One of the most common ways I have seen investors invest in real estate is to purchase and operate one or more single family houses as rentals. It’s a logical approach for many investors as it’s a process they understand, having purchased their own home. In addition, owning a second home can be attractive as the purchaser has likely witnessed the equity in their home grow over time.
However, for investors seeking a more diversified and balanced approach to real estate investing, they may be better off rethinking this strategy and, instead, opting to build a portfolio of passive commercial real estate investments.
Challenges Of Owning Single Family Rentals
Owning and operating single family rentals is tough work and riskier than most people realize. It presents numerous challenges as an investment vehicle, including:
- Lack of sustainable cash flow: Unless you are purchasing without debt, single family rentals produce little to no sustainable cash flow in most markets. Investors typically justify this by acknowledging they are really making a mid-term bet on a housing market. This places the entire focus of the return on appreciation of a market.
- Excess risk: If leveraged, owning a single family rental requires the investor to assume more than a 100% loss of equity risk by taking on recourse debt. This is a substantial element of risk that investors often overlook. In a downside scenario, a rental owner could be on the hook for far more than their original investment.
- Lack of economies of scale: There are a lot of large capital items, such as roofs, driveways, heating and cooling systems, etc. that are only used by one tenant. If a rental incurs unforeseen capital costs, it wipes out any cash flow for the foreseeable future and it can tank future profitability.
- Binary occupancy (100% or 0%): According to Freddie Mac, U.S. multifamily occupancy rates have averaged approximately 95% dating back to 1990. Therefore, large multifamily properties can reliably target 95% occupancy rates in most markets. In contrast, a single month of vacancy in a single family rental equals a 91.75% occupancy rate (or 8.25% vacancy rate) for that year. If the house remains vacant for three months, you are now facing a 75% occupancy rate for the next year, which is equivalent to a seriously distressed multifamily property.
- Costly management: You are either forced to manage the asset yourself at a large opportunity cost to you or pay a large percentage of income (typically 6-10%) to a third party to manage it for you. Either scenario is an undesirable time or cost expense.
- Purely market dependent: Asset value has no correlation to its profitability and is solely dependent upon the overall market.
- Backyard reliant: Due to owners’ desires to maintain direct oversight of single family rental homes, the location of those rental homes is often within a short drive of their personal residence.
These inherent challenges make single family rentals difficult to justify as a portion of a diversified portfolio strategy.
Passive Commercial Real Estate Investing As An Alternative
Once investors begin to understand passive commercial real estate investments, it’s not uncommon to see them move away from owning single family rentals to redeploy their capital across a number of deals. While it’s not impossible for an investor to become a direct owner/operator of commercial real estate, the specialization and amount of capital required to do so typically poses a formidable barrier to entry. As a result, investors can now opt to invest as a limited partner with commercial real estate operating companies. The following are some of the reasons I see investors choosing to do so:
- Asset value correlated to net operating income (NOI): This is the single greatest reason why an investment in commercial real estate is fundamentally different from a single family rental. The fact that the value of a commercial real estate property has intrinsic correlation to its net operating income means that you can make (or lose) money in a deal regardless of what the greater market is doing. This gives commercial real estate a business model. It also puts the operator in far greater control of its own destiny and moves away from a model of simply making a bet on a market and hoping for the best.
- Ability to co-invest with professionals: Once investors are ready to embrace passive investing, they can now seek out sophisticated groups with proven track records. This gives investors the ability to mitigate some risk by teaming up with battle-tested investing veterans.
- Diversification: Diversification in any asset class is a fantastic tool, and real estate is no exception. By passively investing through real estate operators, investors are now able to freely select asset type, geography and business plan. There’s almost no limit to what they invest in and where they invest.
- Loss limitations: In contrast to single family rentals, as a limited partner, the investor’s liability is capped at the investment amount.
- Rationality: The competitiveness of commercial real estate is typically grounded in rationality (e.g. proximity to transit, ingress/egress, loading, suite size, etc.), which, while complex, can actually make it possible to more reliably project a property’s performance.
Business Vs. Investment
My point is not to bash the concept of owning single family rentals — I have owned them myself and benefitted from the experience. Single family rentals can be a good place to start off in real estate investing. However, I advise investors to view them more as operating a small business than making an investment because that is what it will feel like a year into it. The extremely hands-on nature of owning rentals can easily morph the original intent of the purchase and leave investors with a valuable learning experience rather than a yield and a realized return. It all depends upon the path you wish to take in your journey to becoming a sophisticated real estate investor.