Summary: In this article you’ll learn about 6 types of rental properties. Discover the pros and cons of each type to see which option might be best for you.
Introduction
One of the first tasks after you’ve decided to invest in real estate is to determine how you’re going to do it and which properties best meet your goals. Let’s dive into the six most common types of rental properties and the pros and cons of each.
Single Family Homes
Single family homes (or SFHs) are the most common type of real estate. As the name implies, these properties generally have enough space to house one family and don’t share walls with any other unit.
Pros
Being that these types of properties are so plentiful, they’re easy to work with — loans are straightforward and banks are very willing to lend. Most agents are familiar with how to price them, and the inner workings (think electrical, plumbing, etc.) are pretty standard. From an investment standpoint, SFH are likely to be rented by tenants who are established, stay for several years, and pay for most of the utility bills themselves.
Another benefit to SFH is that you won’t have to deal with disputes with other tenants sharing a neighboring wall, as you would in an apartment complex. While they may have a noise complaint about the neighbor next door, you can instruct them to call the police, rather than attempting to play mediator.
If you’re just getting started as an investor, you may only be able to afford a SFH. The cost per unit may be higher than a multi-family, but you can’t buy just one unit of an apartment complex. Plus, SFHs tend to generate better appreciation in strong markets, because they’re impacted by consumer behavior, rather than commercial property that’s impacted by cap rates and other investor-focused metrics. Of course, this is also a downside in uncertain markets like the current one affected by Coronavirus and oil prices.
SFH are easier to sell than other properties since you have both investors and those looking for a new residence in your buyer pool.
Cons
As we mentioned before, SFHs tend to have a higher cost per unit. You’ll pay more for a tenant flip on a SFH — usually because they’re larger square footage and tenants have really settled in. If you have the initial money to invest, you may have a better return by buying a fourplex or an apartment complex. This is also because you pay fees and closing costs each time you purchase and sell property.
The biggest cost to sellers is the 5% to 6% commission fee real estate agents charge. However, when you sell you may be able to reduce listing agent commission costs to 1% or less by working with a low commission agent or negotiating with your agent.
Banks may be less willing to get creative on financing for SFHs and you’re limited on how many mortgages you can have as an individual — that number ranges from four to ten depending on the bank. The large pool of buyers interested in SFHs can also be a negative — you’ll have a lot of competition when shopping and be up against buyers looking to move into the property as their personal residence. Instead of looking at the return on investment (ROI), these buyers are more concerned about the cosmetics of the home and may outbid you.
Note: If you’re looking to invest in single family homes for cash flow and appreciation, RealWealth® can connect you with property teams that sell R.E.A.L. Income Properties around the country. These teams also offer full service property management that includes handling tenant placement and maintenance. Become a member of our network to view sample property pro formas and to schedule a complimentary call with one of our Investment Counselors.
Multi-Family Real Estate
Multi-family properties are any type of residential real estate that have more than one unit. Properties with two to four units are considered small multi-family properties and their value is based on other residential properties in the area. The value of large multi-families — those with five units or more — are figured by comparing the ROI of similar commercial properties in the same market.
Pros
Many of the cons of SFH are pros for multi-family properties. When you purchase a multi-family property, you pay closing costs just once — you’ll also pay one insurance policy, one monthly mortgage payment, and one property tax bill. You can scale your profit much quicker with multi-family real estate. By increasing rents by $50 in each unit of a 10-unit building, you’re increasing monthly income by $500. If you increased rent by $500 on a SFH, your tenant would likely move out as soon as possible. Plus, it may be easier to make income-generating upgrades to multi-families by adding things like garages, coin-operated laundry machines, and other amenities.
Since the valuation of most multi-family properties are based on ROI, you have the ability to move the needle yourself by cutting costs or increasing income. This can’t be done with residential SFHs, where values are based on the fluctuating market. You’ll also have less competition when buying multi-family properties since most people aren’t looking to reside in them (unless they’re house hacking!)
Cons
The biggest negative to owning multi-family properties is the upfront cost to purchase them. You may be able to purchase a SFH for $50,000 in some markets, but a multi-family will cost much more than that — this is why most investors start with a SFH unless they’re house hacking.
While you don’t have to come up with the full amount in cash to purchase a multi-family, it can be harder to convince a bank to lend you that much money upfront. You’ll need a large down payment (unless you can get creative), and you’ll be on the hook for a large monthly mortgage payment. There are also less multi-family properties on the market to choose from.
