Real estate, or real property, is one of the oldest and most popular asset classes. And if you ask many newly-minted millionaires, this is where they often get their start. These investments, however, come in different types depending on your appetite for risk–whether you lean towards conservative or aggressive. Similar to other investment vehicles, the higher the risk, the higher the reward.
This article will discuss the various rental property classifications as well as four types of real estate investments.
A core investment is the least risky type of investment. These are existing and established assets. As such, you’re after the existing cash flow of the property, which is stable and a more secure income. This is best for conservative investors.
A core investment property has the following characteristics:
- Found in high-end locations
- Built within the last few years
- Minimal to zero deferred maintenance issues
- Minimal to zero management issues
- Strong tenant base
- Leverage: 40% to 45%
- Returns: 7% to 10% annualized
Core Plus Investment
A core plus investment is the second least risky type of investment. Typically, it only needs light improvements to reach maximum cash flow. Once these issues are taken care of, you can expect a relatively good income stream.
Here are the characteristics of core plus properties:
- Found in cities with a high-performing submarket
- Built within the last 20 years
- Light deferred maintenance issues
- Light management issues
- Moderately strong tenant base
- Leverage: 45% to 60%
- Returns: 8% to 10% annually
From the term itself, a value-add investment only becomes profitable when you add value to it. You can improve the structure, management, tenants, or all of the above. It poses a moderate amount of risk, with maximum returns expected in about five years.
Here are the characteristics of value-add properties:
- Found in the city with a growing submarket
- Built within the last 30 years
- Heavy deferred maintenance issues
- Heavy management issues
- Quality of tenants needs to be improved
- Leverage: 60% – 75%
- Returns: 11% – 15% annually
An opportunistic investment is not for the faint of heart. Investors who have zero experience should avoid this until they’ve gotten their feet wet with other properties. Not only is it risky, but you will require a significant amount of patience, expertise, and capital to estimate and keep your margins. This is not recommended for solo investors.
Here are the characteristics of an opportunistic investment:
- Found even in smaller cities and submarkets
- Property age isn’t a concern since it will be a completely redeveloped
- Leverage: 70% and more
- Returns: Over 20%
Both value-add and opportunistic investments are best for investors with enough capital to complete all the necessary rehabilitations so that the property is ready for occupancy.
Choosing the Property Type
Whether you’re going after a core, core plus, value-add, or opportunistic investment, it’s important that you also familiarize yourself with the different property types and their key characteristics. Here are some of the more popular:
Residential properties are houses, townhouses, vacation houses, and apartment buildings. Tenants live in the property, and they pay you a monthly fee in exchange for the stay. The lease agreement varies, but in general, you can offer a short-term lease (less than six months) or a long-term one (more than one year). If the tenants are screened properly, residential properties can be a steady source of income.
Commercial properties are those used for business activities, which can refer to land, office spaces, and malls, among others. Rental fees tend to be higher, and lease agreements are longer than residential properties. Businesses tend to stay put, which is great if you’re looking for stable cash flow. Still, long-term contract may keep you from raising rental fees to keep up with market rates, so at the very least, make sure to put an escalation rate to account for inflation.
Industrial properties are a type of commercial real estate primarily used for manufacturing, distribution, production, and warehousing. Here, the income is long-term, but finding a new tenant can take some time since most buildings are fitted specifically for a type of company or machinery. This means if your tenant doesn’t renew their lease, you will ideally need to find one that comes from the same industry.
Retail properties are another type of commercial real estate and are typically strip malls, stores, and shopping centers, among others. Here, you can also be entitled to a percentage of tenant sales, apart from the lease. This is to incentivize you to help in the marketing of your tenants as well as to maintain the location.
As the name implies, a mixed-use development allows for different property types all at once. For instance, you can invest in a high-rise residential building with commercial establishments on the ground floor. Or, you can develop a mix of residential, retail, and commercial establishments. This requires more capital than your average investment, but it also makes your cash flow more stable.
Turnkey Rental Properties
Turnkey rental properties are those that have already been renovated by someone in the business of restoring old houses or buildings. When you purchase them, they are either ready to be leased or already have tenants. Turnkey may be a more expensive type of rental property, but they save you from starting from scratch.
Short-Term Vacation Rentals
This type of investment operates like hotels, where guests have to pay daily or weekly. The rental rates are more expensive than typical long-term residential leases because of the regular upkeep. Although the occupancy is not as stable as long-term rentals, the returns can be great when you invest in the correct location.
Why It Matters
Are you looking for a quick payout, passive income, or a long-term investment? Knowing your income goals will help determine a suitable investment for you. Those who want more significant returns, skip the turn-key rental properties and consider flipping homes by rehabbing them. As always, the greater the risk, the higher the reward.
As with any investment, it pays to know your options so that you can choose wisely. Consider taking it a step further by using tools like Money Weighted to create accurate cash flow models in just a few minutes.