Types of Real Estate Investments

Real estate is one of the oldest and most popular asset classes. Most new investors in real estate know that, but what they don’t know is how many different types of real estate investments exist.

It goes without saying that each type of real estate investment has its potential benefits and pitfalls, including unique quirks in cash flow cycles, lending traditions, and standards of what is considered appropriate or normal, so you’ll want to study them well before you start adding them to your portfolio.

As you uncover these different types of real estate investments and learn more about them, it isn’t unusual to see someone build a fortune by learning to specialize in a particular niche.

If you decide this is an area in which you might want to devote significant time, effort, and resources in your quest for financial independence and passive income, I’d like to walk you through some of the different kinds of real estate investing so you can get a general lay of the land.

Before we dive into the different types of real estate investments that may be available to you, you should know that you should almost never buy investment real estate directly in your name. There is a myriad of reasons, some having to do with personal asset protection.

If something goes wrong and you find yourself facing something unthinkable like a lawsuit settlement that exceeds your insurance coverage, you and your advisors need the ability to put the entity that holds the real estate into bankruptcy, so you have a chance to walk away to fight another day.

A major tool in structuring your affairs correctly involves the choice of a legal entity. Virtually all experienced real estate investors use a special legal structure known as a Limited Liability Company, LLC for short, or a Limited Partnership, or LP for short. You should seriously speak with your attorney and accountant about doing the same. It can save you unspeakable financial hardship down the road. Hope for the best, plan for the worst.

These special legal structures can be set up for only a few hundred dollars, or if you use a reputable attorney in a decent-sized city, a few thousand dollars. The paperwork filing requirements aren’t overwhelming, and you could use a different LLC for each real estate investment you own.

This technique is called “asset separation” because, again, it helps protect you and your holdings. If one of your properties gets into trouble, you may be able to put it into bankruptcy without hurting others (as long as you didn’t sign an agreement to the contrary, such as a promissory note that cross-collateralized your liabilities). With that out of the way, let’s get into the heart of this article and focus on the different types of real estate.

If you’re intent on developing, acquiring, owning, or flipping real estate, you can better come to an understanding of the peculiarities of what you’re facing by dividing the real estate into several categories.

Residential

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 agreement, or the agreement they sign with you, known as the lease agreement. Most residential leases are on a twelve-month basis in the United States.

Commercial

The commercial property consists mostly of things like 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, but if the market heats up and rental rates increase substantially over a short period of time, it may not be possible to participate as the office building is locked into the old agreements.

Industrial

Industrial use real estate can consist of everything from industrial warehouses leased to firms as distribution centers over long-term agreements to storage units, car washes, and other special purposes real estate that generates sales from customers who temporarily use the facility. Industrial real estate investments often have significant fee 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

Retail properties consist of shopping malls, strip malls, and other retail storefronts. In some cases, the landlord 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

Mixed-use properties are those that combine any of the above categories into a single project. 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.

Beyond this, there are other ways to invest in real estate if you don’t want actually 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. Of course, you have to deal with some tax complexity – your dividends aren’t eligible for the low tax rates you can get on common stocks – but, all in all, they can be a good addition to the right investor’s portfolio if purchased at the right valuation and with a sufficient margin of safety.

You can also get into more esoteric areas, such as tax lien certificates. Technically, lending money for real estate is also considered real estate investing, it can be considered a fixed-income investment, just like a bond, because you generate your investment return by lending money in exchange for interest income. You have no underlying stake in the appreciation or profitability of a property beyond that interest income and the return of your principal.

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 the two because you will eventually get the property back and presumably the appreciation belongs to you.

Investing in real estate can be a lucrative way to build wealth, but it’s not always necessary to manage properties directly to see returns. There are several alternative strategies that allow investors to gain exposure to real estate without the hands-on responsibilities. Here, we explore some of the most effective methods.

1. Real Estate Investment Trusts (REITs)

One of the most popular avenues for investing in real estate without direct involvement is through Real Estate Investment Trusts (REITs). When you invest in a REIT, you’re purchasing shares in a corporation that owns and often operates income-generating real estate. REITs are required to distribute a significant portion of their income as dividends to shareholders, making them an attractive option for investors seeking regular income.

However, it’s important to note that the dividends from REITs come with some tax complexities. Unlike dividends from common stocks, which may qualify for lower tax rates, REIT dividends are taxed as ordinary income. Despite this, REITs can be a valuable addition to a diversified investment portfolio, especially if acquired at a reasonable valuation and with a sufficient margin of safety.

2. Industry-Specific REITs

REITs are versatile and can be tailored to match specific investment goals. For instance, if you have a particular interest in the hospitality sector, you can invest in hotel REITs. These specialized REITs allow you to gain exposure to a specific industry without having to manage individual properties within that sector.

3. Exploring Tax Lien Certificates

For investors looking to explore more unconventional real estate investments, tax lien certificates offer a unique opportunity. These certificates are a way to invest in real estate by lending money to property owners who are behind on their property taxes. In exchange for your investment, you receive a lien on the property, and the property owner is required to pay you interest on the amount lent.

While this type of investment is considered more of a fixed-income opportunity, similar to bonds, it still provides a pathway to real estate investment without the need for direct property management. However, it’s crucial to be aware of the risks and complexities associated with tax lien investing.

4. Real Estate Lending

Another indirect method of investing in real estate is by providing loans for real estate purchases. This strategy is often categorized as a fixed-income investment because, like bonds, your return comes from the interest paid on the loan. Unlike traditional real estate investments, where you benefit from the appreciation of the property, real estate lending focuses solely on generating income from the interest payments.

Although you don’t gain from the property’s appreciation, real estate lending can be a relatively secure way to earn income, provided the borrower meets their obligations.

5. Sale-Leaseback Transactions

A sale-leaseback transaction is another strategy that blends real estate investment with fixed-income characteristics. In this scenario, you purchase a property and immediately lease it back to the seller, often a business, such as a restaurant or retail store. This arrangement allows the seller to continue operating their business while freeing up capital, and it provides you with a steady income stream from the lease payments.

While this strategy is primarily focused on generating income rather than capital appreciation, the property’s value may still increase over time, and eventually, you will regain full control of the property.

Conclusion

Investing in real estate offers a variety of options beyond the traditional route of purchasing and managing properties directly. Whether through REITs, tax lien certificates, real estate lending, or sale-leaseback transactions, there are numerous ways to gain exposure to the real estate market and generate income. Each of these strategies comes with its own set of risks and rewards, making it essential for investors to carefully consider their financial goals and risk tolerance before diving in. By choosing the right strategy and approach, you can effectively diversify your investment portfolio and benefit from the lucrative opportunities real estate has to offer.