Real Estate as a Business Model

There are many factors involved in determining whether or not a piece of real estate is a good investment.  What about real estate as a business model?  What’s the difference?  A business model is the way in which a business makes money.  An investment is an asset that is purchased for the purpose of creating wealth.  Both need to be taken into consideration in order to ascertain whether or not the piece of real estate is fiscally viable.  A business is only fiscally viable when it generates enough revenue to meet its expenses while exhibiting the potential to make a profit.

The price of real estate could determine whether or not it is a good or bad investment.  One way to determine if the price is fair is by comparing it to the price of other similar properties in the same geographic area.  Many mortgage companies do this as part of their due diligence process before approving a loan amount.  If you're purchasing a piece of property for the sole purpose of it being an investment, then the assumption of selling the property for more than you purchased it for is the main goal. 

However, there’s more to consider than just the purchase price and sale price.  You will undoubtedly incur additional expenses over the course of time, such as property taxes, maintenance and the amortization and interest that you will be paying on the loan.  People think they made a profit when they purchased a piece of real estate for $30,000 and sold it for $250,000 thirty years later but how much did the loan actually cost them?  How much did they spend each year in taxes and maintenance?  These expenses need to be factored in to determine if the property can be considered a sound investment.

When paying a mortgage, there is a percentage that gets applied to principle and a percentage that gets applied to interest.  Taxes and maintenance are variable because you really don’t know how much your taxes will increase over time and you don’t know how much maintenance your property will require over time.  Sometimes even the mortgage expense can change if the terms are based upon a variable interest rate.

Turning real estate into a business involves getting tenants.  With tenants, real estate can generate income.  As the property owner, you have to determine if you want to make a profit each month when you get the rent check(s) from your tenant(s) or if your rent is merely going to cover your expenses (mortgage, taxes, maintenance, etc.) and your profit will be obtained at the time you sell the property.  Keep in mind that having tenants may also introduce additional expenses such as legal fees.  Even if you don’t need a lawyer to draft a lease agreement, you may need a lawyer’s assistance to evict a tenant who isn’t paying rent or is breaching your contract in some way.

Tenants are not always easy to deal with.  Some don’t pay their rent on-time or at all.  Others might damage your property or cause disturbances to your other tenants or neighbors.  Some tenants won’t vacate the premises when they need to, which can pose additional legal fees and hassles.  In most jurisdictions, tenants have more rights than property owners.  Landlord/tenant laws can vary from region-to-region.  It’s impossible to anticipate what expenses a particular tenant could bring into the equation.

Many homeowners have their property listed as a personal asset.  As a business, it is advantageous from a legal perspective for a landlord to hold the property in a corporate entity, such as a limited liability company.  Doing so could present certain tax advantages and shield the property owner from certain legal liabilities.  It is recommended that property owners and real estate investors consult with a lawyer to discuss these options at length.

Real estate fails as a business model when the property owner has difficulty obtaining tenants or if unforeseeable expenses exceed the rent income.  These scenarios are speculative and sometimes attributed to bad luck which is something that any business owner can, and most likely will encounter.

When considering real estate as a revenue-generating business, it is a good idea to write down all of the expenses and scenarios that are mentioned in this article to determine whether or not the investment makes sense from a business perspective.  You may be okay with the idea of using real estate as a retirement plan and only making a profit at the time that it’s sold, just as long as it is self-sustaining in the years leading up to that.  Being able to make a monthly profit depends on how reliable your tenants are and how lucky you are. 

If you’re not comfortable with these uncertainties, maybe investing in real estate isn’t for you. However, with the right planning and foresight, enormous fortunes have been made by purchasing the right properties and managing them properly.