When it comes to building an investment portfolio, it’s essential to understand the various investment options and how they can benefit you. There are many potential strategies to consider, and if you want to be a real estate investor, you’ll need to have a real estate investing strategy before you begin.
Here at Addition Financial, we often talk to our members about property investment and how to include real estate investments in their portfolios. When there’s an interest in purchasing real estate (instead of buying shares in an REIT, for example) one option is using a buy and hold real estate investing strategy. Here are nine pros and cons to consider.
What is the buy and hold method in real estate?
There are several ways to make money by purchasing real estate. One strategy that gets a lot of attention on television is the “fix and flip” strategy, which involves buying an investment property that’s in need of renovation, investing the time and money to fix it and increase its property value and then selling it for a profit.
The opposite of fix and flip is the buy and hold method, which involves buying one or more rental properties and holding them while collecting rental income. For most investors, the rental part of the equation is a must because most people don’t have enough income to purchase a property (assuming they already own a primary residence) and make second mortgage payments without offsetting their costs with some income.
What types of property can be used in a buy and hold strategy?
There are many possibilities when you look for properties as part of a buy and hold strategy. Types of property that may be part of a buy and hold strategy include the following:
- Single family homes
- Duplexes
- Triplexes
- Condo units
- Apartment buildings
Some investors prefer to build a real estate portfolio that contains several properties of different types to maximize their rental income and profits. For example, buying a condo to rent has some advantages that you can’t get with other types of property, including the fact that the condo board is likely responsible for external maintenance and repairs.
What characteristics should a property have for a successful buy and hold investment?
You’ll need to consider several factors before you opt for a rental property investment as part of a buy and hold strategy, including both the property itself as well as its location. Here are the most important things to investigate before you buy:
- Overall quality. If you need to earn rental income immediately, you shouldn’t invest in a property that needs extensive repairs to be rentable. You’ll need to rely heavily on your inspector to identify potential issues before you buy.
- Size. As a rule, it’s easier to maintain and sell small properties than it is to do the same for large, luxury properties.
- Average rent in the area. You should buy a property only if you’re confident that you can charge enough rent to cover your mortgage, property taxes and other expenses. Researching average rents in the specific area where a prospective property is located is the only way to be sure that you’ll earn enough to make the purchase worthwhile.
- Neighborhood location and characteristics. For obvious reasons, it’s easy to buy and hold when you have a property in a desirable neighborhood where people want to live. For example, you might choose a property in an area with low crime and good schools, making it a more desirable location for families than a place with a lot of crime and below-average schools.
- Rent seasonality. Buying rental property in a college town can be a good thing because you’re likely to have a large tenant pool to choose from. The flip side of being in a college town is that you might have difficulty renting your property during the summer months. The opposite can be true if you purchase a rental property in a popular summer tourist location.
- Property taxes. Some states and cities have higher property taxes than others, so you’ll want to research the rates before you buy to make sure you can collect enough rental income to pay your taxes.
- Job market. As a rule, it’s easier to find tenants in an area where the job market is good and people are eager to move to the area as a result.
Choosing rental properties with these characteristics will help you be successful with a buy and hold strategy. It’s essential to look at the big picture before you make an offer on any rental property.
5 pros of buying and holding real estate
Here are some of the most important advantages of using a buy and hold real estate strategy.
#1: Real estate investments are a hedge against inflation
One of the biggest advantages of buying rental properties for your investment portfolio is that unlike other investments, real estate tends to be a good hedge against inflation. Housing prices rise at (or sometimes above) the rate of inflation, and those market adjustments mean that if you choose wisely, you are unlikely to lose money even if you have to sell during an inflationary period.
#2: Property values increase with time
While there are some mitigating factors, as a rule real estate prices increase with time. While there are periods where prices drop, the year over year average housing price increase from March 1992 to December of 2022 was 5.4%. Buying real estate can greatly increase your chances of getting a good return on your investment.
#3: Owning property has tax advantages
If you’re already a homeowner, you know that there are tax advantages to owning property and these advantages apply to rental properties, too. You can deduct mortgage interest if you claim it as a business expense and the same goes for property taxes. You may also be able to deduct property management fees, maintenance expenses, and even advertising costs if you pay to find new tenants.
#4: You can earn passive income
If you choose to hire a property management company to screen tenants and handle maintenance for your rental properties, any money you earn above your expenses will be passive income. That means you’ll have money flowing in without doing any work to earn it, something that can help you pay for routine expenses or save for your retirement. Of course, you’ll need to keep in mind that passive income is still income and you’ll need to report what you earn to the Internal Revenue Service and pay taxes on it.
#5: Real estate delivers a high return on investment
It’s certainly possible to earn a high rate of return on many investments, including stock purchases. At the same time, not every investment comes with that potential, but real estate does. Between the rental income you collect during the hold period and potential profits due to rising real estate profits, you could easily double, triple or even quadruple your investment.
4 potential cons of buying and holding real estate
While there are many benefits of purchasing buy and hold real estate, there are several potential downsides to keep in mind.
#1: You must hold your property long-term to realize a profit
At the heart of the buy and hold real estate strategy is the understanding that you must hold your property for at least five years, possibly longer, to realize a profit. Real estate prices and markets move in cycles, and you may need to be patient to sell at a time that’s advantageous for you. If you feel you need to sell during a market downturn, you’re likely to earn a far lower return on your investment than you would if you sold at a more propitious time.
#2: Property management can be time-consuming and expensive
All rental properties require maintenance. If you choose to manage your rental properties yourself, you should be aware that doing so can be quite time-consuming. You’ll need to be available to tenants to deal with questions and maintenance issues. You have the option of hiring a property management company to free up your time, but that can be expensive.
#3: Real estate isn’t as liquid as other investments
One of the biggest potential risks of buying real estate as an investment is that it’s not as liquid as some other investments. While you can sell REIT shares quickly, the same may not be true of a rental property. You’ll need to get the property appraised, make any necessary repairs, list the property for sale and wait for the right buyer, and it may take months before you liquidate your property.
#4: You may be on the hook for capital gains tax when you sell
When you own real estate, you aren’t required to pay taxes on its appreciated value with the exception of property taxes. If you sell your property, however, you are likely to be required to pay capital gains tax. People whose income is less than $44,625 ($89,250 if married and filing jointly) are exempt from the capital gains tax. If your income is higher than that, you’ll be required to pay either 15% or 20% unless you reinvest your capital gains via a 1031 exchange or by investing in a Qualified Opportunity Zone.
Incorporate buy and hold real estate into your portfolio with Addition Financial
When you’re building an investment portfolio, diversification is essential because it minimizes your risks and can help to increase your profits. Investing in buy and hold real estate is a good way to accomplish both things at once. The 9 pros and cons of buy and hold real estate that we’ve outlined here can help you navigate the process and find the right properties to buy.
Do you need assistance building a robust, diversified investment portfolio that meets your needs? Addition Financial is here to help! Click here to read about our MEMBERS Financial Services program and schedule an appointment with a Financial Professional today.
Posted on Jul 18, 2023
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