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The Best Real Estate Business Model

Rentals can be lucrative short- or long term-investments, and each person's unique strategy can produce excellent returns.


[Updated: Feb 09, 2021] Oct 21, 2019 by Matt Frankel, CFP
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Real estate can be an excellent way to create wealth and diversify your investment portfolio, but just like everything else in investing, it isn't one size fits all when buying and managing investment properties. A great way to find a real estate investment model that works for you when you're just getting started in real estate is to take notes from those who have been successful. Then you can develop a real estate business model specific to your needs, which has a plan for acquiring, managing, and disposing of real estate profitably. Let's see what we can learn from some residential REIT heavyweights and the habits of other successful real estate investors.

Acquiring real estate

One thing you will hear over and over again when getting started in real estate is location, location, location. And that's because your property's location is the one thing you won't be able to directly change yourself, so it's worth the time and effort to choose wisely. Every local market is different, so this will require a little research on your part, hence every investor's ideal location will look different. Even investors in the same exact city may have a different target area based on the money you have to invest or the goals you're trying to reach.

There are many factors to consider when choosing target locations for your real estate development business model. You might want to consider job growth in the area or proximity to favorable landmarks, services like public transportation, and shopping/entertainment areas. Another thing to look at is the demographics of the neighborhood. According to residential REIT AvalonBay (NYSE: AVB), the 25-34 age group will increase by 1.1 million over the next three years. And since the homeownership rate among young adults has dropped from 43.6% to 35.3% over the past decade, this is a group likely to rent. If you're looking to hold rentals for the long term, areas with high concentrations of this age group could be favorable places to own rental properties.

In most cases, you'll want to focus on buying properties in areas where rental demand is growing faster than supply as the general rule of thumb. This does include many metropolitan markets, but there are likely to be examples of this anywhere in the U.S. For example, if you live close to a major university with a student population growing faster than the number of available housing units and intend on managing the property yourself, this could make for an excellent place to buy rental property.

Managing real estate

In a perfect world, your investment properties would never sit vacant, you would never have to evict a tenant, and nothing would ever break. Unfortunately, we don't live in a perfect world -- sometimes things don't go as planned. If you plan to hold your rentals rather than flip them, pretty much all types of real estate business models will benefit from having a good landlord insurance policy. And if you plan to have more than a few properties, an umbrella insurance policy might also be a good idea to protect your assets in case a tenant decides to sue you.

It's important to plan ahead for unexpected expenses across the board. Regardless of whether you target low income multifamily housing or blue-collar single-family homes, there will inevitably be higher costs during rehab than expected or big-ticket maintenance items that pop up a few years down the road. As a general rule, plan to set aside 10% of the rent to cover maintenance expenses. This should be adjusted upward depending on the age of the property. And another 5-10% should be set aside for a vacancy reserve. That way, if the property sits empty for a couple of months between tenants, you can still cover your expenses.

Once you've chosen a property and you have decided to hold it rather than flip it, the next step is finding a tenant. For many real estate investors in addition to a credit check, some important factors to consider (and verify) might include stable employment, more than enough income to cover the rent, and a solid rental history. But everyone needs a place to live, and this is when each person's real estate investment model can really start to differentiate. You may personally choose to focus on high turnover rentals or perhaps long-term stable rentals -- both of which can be lucrative. So as you're getting started in real estate, remember that one person's sage advice may be for a specific niche or desired outcome, which may not necessarily apply to your goals or approach.

Disposing of real estate

One effective real estate investing strategy is "buy, rehab, rent, refinance, repeat," also known as BRRR. By purchasing properties with solid structural integrity but some cosmetic issues, you can acquire the property for less than market value, do some rehab work, and rent it out with a low mortgage and minimal funds invested. By doing some minor renovations, you have the potential to quickly and easily improve the property's appeal. This could make it an easy property to rent out with very little out of pocket.

On the other hand, you may go into a property with the intention of rehabbing it then waiting for the appropriate time to sell, which could be right away or a couple years down the road. Let's say you bought a property for $100,000 with 25% ($25,000) down five years ago and that the property is now worth $150,000, meaning you could collect a check for $75,000 or more by selling. Instead of continuing to collect a stream of rental income, you could potentially sell that property and take the proceeds to use as a down payment on two or three more properties. The leading REITs use this as a part of their value-creation strategy, and it has been rather effective. For example, sector leader Equity Residential (NYSE: EQR) sold 10 properties consisting of nearly 3,100 apartment units during 2014 and has another 5,273 under construction where it feels its capital will be put to better use.

Your intended real estate investment model will also affect your approach to financing.

Many successful REITs have investment-grade credit ratings, and maintaining excellent personal credit is a key to success for many individual real estate investors as well. Upon acquisition, many investment properties don't typically cash flow (profit) more than a few hundred dollars per month, if that. If you intend to hold the property for a longer time frame, this can literally make the difference between a solid monthly profit and struggling to break even. For example, on a $100,000 mortgage, the difference between a 620 credit score and an 800 is a $95 difference in mortgage payments, based on current rates.

The bottom line

The best real estate business model is the one that works for you and achieves your desired financial goals or returns profitability. This means that the approach you decide to go with based on your goals, income, time, age, risk tolerance, knowledge base, location, and connections will probably look completely different than the next real estate investor. To sum it up: Don't assume you have to follow a cookie cutter process. When getting started in real estate investing, find the real estate investment model that works best for you.

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Matthew Frankel, CFP has no position in any of the stocks mentioned. Bank CD rates recommends AvalonBay Communities. Bank CD rates has a disclosure policy.