Investment Property Definition
An investment property is a real estate investment purchased with the intent of earning a return on the money used to purchase the property. The return on the investment can be earned through rental income on the property, a gain on the sale of the property, or both. The investment can be made by an individual, a group of investors, or a corporation or some other type of organized entity.
Types of Investment Property
Investment properties can fall under many different categories.
One of the most popular investment property sectors is residential real estate. Typically, investors purchase either single family housing, condominiums, or apartments in order to generate income from rent. Investment properties also refer to commercial or mixed-use (commercial and residential) properties.
Only properties that are not used as the owners’ residence are considered investment properties. A purchaser may refer to a second home as an “investment property,” but although a vacation home, for example, may be purchased and later sold for a profit, unless it is producing rental income for the owner, it doesn’t truly fit the definition of investment property.
Commercial property designed for business use—whether retail or office—is another form of investment property. An investor or investors may either purchase an existing property, such as an office building or a shopping center, or they may develop the project building it from the ground up.
Another form of investment property is known as “mixed use,” combining elements of both residential and commercial properties. Residences typically include multi-family housing such as apartments or condominiums. Commercial use includes retail, office, or both. Often, these types of real estate developments target an upscale market by combining luxury housing with luxury retail brands and professional office space. They are also popular as areas where people can “live, work, and shop” without needing a car.
Investment Property Financing
Residential investment property financing is more like a business loan than a conventional mortgage.
Mortgage insurers do not insure mortgages on residential investment properties. In addition to at least a 20% down payment, the borrower needs a high credit score and solid credit history, as well as other assets. The loan to value ratio on the property will also be much lower than traditional home buyer financing. And, traditional mortgage financing such as FHA, VA, or conventional mortgage loans are not available for investment properties.
Financing a commercial investment is even more complex. Commercial real estate developments require much more capital than residential, therefore the transactions and requirements of the borrowers are extremely complicated. Most institutions will only lend to developers with a proven track record and, usually, those they have worked with successfully in the past.
Often, commercial real estate investors will bypass bank lending altogether in favor of private equity financing. The lead developer will form partnerships selling proportional units of ownership in the venture in exchange for the same proportional percentage of rental income and profits in an eventual sale.
Investment Property Mortgage Rates
Historically, borrowing rates for purchasing residential investment property will be at least 0.5% to 0.75% higher than rates for purchasing a primary residence. So if the current rate for a traditional mortgage is around 3.7%, the borrowing rate to purchase an investment property will range from 4.2% to 4.45%.
Because of the complexity of commercial real estate investment, borrowing rates are much harder to determine. Some can be as low as 3.9%, depending on the type of project or purchase, to more than 10%.
Tax Treatment of Investment Property
Rental revenue from investment properties is taxed as ordinary income to the investor. However, expenses related to maintenance, management, and upkeep of the property may be deducted against the rent received, thereby lowering the tax consequences for the investor.
If an investor sells a property for a profit, the profit on the sale is taxable at the capital gains rate, which is usually lower than the tax rate on ordinary income. If the investor has spent money improving the property such as upgrading the plumbing or installing new air conditioning, those expenses may be used to reduce the gain, thereby reducing the amount of capital gains tax owed.
