How should I invest $500,000 in Real Estate?

Question

As an individual investor, I have $500,000 allocated to real estate investments.  Which segments of the real estate market would you advise investing in?  Single-family?  Multifamily?  Self-Storage? Modular/mobile homes?

Asked by: GG – New Jersey
Answer

To answer the question, I have to set up some parameters.  First, the options presented are the only available options, and the allocation is all cash with no mortgage debt.  I will offer a secondary perspective using reasonable mortgage debt. Let's look at each choice individually.  

Consider that so many of our decisions, including real estate investment decisions, are based on sentiment, how we "feel" about something. It's the human condition.  Sorry – there's no way out.  

$500,000 Investment – No Mortgage Debt

At this level of investment, I would immediately eliminate self-storage and mobile homes.  Both require a much larger investment footprint to make them work.  To purchase a mobile home park or mini-storage this small makes the purchase a higher risk than the other alternatives and a proverbial management headache.  These investment types require some scale to work.   

Concerning single-family versus multifamily, the initial investment criterion leans heavily on market selection.  In Ventura County (just north of Los Angeles), $500,000 buys you one single-family house; a 3-bedroom, 2-bath house with a 2-car garage built in the 1960s will rent for around $3,200 monthly.  This same investment will buy you two beautiful brand-new townhomes that rent for $1300 each in Houston, Texas.  

Which is a better single-family investment? It's a toss-up because so much of this is a personal choice, based on sentiment, familiarity, or comfort level.  Proximity is a big deal; they want to drive by their real estate investment at will.  I advise against this perspective because a quality real estate investment, when viewed clinically and professionally… doesn't care about what zip code you live in – there is NO correlation between where you live and what makes for a suitable investment property.  

As you may already know about me, I have a strong preference for multifamily over single-family.  For starters, rents are diversified over more "doors." One vacancy doesn't mean income goes to zero until that one unit is re-rented.  At $500,000 invested, this may only purchase a duplex in larger markets and 4 to 8 units in smaller markets.  Each offers the opportunity to benefit from multiple streams of income from a single investment property.  And you are not dependent on one tenant's financial fate to see revenue from one month to the next.  

When considering any purchase, but mainly an all-cash purchase, make sure to hire independent inspectors.  This is a sunk cost that protects your investments on the way into committing capital.  The fees on a small asset will range from $300 to $2,000. This range assumes using a licensed home inspector. Still, it may require a professional to perform a  capital needs assessment on a larger asset to eliminate the guesswork about the condition of effective systems and practical use. 

Here's the best advice I can offer given the examples presented above:

  • Consider your intended term of ownership as a significant factor in the decision point.  Five years in a hard asset such as real estate is a concise time horizon and subject to market fluctuations outside your control.  Remember that many markets have yet to return to 2008 valuations over a decade later! 
  • Factor in all expenses related to ownership – don't fool yourself into thinking you are so unique that your costs will be less because of your built-in genius or market-knowledge or local market connections.  Taxes and insurance happen to everyone. Vacancy does occur.  Every property needs a replacement reserve. 
  • Build into your investment analysis the costs of hiring a professional property management company. It's an "expense" that will buy you much piece-of-mind. 
  • Geographic diversity is essential, but it's not the be-all, end-all.  However, you should have a high level of confidence in the market or markets you select. 
  • Consider your choices for property management in the selected market. Consider "shopping" for a property manager before buying an asset there. The knowledge you gain will be eye-opening!
  • Avoid complacency – be an active manager of your real estate investments.  Even when you have a property manager, you review the reports and check the bank balances to ensure alignment with your expectations.  This means inquiring about annual rental increases and addressing any deferred maintenance.  It means being involved. 

$500,000 Investment – Using Mortgage Debt

With $500,000 in cash, let's move our investment horizon up $1,500,000. This level of investment provides some flexibility and the alternative to look at all four investment choices. 

I will still segregate mobile home parks and mini-storage as specialized investment types because they require particular expertise to run the business. So unless it's you running the business, as I have shared earlier, consider interviewing management companies in advance of a purchase.  You may find the perfect fit.  That would be great. 

However, you may find that no one is interested in managing this type of investment type in the geographic area you seek to invest. Wouldn't that be a pickle! You buy a mini-storage, and no one steps up to manage the asset, and it's up to you (and only you) to figure out how to operating the business and keep the doors open!  Best to find out before making the purchase.  Exasperated, you start looking to sell just months after buying. Don't expect competitors to have empathy for your fate. 

Asset prices for both single-family and multifamily have recently firmed up as Corona Virus has taken its toll on our society.  The income gap is widening.  Rentals are struggling in big cities as people leave for more space (if they can).  Vacancy is rising as evictions tick up.  Getting a small commercial loan is an extended dance that includes heavy underwriting, everything but blood samples, and a psychological exam, it would seem.  

The good news is that there is real estate product available for purchase, selectively. Consider a longer time horizon for making a purchase based on what's right for you in the long term.  Try not to rush.  However, when you identify and tie up the right piece of property, go through your due diligence and buy the deal.  Don't second-guess your process.  Product may be harder to come by, but if you are actively in the market, you'll know when to pull the trigger – but the timeline for finding the deal, financing, and closing, will be longer than you expect.  

Like politics, all real estate is local.  There is no one-size-fits-all capitalization rate or investment return.  Duplexes do not sell for 115X monthly rents all over the country. Values and valuations are market-specific.  People buying $1,000,000 homes all cash that rent for $5,000 a month are parking money.  Their investment is based on security and not yield.  

Consider if you are borrowing $1,000,000 with $500,000 equity to invest in real estate, if your cash-on-cash return is less than three percent (3%), then you too are parking money, but with the added risk of mortgage debt.  The upside is appreciation on the leveraged purchase price.  The downside is debt-service that doesn't go away no matter your rental income. 

My conclusions rest on your investment time horizon. If it's short, stick with an all-cash investment in a small property close to home.  The longer the time horizon, the more options you can consider in terms of distance, leverage, and property type.  Build-in professional property management into your calculations and run everything past your real estate attorney before buying.  

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