A real estate arbitrage strategy can be an excellent way for real estate investors to earn a quick profit. But what is it?
We’ve put together this article to help you understand the basics of arbitrage in real estate investing. It goes over the definition of real estate arbitrage, how it works, the types of arbitrage in real estate, and the pros and cons of a rental arbitrage business. Use it as a guide when deciding if arbitrage is your best real estate investment strategy.
Key takeaways:
- Real estate arbitrage is an investment strategy where an investor purchases an investment property below market value and then sells or rents it for a profit.
- There are four main types of real estate arbitrage: wholesaling, house flipping, master leasing, and vacation rentals.
- Talk to your real estate agent or financial advisor to determine if arbitrage is the right investment strategy for you.
What is arbitrage?
In finance, arbitrage refers to the simultaneous buying and selling of assets in a different market for profit. It typically occurs when a stock, commodity, or currency is purchased in one market and simultaneously sold in another for a higher price. It’s considered a low-risk investment strategy.
In real estate, arbitrage is when an investor purchases an investment property below market value and quickly sells or rents it for a profit. It happens when a property listed below fair market value is purchased and sold for its fair market value. It’s a low-risk investment strategy that can quickly increase cash flow.
How arbitrage works
There are two ways to use arbitrage in real estate. The first is buying a below-market-value property and selling it for a higher price in as little time as possible. The second is leasing a below-market-value property and renting it for a higher price in as little time as possible. The goal of both is the same – earn money in a short time.
An arbitrage strategy can be applied to every type of real estate property. Real estate investors can use it for residential properties, rental properties, commercial properties, and vacant lots. However, most real estate investors use it for residential properties through wholesaling or house flipping.
4 types of real estate arbitrage
There are four main types of real estate arbitrage. They are wholesaling, house flipping, master leasing, and vacation rentals. Below is a closer look at each of them.
Wholesaling
Real estate wholesaling is a real estate investing strategy where a wholesaler contract on a property and sells the contract to an investor. It’s the most common type of arbitrage in real estate.
Here’s how it works as an arbitrage strategy.
Let’s say a wholesaler finds a property listed below market value for $150,00. They make an offer to help the homeowner sell the property. The homeowner agrees, and they sign a wholesale contract. The wholesaler then finds a potential investor to purchase the property for $175,00 and makes $25,000 when the property closes.
Wholesaling is a great arbitrage opportunity because the wholesaler doesn’t exchange any money with the homeowner until a buyer has been found.
House flipping
House flipping is a real estate investing strategy where an investor buys a property, completes renovations to increase the property’s value, and then sells the property for a higher price. It’s the most well-known type of real estate arbitrage, thanks to popular television shows on TLC and HGTV.
For a few reasons, flipping houses is a more involved arbitrage strategy than real estate wholesaling:
- There is no intermediary.
- The buyer of the below-market-value property is also the investor.
- The investor must make necessary repairs and renovations to increase the property’s value.
- The investor lists and sells the renovated property for more than the total amount of money invested in the property (purchase price plus costs of renovations).
Real estate investors interested in this type of arbitrage need to manage their renovation budget carefully. It can be the difference between earning a profit and losing money.
Master leasing
Master leasing is commonly known as subletting and is a form of rental arbitrage.
According to Mashvisor, a master lease is an agreement where an investor leases an income property as a single tenant (lessee) and then subleases it to another. A master lease gives the lessee equitable title and “frees” the property owner from any responsibility for the property. Most lessees renovate the properties so they can charge higher rents and pocket the difference between their master lease and the rent they’re collecting.
There are two types of master leases: performance master leases and fixed master leases.
A performance master lease requires the lessee to pay the property owner a percentage of received profits.
A fixed master lease requires the lessee to pay a percentage of profits to the property owner regardless of occupancy. In other words, the lessee pays even when the property is vacant.
A master lease can help increase cash flow through rental income without a lot of upfront costs. It’s an excellent arbitrage strategy for real estate investors who don’t have a lot of capital or money for a down payment. Plus, they often don’t require lenders.
Vacation rental
Short-term vacation rentals can be another type of rental arbitrage.
A short-term rental property (vacation rental) is a furnished living space available to rent for short periods. Nearly all real estate types, excluding commercial real estate, can be turned into a vacation rentals.
As an arbitrage strategy, “Airbnb rental arbitrage” doesn’t require real estate investors to own the property they’re renting. Instead, the real estate investors rent the vacation property from the property owner, act as the Airbnb host, and sublease it on a short-term rental website like Airbnb or Vrbo.
It’s a great arbitrage opportunity to earn passive income because, like master leasing, it comes with very low startup costs.
The pros and cons of a rental arbitrage business
Rental arbitrage is buying or leasing a rental property at a lower price than the property could generate. It can be a profitable investment strategy. However, as with all real estate investments, they have benefits and drawbacks. Below are some of the pros and cons of a rental arbitrage business. Use it as a guide when deciding whether or not it’s right for you.
Pros of rental arbitrage
- Demand: In almost any real estate market, there’s always demand for long-term rental properties. And, in other markets, there’s always demand for short-term rental properties. Furthermore, tenants and landlords often appreciate having a neutral third party to help manage and mitigate their relationship.
- Low maintenance: A rental arbitrage strategy requires a lot of work upfront to find below-market-value properties and finding renters. However, once the properties are rented, it’s a relatively low-maintenance investment strategy.
Cons of rental arbitrage
- Market risk: It’s no secret that real estate markets fluctuate over time. If demand for rentals decreases, cash flow can decrease. Vacant rental properties don’t generate income.
- Competition: There is fierce competition for properties listed below market value. This can make it challenging to start a rental arbitrage business and thrive.
- Property management: Property management is one of the most expensive, in terms of cost and time, when it comes to rental properties. It takes a lot of work to keep them maintained and occupied. In fact, some financial advisors estimate that property management can cost around 40% of your rental income.
- Low profit margins: Most real estate investors don’t make more than a 2% profit margin on their long-term rental properties and around 10% on their short-term rental properties.
The bottom line
Real estate arbitrage is a great investment strategy because it’s low risk, requires little capital, and has the potential to yield significant returns. However, finding below-market-value properties is highly competitive, making it challenging to get started and keep going. Talk to your real estate agent and financial advisor before deciding whether or not it’s the right investment strategy for you.
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