What Is an Investment Property?

DEFINITION

Investment property is real estate designed to generate a profit for the owner, generally through either rental income or appreciation. Some of the types of investment properties available include residential real estate, commercial real estate, and raw land.

Definition and Example of an Investment Property

An investment property is real estate that isn’t occupied by the owner and is meant to result in either rental income or capital appreciation (or both). Your primary residence doesn’t count as an investment property unless you rent part of it. This type of investment can be anything from a single-family home to a large commercial property. However, if you’re just starting to dabble in real estate, most likely you’ll find it best to start with residential real estate.

A popular example of owning investment property, especially for beginners, is house hacking. This strategy involves purchasing a duplex, living in one side, and renting out the other to help offset your mortgage payment.

While one side of the duplex serves as your residence, the other side is an investment property. Many people who begin investing using house hacking go on to own other investment properties or move out of the duplex to rent out both sides.

Key Takeaways

•An investment property is a piece of real estate that isn’t owner-occupied, and one that’s meant to generate a profit through rental income or appreciation.

•Many people purchase investment properties for the ongoing rental income, but may also flip houses for a short-term profit.

•Some of the types of investment properties available include residential real estate, commercial real estate, and raw land.

•Those who want to invest in real estate without buying investment properties can invest in REITs or real estate crowdfunding.

•The process for financing a residential investment property may be similar to buying a primary residence but with stricter requirements.

How Investment Properties Work

The financial benefits of an investment property are its income generation or capital appreciation. Depending on the property, you may be able to enjoy both of these benefits.

In most cases, investment property is ownership of real estate and renting it to others. Rentals can range from short-term Airbnb rentals to multifamily homes or large commercial properties.

Owning an investment property is a hands-on job unless you find someone else to manage the property for you. First, you have to purchase the property, either with cash or financing. Once you own the property, you’re responsible for maintaining it and finding tenants to rent it.

The primary benefit of owning an investment property comes from the regular income you’ll get from your tenants’ rent. Those rental payments help cover the mortgage payments, pay for property maintenance, and, hopefully, result in some profit.

While many people purchase investment properties for rental income, others may buy them to flip for a profit. Generally, this business model has a shorter timeline since you buy a home to improve it, then sell it in a few weeks or months.

Types of Investment Properties

If you decide to purchase an investment property, you’ll have three primary options: residential real estate, commercial real estate, and raw land.

Residential Real Estate

Residential real estate is most likely the route you’ll take if you choose to add an investment property to your portfolio. Residential real estate can include a few different types of properties:

•Long-term and short-term rentals

•Single-family homes

•Multifamily homes

•Apartment buildings

Commercial Real Estate

A commercial investment property is rented out to business customers instead of individuals. Commercial real estate investments could include standalone commercial buildings, storefronts, warehouses, and other buildings that a company might rent for business purposes.

Raw Land

While it may not be as common or straightforward as residential or commercial properties, raw land is also a type of investment property available. When you invest in raw land, you can enjoy the benefits of standard appreciation over time, and exponential capital appreciation if the city zoning changes to more lucrative use of the land such as housing development or industrial use.

The raw might sometimes even earn you recurring income by renting it out to a farmer to grow crops on, campsite, temporary parking, or other uses.

Alternatives to an Investment Property

Owning an investment property has some key advantages, including the opportunity to earn a regular income from your investment. But due to the investment of time and money required, it’s not right for everyone. However, there are a couple of ways you can add real estate to your portfolio without directly purchasing an investment property.

Real Estate Investment Trusts

A real estate investment trust (REIT) is a company that owns and operates investment properties and allows individual investors to join. Investing in REITs is quite similar to investing in other companies’ stock—you buy shares in the company, then enjoy the perks of being a partial owner.

REITs often provide higher dividends than other stocks, since the investment properties the company owns result in a regular source of income. The good news is they’re simple to purchase. You can buy publicly-traded REITs through your normal brokerage account.

Real Estate Crowdfunding

Real estate crowdfunding is a way for many investors to come together to finance a particular investment property or project rather than each buying their own property.

Popular real estate platforms allow you to invest in specific properties or gain exposure to several different properties with one investment. Depending on the platform, you may be able to invest with just a small amount of money and earn a fixed income in the form of dividends.

Real estate crowdfunding comes in two primary forms: debt crowdfunding and equity crowdfunding. When you invest in debt crowdfunding, you’re essentially lending the company money, which it will repay down the road with interest.

Pros and Cons of an Investment Property

Pros

•Recurring income

•Tax benefits

•Long-term appreciation

Cons

•Lack of liquidity

•Time investment

•Unexpected costs

Pros Explained

•Recurring income: One of the most significant benefits of owning an investment property—and the reason many people purchase one in the first place—is the opportunity for a recurring income. Each month, you’ll have a source of income from the tenants who rent your property. As long as your income exceeds your expenses, an investment property can result in positive cash flow.

•Tax benefits: Several tax benefits come with owning an investment property, including the ability to take a deduction for depreciation and other expenses associated with owning the property.

•Long-term appreciation: The recurring income isn’t the only way to make money from your investment property. Like stocks, rental properties can experience appreciation, meaning they increase in value. Based on a study by the American Enterprise Institute, homes appreciated between 4% and 8% from January 2013 to January 2020. Home appreciation increased year-over-year from January 2020 to January 2022, appreciating as much as 17.0%.

Cons Explained

•Lack of liquidity: Once you buy an investment property, a significant amount of your assets become tied up in it. While that’s not necessarily a problem, it does mean that you lose some liquidity because part of your net worth isn’t as accessible in a financial emergency.

•Time investment: Unless you hire an individual or company to manage your investment property for you, this investment will probably be a hands-on one. You’ll be responsible for maintenance and the time it takes to find and interact with tenants.

•Unexpected costs: Anyone who has owned a home will tell you to be ready for unexpected costs. As a property owner, you’re on the hook for repairs needed in the building, whether a broken pipe or a new roof. You may also face the unexpected cost of covering the mortgage on your own when you’re between tenants and the property is vacant.

How to Get an Investment Property

The process for buying an investment property depends on its type. As an individual investor, you’ll most likely purchase a single or multifamily home rather than a large complex or commercial property. And in that case, the process of obtaining financing isn’t all that different from financing a personal residence.

First, many of the same lenders that offer mortgages on personal residences also offer financing for investment properties.

To qualify, you’ll have to meet many of the standard mortgage requirements, including:

•A good credit score

•Cash reserves (usually at least six months for an investment property)

•A down payment (as low as 15% for a single-family home or higher for a property with two to four units)

•A debt-to-income ratio (DTI) of less than 36%

•Proof of stable income in the form of W2s, pay stubs, or tax returns

What It Means for Individual Investors

If you’re an individual investor, you might be considering adding an investment property to your portfolio. Real estate has remained a popular investment for years; a 2021 Gallup Poll found that 41% of Americans believe real estate to be the best long-term investment, up from 35% the year before. Stocks lag behind considerably, with just 26% of Americans believing them to be the best long-term investment.

While an investment property can be an excellent investment, investing is personal—what’s right for someone else may not be right for you. Before taking on the responsibility of an investment property, be sure you understand what you’re getting into, including the time and money investments.

And remember, there are ways to add real estate investments to your portfolio without purchasing your own real estate investment. REITs and real estate crowdsourcing are more accessible than ever, and are options worth exploring for someone who wants a more hands-off approach to investment properties.

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