What is an investment property?

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What is an investment property

Are you a beginner looking to invest in real estate? There are many different types of properties and opportunities out there, and millions of people are taking advantage of the real estate market.

Real estate is a popular investment choice because it has proven to be a solid source of income. However, before you purchase your first investment property, it’s important to know what real estate entails. Let’s find out if you are fit to be a landlord.

What qualifies as an investment property? 

An investment property is real estate that is purchased with the goal of generating income either by renting, hosting, or flipping the property through appreciation of its value. These properties can be purchased, managed, and owned by an individual or a group of investors.

Technically, any property that you own that is not your primary residence and operates as an income property qualifies as an investment property. Whether it’s a residential property or a commercial property, mortgage lenders will typically treat these properties differently in terms of requirements that must be met in order for a loan to be offered.

Types of investment properties

There are many different types of investment properties. When thinking about them, people tend to regard real estate as residential or commercial buildings that can be rented out, but investment properties can actually be defined as any type of permanent structure that generates income. The three main categories of investment properties are residential, commercial, and mixed-use.

Residential

Residential properties are purchased by a single investor or group of investors and inhabited by tenants that use the property as a home or place of residence. The two main ways income is typically generated via residential properties is by renting them out as either short-term or long-term rentals or by reselling the properties for a profit.

Long-term rental property

With long-term rental properties, you’ll buy real estate that you plan to rent for relatively long periods of time. That is why it is sometimes called the buy-and-hold strategy because many investors will hold on to these properties for at least five years.

Vacation rental

A vacation rental is an investment property that is professionally managed and rented out temporarily to people who are traveling. Vacation rentals can be apartments, condos, houses, rooms, or any sort of decent living space. They typically serve as an alternative to a hotel. 

Flipping homes

The process of flipping homes involves buying real estate and then increasing the value of the home so that you can resell it for a profit. This process involves renovating, making modifications, or holding and waiting to sell at a time when the market is favorable.

Micro-flipping

Micro-flipping involves buying properties well below the market price because they require significant renovations. In most cases, research is conducted in an effort to identify an opportunity that will require little-to-no improvements in order to flip for a profit. This is usually done without actually physically being present at the property. Also, micro-flipping tends to be a short-term real estate investment because the goal is to buy, fix, and sell the property in a short period of time.

Accessory dwelling units

Accessory dwelling units are independent residential properties that are smaller in size. They are also located on the same property as the primary home. Often referred to as granny homes, accessory suites, or secondary suites, they are legally part of the same home, so they cannot be sold separately. 

Commercial 

Commercial investment properties differ from residential properties in that they are solely designed for business purposes. Alternatively, they can be rented as a place of work rather than living quarters. They usually require a much larger investment upfront, and their business purposes can be quite diverse. 

Commercial property investors can be individuals, groups of investors, or both private and public companies. They can also be owned and operated by real estate investment trusts (REITS). REITs can be publicly traded or offered in private sales and are a great way to own investment property without actually physically owning the property. Many publicly held REITs are headquartered in Texas..

In most cases, the commercial real estate (CRE) is leased to businesses that are engaging in some type of income-generating activity. 

The most popular forms of commercial real estate include, but are not limited to, the following:

  • Hospitality 
  • Multi-family
  • Office space
  • Student housing
  • Industrial
  • Retail

In a much broader sense, commercial real estate can refer to any type of property that is regarded as a permanent structure, including cell towers and fiber networks. 

Mixed-use

Mixed-use real estate is property that combines both residential and commercial real estate. They are usually owned and operated by truly experienced real estate investors who are looking to capitalize on the uniqueness of the opportunity at hand.

An example of a mixed-use investment property at its most basic level would be something like a restaurant with a small apartment complex upstairs. Mixed-use property usually provides some type of perk or convenience to the residents who live there. Other types of mixed-use real estate include live-work properties, hybrid hotels, residential spaces that double as offices, and certain other dual-purpose properties.

Tax implications of an investment property

An important thing to understand about investment properties is that rental income is taxable. That being said, a major bonus about the income generated via real estate is that it is considered passive income, meaning Medicare and Social Security taxes do not apply.

Another positive is that there are many tax deductions you can claim when owning an investment property:

  • Rental expenses
  • Qualified business income deductions
  • Property depreciation tax deductions
  • Rental property loss deductions
  • Additional expenses associated with running a real estate business

Business expenses tend to be much higher for those who own a commercial investment property. That is mainly because the value of the property is usually much higher and there is much more work that needs to be done. 

