Most real estate investors deal with single family houses. Having bought their own homes, this process is something they understand. Moreover, buying a second home is an attractive venture to the homeowner who has witnessed the gradual equity growth of their first home.
This strategy is great. However, for the investor seeking to diversify in real estate, commercial real estate is a good way to build your portfolio. People do not realize it but having single family rentals is risky and tough. They come with many challenges such as:
No sustainable cash flow: many people purchase their single-family rentals with debt, hence little or no sustainable cash flow. Too much risk: there are great risks associated with owning single family rentals, especially when the property is leveraged. You may end up losing more than you invested. Lack of economies of scale: some large capital items such as cooling systems, driveways, roofs, and heating are used by one tenant.
When the property incurs sudden capital costs your cash flow can be temporarily wiped out. Costly management: when you own single family rentals, you either hire someone to manage them for you (at a huge percentage of your income) or do it yourself (at a great opportunity cost). None of these scenarios is desirable. 100% market dependent: asset value is purely dependent on the overall market—it is not correlated to its profitability.
Backyard reliant: investors will usually want to oversee their rental properties, so these rental homes have to be close to the investor’s residence. Because of these challenges, single family rentals can hardly be justified as a component of a diversified portfolio. The Alternative: Passive Commercial Real Estate Investing
When investors understand how commercial real estate investment works, they will start moving away from single family rentals. An investor can directly own or operate commercial real estate. However, this is not easy as it requires specialization and a large amount of capital which may be a barrier to many investors. The better option is to be a limited partner with operating companies.
Here is why:
Asset value in correlation to NOI (net operating income): this means that the greater market does not necessarily determine whether you lose or gain money. The value of the property is correlated to its net operating income. The operator controls the destiny and it is not just about betting on the market. Co-investing with professionals: when you are ready to passively invest, you can look for sophisticated groups with great track records.
Teaming up with veterans will help you mitigate some risk. Diversification: even in real estate investing, diversification is an awesome tool. Passive commercial real estate investing lets you choose a business plan, asset type, and geography with almost no limits.
Loss limitations: your liability as a limited partner is set at the investment amount.
Rationality: because commercial real estate has its competitiveness grounded in rationality, it is possible to reliably project the performance of a property. Single family rentals are not entirely bad. However, investors should view them as a starting point in real estate investing.