Look Before You Leap: A Guide to Investment Properties

March 22, 2024
  • Private Banking
Relationship Manager Michael O'Connor reviews the advantages and risks of purchasing and owning an investment property.

It is often said, “there is no place like home.” In most cases, though, “home” does not generate income. Those who want to diversify their existing portfolio and consider how to make passive income might want to explore the idea of purchasing an investment property.

Owning an investment property can be a unique, rewarding, and lucrative endeavor that can lead to the growth and preservation of wealth over the long term. Becoming a landlord can also provide valuable tax benefits and inflation protection. But as with most investments, there are also risks.

The Upside

There can be an upside in making an investment in real estate, and even more specifically in a second home/investment property. At BBH, portfolio diversification is a key tenet of our investment philosophy – real estate provides an additional asset class in a portfolio that often has a low correlation with other major classes like equities.

Interestingly, an investment property can serve as a useful inflation hedge because real estate typically has a positive relationship with rising Gross Domestic Product (GDP) and expanding economies. In addition to the potential value added to an investment portfolio, a real estate investment may generate passive cash flow for an owner as well as favorable tax deductions. Alongside the net income from rent and potential tax deductions, any capital that is spent on operations and maintenance of the property increases an owner’s equity.

Evaluating the Risks

In real estate investing, it is productive and prudent to approach a purchase with responsible pessimism. Although one can hope that all will go according to plan with a new investment property, it is essential to consider all the ways in which the situation can go wrong. Specifically, one should evaluate the upfront cost, operational burden, and litigation risk of owning a property.

Upfront Cost

From a cost standpoint, most lenders will require a down payment of close to 15-20% for a mortgage on a rental property, as opposed to lower payments for a residential home. This sizable upfront cost can be a barrier to entry for some investors, but that’s something you can plan for with additional saving over time in advance of a purchase.

Operational Burden

Outside the initial financial requirement, owning an investment property is expensive – both in time and money. A new owner should understand that they are responsible for the maintenance of the property, from standard upkeep to emergency repairs and tenant requests which can be costly.

If an owner has never encountered a broken pipe or faulty foundation, he or she can hire a property manager. A professional can lessen the operational obligation of day-to-day ownership, but a management service also comes at a meaningful cost.

Litigation Risk

Furthermore, owning a rental property creates significant liability for an individual owner. The consequences of any damages or negligence related to a property can fall squarely on the landlord.

To protect against this legal exposure, we strongly recommend buyers create an LLC to own and to be the titleholder for an investment property. If you choose to go this route, be mindful of the new reporting requirements for LLCs imposed by the Corporate Transparency Act (CTA). 

These risks and requirements should not act as obstacles to investing in real estate, but rather should serve as valuable guideposts in forming an organized, intentional plan. A potential owner should be prepared and well-informed on the varied aspects of investment property ownership.

Preparing for Ownership

Two critical steps in formulating this plan are assessing your personal and financial goals in purchasing real estate and having an investment thesis. As you develop these goals and an investment thesis, it can be helpful to ask questions such as:

  • How long do I foresee owning this property? Do I plan to maintain this property over generations?
  • Is it important to me that I live near the apartment or home?
  • If I am in a different town, state, or country, do I have the appropriate team in place (property managers, contractors)?
  • What micro and macroeconomic factors impact the region in which I am looking (job growth, population growth, new housing supply risk, climate change threats)?
  • What transaction costs and operational expenses can I reasonably afford?
  • Does my personality match that which is needed to assume landlord responsibilities?

That last question might prove most important. Being confident about the why in this decision will inform the where and how.

Investing in real estate can be financially and personally advantageous, providing diversity in a portfolio, generating income, and bringing tax benefits. Much like how BBH invests, a prospective real estate owner should take a long-term, bottom-up approach when considering an investment property.

To learn more about the benefits of investment properties or the BBH Real Estate investment group, reach out to the Next Generation team.

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