s oil and gas-based economy recovering, finding tenants and making a profit from renting houses is much easier than in San Jose.
Still, San Jose beats Oklahoma City when it comes to potential home price increases. There is little room for new homes in San Jose. For this reason, new buyers will often have to bid prices higher to coax homeowners into selling.
No such pressures exist in Oklahoma City, where vacant land remains plentiful and real estate prices consequently rise more slowly. As a result, landlords must rely more on rental revenue in lower-cost markets like Oklahoma City.
Investment Property: Interest Rates and Remodeling are Also Crucial Factors
Another factor working against new investors is interest rates. Rock-bottom rates have begun to rise. With few cash buyers in the market, sales usually hinge on house payments. When people have to pay more interest, they cannot afford higher principal costs. As a result, the prices that buyers are able to pay decline.
Finally, future buyers, especially stock investors, need a thorough understanding of their abilities and talents. Business acumen and construction skills are also critical. Finding the best deals on properties often involves buying distressed homes. Knowing the actual remodeling cost remains a crucial factor in calculating the right bid price. Bidding on a property without the ability to evaluate this cost could increase buyers’ costs by tens of thousands of dollars. Also, the more work one must outsource, the lower the profits. Therefore, investors with few remodeling talents will have a harder time succeeding with investment property.
Investment Property: REITs are Another Possibility
Investors lacking the talents described above can turn to real estate investment trusts, or REITs. REITs allow investors to buy stocks in companies that invest in specific types of real estate. REIT investors do not have to worry about broken pipes, bad tenants or 3:00 a.m. maintenance calls.
Also, the rules governing REITs require them to return at least 90% of their net income to shareholders. As a result, REITs’ cash flows will usually be higher than those of a typical S&P 500 stock.
REITs also allow investors to think like a stock trader when they buy investment property. For example, the growth of e-commerce has made industrial i.e. warehouse REITs such as First Industrial Realty Trust (NYSE:FR) popular.
It has also led to the advent of data center REITs such as Digital Realty Trust (NYSE:DLR). Conversely, the decline in malls could create future bargains in retail REITs such as Simon Property Group (NYSE:SPG).
The Bottom Line on Investment Property
Although buying the right investment property at the right time can be very lucrative, investors need to understand the economy, their local market, interest rates, and their personal investment preferences.
Markets that have both a vibrant job market and a limited supply of housing will have the least amount of property available for real estate investments.
Rising interest rates also hurt new investors, as the higher cost of interest lowers the price points that buyers can afford. Finally, investment property buyers need both business acumen and the ability to remodel to earn profits.
Those who lack these talents or fail to find the right property can still turn to REITs, which allow people to invest in real estate while utilizing the skills of a stock investor.
Whichever option buyers decide to take, it’s most critical that they first understand themselves.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.