Different Types of Real Estate Investments
A Guide for New Investors
Real estate is one of the oldest and most popular asset classes. Most new investors in real estate know this, but what they don't know is how many different types of real estate investments exist.
As you uncover these different types of real estate investments and learn more about them, it isn't unusual to find a reference to someone who has built a fortune by learning to specialize in a particular niche.
Getting Started in Real Estate Investment
It goes without saying that each type of real estate investment has potential benefits and pitfalls, including unique quirks in cash flow cycles and lending traditions. Standards of what is considered appropriate or normal do exist, so you'll want to study opportunities well before you start adding them to your portfolio.
Before diving into the different types of real estate investments that may be available to you, you should know that most real estate investors do not buy investment real estate directly in their own name. There are myriad reasons, some having to do with personal asset protection.
If something goes wrong and you find yourself facing a lawsuit settlement that exceeds your insurance coverage, you'll want the ability to hold on to your personal assets. This can be accomplished by forming a legal entity for purchasing your investments, such as a limited liability corporation (LLC).
Form a Protective Entity
A major tool in structuring your affairs correctly involves the choice of a legal entity. Virtually all experienced real estate investors use an LLC or a Limited Partnership (LP).
Forming an entity to hold your real estate investments allows you to have an option to place that entity into bankruptcy without risking your personal property and holdings. This technique is called "asset separation" because it protects you and your holdings.
These special legal structures can be set up for as much as only a few hundred dollars but can cost as much as a few thousand. The paperwork filing requirements aren't overwhelming, and you could use a different LLC for each real estate investment you owned.
Categories of Real Estate Investments
If you're intent on developing, acquiring, owning, or flipping real estate you, you might come to a better understanding of what you're facing by dividing types of real estate into several categories.
Residential structures 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 or lease agreement. Most residential leases are on a twelve-month basis in the United States.
Commercial properties consist mostly of 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. One consideration is that markets do fluctuate, and rental rates could increase substantially over a short period of time. However, it may not be possible to raise rates if commercial property is locked into older agreements.
Industrial real estate consists of everything from industrial warehouses, storage units, car washes, or other special purposes real estate that generate sales from customers who use the facility. Industrial real estate investments can often have significant fees 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 properties consist of shopping malls, strip malls, and other retail storefronts. In some cases, the property owner 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 properties are those that combine any of the above categories into a single project. As an example, an investor in California 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 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.
Ways to Invest in Real Estate
Beyond this, there are other ways to invest in real estate if you don't want 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.
There are tax complexities—your dividends aren't eligible for the low tax rates you can get on common stocks—but they can be a good addition to your portfolio if purchased at the right value, with a sufficient margin of safety. You can even find a REIT to match your preferred industry; e.g., hotel REITs.
You can also get into more esoteric areas, such as tax lien certificates. Technically, as lending money for real estate is considered real estate investing, it can be considered a fixed-income investment. This is similar to a bond because you generate your investment return by lending money in exchange for interest income.
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 between investing and financing. You will eventually own the property, while its appreciation and profits belong to you.