Owning investment properties can have a number of advantages if you're an investor. Among these is owning an asset that is not directly correlated with the stocks and some other more traditional types of investments. Here are some of the potential advantages investors should be aware of when considering owning an investment property.
They're an Alternative Asset Class
Real estate is an alternative asset class, meaning it has a relatively low correlation to stocks and bonds. Because of this, real estate can help investors diversify their overall investment portfolio.
The correlation to stocks over time will vary by location and the type of investment property, but, overall, investment properties can provide diversification, especially if your portfolio is filled with more traditional holdings in stocks and bonds, including mutual funds and ETFs.
Beyond diversification via a low correlation to other holdings, investment properties can also offer variation in terms of your income stream. Generally, investment properties bring in monthly rental income. The cash flow from the rental income can sometimes cover the costs of operating the property and still leave room for ongoing positive cash flow. Most other types of investments are different—they may offer distributions quarterly.
Price Appreciation and Leverage
Real estate offers the opportunity for long-term appreciation and can be purchased with a relatively small down payment in some cases. This offers the opportunity for you to use leverage to multiply the return on your investment.
Leverage in real estate means that you're essentially working with someone else’s money. Leverage comes out of borrowing some, or all, of the purchase price and can serve to magnify your return on a real estate investment. Gains on the property of the same dollar amount will be a greater percentage of your investment, the lower the amount of your own cash you invest in your purchase of the property.
Property that generates an income from tenants can provide an income stream that can help pay some portion of the mortgage and real estate taxes while the property appreciates. Coupled with the benefits of using leverage, this can make investment property an attractive investment.
Potential Tax Benefits and Inflation Hedge
Investment properties can offer both an inflation hedge and the ability to write-off some of the costs of ownership.
Income property can give a number of tax advantages, including the ability to claim depreciation on the property and to write-off expenses to maintain it.
An accounting method used to expense the cost of a physical asset over its useful life, depreciation is often used in connection with capital equipment and buildings. The same principles apply to investment properties.
The IRS sets the rules in terms of how the depreciation works and the time period over which the asset can be depreciated. The depreciation for a given year is recorded as an expense that will reduce the income from the investment property.
Depreciation is a non-cash expense, meaning it's not tied to when the property was initially purchased either for cash or financed (all or in part). Depreciation reduces the value of the property on your balance sheet, resulting in a lower cost basis at the time you might sell the property, potentially increasing the gain on the sale.
Management and Maintenance Benefits
Expenses connected with the management and maintenance of the property are also deductible. This could range from the cost of a property manager (if you choose to use one) to lawn maintenance or snow removal. In some cases, maintenance items can be expensed, in others, they may need to be capitalized if they're a certain type of item. In the latter case, the expense would be added to the cost of the property and then depreciated.
Taking into account the depreciation and management benefits, buying investment properties should be thought of like running a business. After buying a property, you need to bring it up to a condition where you can rent it to tenants—either residential, retail tenants or commercial tenants—depending upon the type of property. You then need to find tenants to bring in revenue that will hopefully offset most or all of your expenses in owning the property. Lastly, you need to maintain and sometimes improve the property to keep it desirable to prospective tenants and ultimately to a buyer down the road when you might want to sell the property.
Income property, like all real estate, can be a hedge against inflation over time. Although this will vary by location, real estate values in many parts of the country have kept up with or exceeded the rate of inflation over time. With an investment property, the owner has the added benefit of ongoing cash flow from rents while holding the property.
Cautions and Due Diligence
Before jumping headfirst into buying an investment property, make sure to understand the rental trends in the area you're looking to purchase. What are the trends in the general local real estate market? Is this a desirable area for residential income property and/or commercial, depending upon the type of property you're looking to buy?
You'll also need to consider whether or not you want to be your own property manager or hire an outside firm. This will depend upon the type of property you're looking to buy, among other factors. Managing a single-family home or duplex with a couple of tenants is far different than managing a number of apartment buildings or a large commercial property. Your own physical location relative to where the investment property is located is a factor as well.
Investment property can have many advantages as an investment, but you'll need to do the proper work upfront to mitigate the potential risks involved. Especially in the current economic environment in the wake of the coronavirus pandemic, it’s important to assess the relative valuation of a property compared to its potential for appreciation, as well as prospects for tenant demand.