Advantages and Disadvantages of Income Property

Income properties are best described as real estate assets that are generating some form of steady income in the form of rental or some other source. This type of asset is a preferred asset class for many investors looking for steady income and possibly capital gains over the long run.

Let’s explore on how income property is beneficial to the investors and its related disadvantages. One the benefits from properties that are generating income as an investment vehicle include the fact that real estate asset is something tangible. Essentially this means that your investment will never be zero since tangible assets have a “some” value even when market conditions are not favorable.

If you compare investment in income generating real estate with other financial instruments like Stocks the fundamental difference is the added security of a tangible asset. For example when someone invested in Enron stock when its price was $90 they would not have imagined losing their entire investment in a matter of a few weeks or months. This was at a time when Fortune magazine was calling it “America’s Most Innovative Company” for six consecutive years and the company’s CEO reassured investors that stock price will reach $130-$140 range.

Apart from the fact that asset value will not drop down to zero in a matter of weeks or months here are some other advantages of investment in income generating assets.

Passive Income- This is the net income generated from renting the asset and associated expenditure. Investors of income property can reasonable expect to receive this amount month-on-month which will help recover their investment. According to investment guru Warren Buffet if an investor is able to hold a real estate asset until they recover their investment from its rental income then the overall return on investment is quite substantial.

Capital Gain- In simple terms this defines the expected increase in the price of real estate, although determined by the forces of demand and supply it is historically observed that assets in connected areas with transport have witnessed significant increase in price over time. At the same time many areas which were in proximity to the city witnessed great growth mainly due to demographic features such as population.

Equity- Income generating assets can be acquired using debt instruments and as an investor only a fraction of the asset price needs to be committed. Cost of debt can be secured from the income of the asset. In case of default on the loan only the acquired asset is lost including the percentage of the purchase price committed to secure the asset this does not include any returns which may have been recovered from the asset.

Tax Benefits – If the income generated from the asset is being used to service any debt on the asset then the entire return is tax free. The return percentage therefore represents an increase in equity of the income generating asset while the purchase price is held constant and in the event of appreciation of the asset returns can be significant. These returns can also be tax free if reinvested in other real estate assets or if invested in countries like the UAE which are essentially tax free.

While these were some of the many advantages of investing in real estate assets that generate some form of income it also has many risks and disadvantages discussed below:

Occupancy risk- This refers to the risk associated with an unoccupied asset, delay or complete avoidance of rental income by the tenant. If the asset is leveraged this can result in serious problems for the investor. One of the methods which protect an investor from rent default is the security deposit; however vacant asset is still a serious risk of any income property.

Diversification- Investment in a real estate asset regardless whether it is generating income or not means asset is concentration and entitled to what in finance is referred to as concentration risk. Average investors are more prone to this risk which can be diverted through diversification but unless portfolio of an investor includes more than 4 assets this risk will still hold, it is as simple as “having your eggs in one basket”.

Maintenance- Asset maintenance is the responsibility of the landlord. On most occasions tenants leave the property in a not so perfect condition. Additionally any maintenance work on the property needs to be done by the landlord. This entails additional costs; if however investor desires to completely remain passive they can hire a maintenance and management firm to look at these requests from tenants on behalf of the investors. This can be costly and reduce the overall net return and income from the asset.

How to purchase income property

Purchasing an asset which is already generating income is similar to purchasing a regular asset. Investor just needs to communicate their requirements and preference to the real estate broker who usually have such assets under their radar.

However purchasing these assets can be costly and not everyone has the resources for down payment or cash buyout of income generating assets. One option is to invest via a real estate crowdfunding platform that makes an investor co-owner in an income generating asset with very little capital at stake as opposed to doing it alone, investing in income assets through real estate crowdfunding also dilutes the tenancy and maintenance risk.