Different Types of Real Estate Investments
A New Investor's Guide
Real estate is one of the oldest and most popular asset classes. Most new investors in real estate know that, but what they don't know is how many different types of real estate investments exist.
It goes without saying that each type of real estate investment has its own potential benefits and pitfalls, including unique quirks in cash flow cycles, lending traditions, and standards of what is considered appropriate or normal, so you'll want to study them well before you start adding them to your portfolio.
As you uncover these different types of real estate investments and learn more about them, it isn't unusual to see someone build a fortune by learning to specialize in a particular niche.
If you decide this is an area in which you might want to devote significant time, effort, and resources to in your own quest for financial independence and passive income, I'd like to walk you through some of the different kinds of real estate investing so you can get a general lay of the land.
Before We Talk About Real Estate Investments
Before we dive into the different types of real estate investments that may be available to you, you should know that you should almost never buy investment real estate directly in your own name. There is a myriad of reasons, some having to do with personal asset protection.
If something goes wrong and you find yourself facing something unthinkable like a lawsuit settlement that exceeds your insurance coverage, you and your advisors need the ability to put the entity that holds the real estate into bankruptcy, so you have a chance to walk away to fight another day.
A major tool in structuring your affairs correctly involves the choice of legal entity. Virtually all experienced real estate investors use a special legal structure known as a Limited Liability Company, or LLC for short, or a Limited Partnership, or LP for short. You should seriously speak with your attorney and accountant about doing the same. It can save you unspeakable financial hardship down the road. Hope for the best, plan for the worst.
These special legal structures can be set up for only a few hundred dollars, or if you use a reputable attorney in a decent sized city, a few thousand dollars. The paperwork filing requirements aren't overwhelming, and you could use a different LLC for each real estate investment you owned.
This technique is called "asset separation" because, again, it helps protect you and your holdings. If one of your properties gets into trouble, you may be able to put it into bankruptcy without hurting the others (as long as you didn't sign an agreement to the contrary, such as a promissory note that cross-collateralized your liabilities). With that out of the way, let's get into the heart of this article and focus on the different types of real estate.
Find the Project That Appeals to Your Personality and Resources
If you're intent on developing, acquiring, or owning, or flipping real estate, you can better come to an understanding of the peculiarities of what you're facing by dividing real estate into several categories.
- Residential real estate investments are properties such as houses, apartment buildings, townhouses, and vacation houses where a person or family pays you to live in the property. The length of their stay is based upon the rental agreement, or the agreement they sign with you, known as the lease agreement. Most residential leases are on a twelve-month basis in the United States.
- Commercial real estate investments consist mostly of things like office buildings and skyscrapers. If you were to take some of your savings and construct a small building with individual offices, you could lease them out to companies and small business owners, who would pay you rent to use the property. It isn't unusual for commercial real estate to involve multi-year leases. This can lead to greater stability in cash flow, and even protect the owner when rental rates decline, but if the market heats up and rental rates increase substantially over a short period of time, it may not be possible to participate as the office building is locked into the old agreements.
- Industrial real estate investments can consist of everything from industrial warehouses leased to firms as distribution centers over long-term agreements to storage units, car washes and other special purposes real estate that generates sales from customers who temporarily use the facility. Industrial real estate investments often have significant fee and service revenue streams, such as adding coin-operated vacuum cleaners at a car wash, to increase the return on investment for the owner.
- Retail real estate investments consist of shopping malls, strip malls, and other retail storefronts. In some cases, the landlord also receives a percentage of sales generated by the tenant store in addition to a base rent to incentivize them to keep the property in top-notch condition.
- Mixed-use real estate investments are those that combine any of the above categories into a single project. I know of an investor in California who took several million dollars in savings and found a mid-size town in the Midwest. He approached a bank for financing and built a mixed-use three-story office building surrounded by retail shops. The bank, which lent him the money, took out a lease on the ground floor, generating significant rental income for the owner. The the other floors were leased to a health insurance company and other businesses. The surrounding shops were quickly leased by a Panera Bread, a membership gym, a quick service restaurant, an upscale retail shop, a virtual golf range, and a hair salon. Mixed-use real estate investments are popular for those with significant assets because they have a degree of built-in diversification, which is important for controlling risk.
- Beyond this, there are other ways to invest in real estate if you don't want actually to deal with the properties yourself. Real estate investment trusts, or REITs, are particularly popular in the investment community. When you invest through a REIT, you are buying shares of a corporation that owns real estate properties and distributes practically all of its income as dividends. Of course, you have to deal with some tax complexity - your dividends aren't eligible for the low tax rates you can get on common stocks - but, all in all, they can be a good addition to the right investor's portfolio if purchased at the right valuation and with a sufficient margin of safety. You can even find a REIT to match your particular desired industry; e.g., if you want to own hotels, you can invest in hotel REITs.
- You can also get into more esoteric areas, such a tax lien certificates. Technically, lending money for real estate is also considered real estate investing, but I think it is more appropriate to consider this as a fixed income investment, just like a bond, because you generating your investment return by lending money in exchange for interest income. You have no underlying stake in the appreciation or profitability of a property beyond that interest income and the return of your principal.
- Likewise, buying a piece of real estate or a building and then leasing it back to a tenant, such as a restaurant, is more akin to fixed income investing rather than a true real estate investment. You are essentially financing a property, although this somewhat straddles the fence of the two because you will eventually get the property back and presumably the appreciation belongs to you.