Those who live in apartments are sometimes more mobile — in markets where housing prices are lower you can expect to flip each unit every year, which can be a big expense. Tenants may also have more drama in their lives and more disagreements with fellow tenants in the building. Apartment dwellers are usually less handy — they might call you for every little thing (even as little as changing a light bulb!) If you’re not so keen on this, you might consider building the cost of a property management company into your budget.
Condos and Townhomes
Condos and townhomes are a hybrid between SFH and multi-family properties. Each individual unit is owned separately, but there are shared amenities — like a tennis court, pool, or lawn care — that are provided by a homeowner’s association (HOA). There are some delineations between the two, so do your research, but for the sake of simplicity, we’ll explore the two of them jointly.
Pros
One of the major benefits to renting out condos or townhomes is that there is little ongoing oversight or property management needed. In exchange for paying your required HOA fees, the association typically handles things like repairs to communal spaces, lawn care, and snow removal. In the case of condos, they may even provide some maintenance work.
Cons
While you may be able to offload some maintenance to an HOA, they also carry restrictions on how you can use the property, HOA rules can change at any time if approved by the HOA’s owner board, and the association may not even allow you to rent out your unit. HOA fees can also significantly reduce your monthly cash flow.
Foreclosures
Foreclosures are bank-owned properties that have been taken over after a previous owner failed to keep up with their mortgage payments.
Pros
Investors can usually snag foreclosed properties for under market value. The lender is looking to quickly recoup their loan amount and will request a quick closing so they don’t have to pay for any ongoing costs of holding the property. Since these homes are usually distressed and have deferred maintenance, there may be little competition and huge room to improve the property if you’re willing to put in some work.
Cons
As mentioned in the above section, foreclosures may come with problems with mold, vandalism, or other defects. If you’re not one who wants to get your hands dirty, foreclosures may not be the way to go. You may also need a few months to clean up the property and make it rent ready — meaning you won’t realize any positive cash flow for quite some time.
Fixer uppers
Similar to foreclosures, fixer uppers require a certain level of cosmetic repair or rehabbing but are owned by homeowners, instead of a bank.
Pros
Fixer uppers can be purchased in good neighborhoods for under market value — one of the greatest appeals to purchasing one. You’ll see less competition since some work is needed before the property is move-in ready and most people simply won’t have the time or money to make it happen. After doing this, your property will experience forced appreciation — meaning that by bringing it up to the quality of other properties in the same neighborhood, the value will be in line with them as well. For example, you could increase its value by $50,000 by only spending $20,000 in repairs.
Cons
It can be difficult to get a traditional lender to loan funds for a fixer upper, so you may need to resort to working with a private or hard money lender. This is doable, but you just need to be creative. Hard money lenders typically have high interest rates and request to be paid back in six to 12 months — which can be stressful, especially if the rehab ends up costing more than expected. Since most fixer uppers are purchased “as is,” it can also be difficult to accurately access needed repairs until you become more familiar with the property and dig in.
A strategy used frequently by investors purchasing distressed properties is BRRRR — buy, rehab, rent, refinance, repeat. By doing this, you can pay back your short term private investor and eventually secure a more traditional long term mortgage.
Commercial Real Estate
Commercial real estate is property that is home to commercial businesses like grocery stores, hair salons, restaurants, etc.
Pros
Commercial real estate generally requires less hands-on interaction from the owner — business owners pay all the bills, perform and pay for their own maintenance and capital expenditures. They may even pay the property taxes for the building. Commercial leases are also typically at least several years — sometimes even 10 or more — so you won’t deal with much turnover.
Cons
Although you shouldn’t have to find new commercial tenants often, when you do, you may experience long periods of vacancy. You’ll need to find a tenant whose business can function in the exact space and location you have available, which can take some time. Additionally, margins on commercial real estate are typically lower than residential real estate and you may need 30% in a down payment in order to secure a loan to purchase a commercial property.
Which type is best for you?
Assess your current skill set when determining which type or types of rental property are best for you. You may wish to start out in SHFs until you are able to build up enough equity and cash flow to move to multi-family properties. Or, maybe you are able to house hack by living in one side of a duplex so you prefer to start off with a multi-family. Whatever you choose, pay close attention to the pros and cons of each in order to minimize your investment risk.