Aside from the fact that property taxes for commercial properties are much higher, another important difference to make note of between commercial and residential property taxes is that taxes are calculated based on the assessed value of the investment property rather than the actual value.

Advantages of investment properties

Investment properties offer a diverse set of opportunities when it comes to generating income. As such, there are many advantages to owning investment properties.

Cashflow 

Collecting rental payments or payments on lease agreements can generate a steady cash flow. If you update the home, you can increase your cash flow. You can do this by renovating the property, furnishing the space, offering amenities, minimizing expenses as much as you can, and, if possible, refinancing the house.

Appreciation value

With a little bit of work, it’s very possible that your home will appreciate in value over time. It’s also possible that the home will appreciate naturally as the housing market improves. Selling or flipping your home after it has been appreciated can result in a serious profit. 

Tax breaks and deductions

Investment properties offer many opportunities for tax deductions due to the amount of expenses that owning real estate can cause for you. Major expenses can often be written off, though this does not apply to all expenses. Any losses on your property can typically be written off as well, and even your mortgage interest is tax-deductible.

Build equity

Building equity over time can happen when you pay down your mortgage with principal and interest payments. As you do so, it’s possible that the value of your home will also rise, meaning that you’ll gain even more equity.

Leverage

In real estate, you’re able to use leverage, or borrowed funds, to increase capital and purchase an investment property. This helps you get your foot in the door much faster, both literally and figuratively. Doing so can make it possible for you to increase your returns by using other people’s money, not your own.

Disadvantages of investment properties 

Just like there are advantages to investing in real estate, there are downfalls to be aware of as well. Before you decide if you want to purchase an investment property, it’s important to know what they are and how they could affect your financial situation.

Risk

Investment properties are definitely a risk. Many remember the financial crisis of 2008 that crashed the housing market and sent millions of Americans into foreclosure.

Two huge risks associated with investment properties are the volatility of the market and the potential of it crashing. Other risks include things like the location of your property, liquidity, lawsuits, bad tenants, and difficult neighbors.

Down payments and interest rates

Most mortgage lenders will require a higher down payment for investment properties because your stake in the property has to be higher in order for them to take on the risk. This also can sometimes include higher interest rates. Be prepared to have at least 20% of the mortgage to put towards a down payment. 

Property management

Management of the property is something that you will need to partake in either yourself or through a property management company. For this reason, it may be a good idea to invest in property in a location that you have at least some familiarity with.

Property management will include keeping up with the maintenance of the property, repairing and replacing any troubling plumbing or HVAC issues, landscaping, and can sometimes even include cleaning. There are many third party property management companies that specialize in all-inclusive services.

Lack of liquidity

Liquidity refers to the time it takes to make a property available for sale. When it comes to real estate, this can be one of the most drawn out and slowest processes in business. For this reason, investment properties are considered to be one of the most illiquid industries.

Difficult tenants

Difficult tenants can be considered high risk because these are tenants that are most likely to cost you both time and money. They can do this by not paying rent, causing damage to the property, or even running an illegal business on your property. It’s important to avoid the risk of potentially difficult tenants by vetting them before approving them as tenants.

Rising taxes and insurance premiums

Taxes and insurance premiums will account for a large percentage of your costs as an owner of investment properties. The difference between taxes and premiums is that taxes are completely out of your control, whereas insurance premiums can be semi-controlled by mitigating your own losses. In both scenarios, it’s extremely important to be prepared for any potential rising costs.

Financing investment properties

Financing investment properties is different from financing a home because financial institutions consider them to be more of a risk, and therefore they are partially assuming that risk. For that reason, it is quite common for the bar to be raised in terms of the requirements to obtain a loan.

This can mean that you will have to pay higher down payments, have better credit scores, and earn more income. On the other hand, there are some companies that specialize in loaning money to those who invest in real estate. They will often offer unique products, like loans, multiple properties bundled into one, or perks that are tailored for business opportunities.

Find the right opportunity to invest in

If you’ve decided that you are cut out for the world of investment properties, then the next step is to figure out what is important in terms of the growth of those investments. Certain things worth considering are location, nearby schools, neighborhoods, the types of properties available, and the future development of the area.

FAQ

Are rental homes considered investment properties?

Rental homes generate income. Therefore, they are considered investment properties instead of secondary homes.

Is an investment property a good idea?

An investment property can be a good idea if you decide you are cut out to be a landlord and you have enough capital to get started.

What is considered an investment property?

Any permanent structure that generates income via renting, hosting, or leasing can be considered a rental property.

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