Over recent years, direct investing in rental properties has been a popular topic. One of the key attractions of rental properties is the idea of passive income – another source of income to complement your salary or business income that doesn’t involve a lot of extra work.
In an ideal scenario, the property is bought at an attractive valuation, generates healthy income, and appreciates over time, all while generating few headaches and requiring little work. This sounds like a great investment!
On the other hand, you may end up with an investment that does not generate positive cash flow, has required numerous unexpected repairs and has tenants that have stopped paying rent. This leads to a significant extra work during nights and weekends along with an unexpected drain on your financial resources.
In this article, we will explore the potential benefits and challenges of adding rental properties to your portfolio and some of the key questions you should consider before investing in this area. For the purpose of this article, we will focus on residential rental properties.
Let’s start with some of the reasons why rental properties can be an attractive investment:
Diversification – Rental properties can be a complementary asset to a traditional portfolio of stocks and bonds. Although they have some of the same return drivers, rental properties have some unique factors which may provide diversification benefits. These can include the local economic climate, property location, supply-and-demand dynamics of the local housing market, and mortgage rates. Rental properties may also serve as a hedge against inflation as landlords can raise rents over time.
Passive Income – Assuming that your rental property is currently running smoothly or that you have outsourced the management of your property, the income from rentals may be “passive” in the sense that you are not having to do much day-to-day work to keep the rent checks coming. The degree to which an investment is actually passive for an investor varies widely on how the property is managed (do you plan to manage the property yourself or hire a property management company which is typically paid a percentage of gross rents?) and the individual experience of each investor. Factors related to the degree of involvement required in a rental property include the tenant mix, the age of the property and the location, among others.
Tax Benefits – The deductions provided by real estate investing can be one of the most powerful benefits of investing in these assets. Investors can take deductions for depreciation of the buildings (not the land) over 27.5 years, allowing them to shield some of their income from income taxes. For example, let’s say you have acquired property that generates $7,500 in income for the year after your expenses (such as property management, repairs and maintenance, property taxes, and insurance). The property cost $125,000 and the building is valued at $100,000. In this case, you could depreciate $3,636 each year ($100,000/27.5), reducing your taxable income by almost half. When you go to sell the building, this depreciation would be recaptured, and ordinary income taxes would be due on this amount. However, there is a provision in the tax code under section 1031, that would allow you to reinvest the proceeds from a property sale without having to recapture the depreciation if certain conditions are met. The 1031 exchange can be a very beneficial mechanism by which to build and preserve wealth. Also, if the property is financed with debt, mortgage interest would be deductible as well.
Easy to Leverage – It is relatively easy to get a loan to purchase a rental property. These assets typically generate cash flow and there is a hard asset to lend against. This leverage allows investors to amplify their returns. Let’s revisit the example above and see what the impact of purchasing the property with debt. If the building is purchased without any debt, the cash-on-cash yield in the above example would be 6% ($7,500/$125,000). Now, let’s look at what the cash-on-cash yield would be if you financed 70% ($125,000 x 70% = $87,500) of the building purchase with a 30-year mortgage at a 3%. Your annual payment of principal and interest would be $4,416 ($368 x 12) and your equity investment would be $37,500 ($125,000 – $87,500). This would result in annual cash flow of $3,084 ($7,500-$4,416) and a cash-on-cash yield of 8.2% ($3,084/$37,500). In this scenario, you improve your yield by over 2% while also paying down the principal of the mortgage over time. Leverage also can improve your returns dramatically when selling your investment, if the property has appreciated.
Cash Flow – Assuming that the property is purchased at an appropriate price and the rental income and expenses are as expected, rental properties can generate strong cash flows for investors. As seen in the example above, leverage may allow investors to improve their cash yield while paying down the principal of the mortgage at the same time, thus building equity (assuming the value of the asset stays the same or increases over time). The cash flow generated by a property depends heavily on the purchase price of the investment.
Along with the benefits, however, there are potential pitfalls that come with investing in rental properties. These include:
Trading Time – If you are directly investing in residential real estate and managing the properties yourself, you may have just created a part-time job for yourself. Managing the properties can be a lot of work as you find and screen new tenants, perform maintenance, deal with delinquent tenants, deal with property tax assessments, and handle additional headaches that come up. If this is not what you are looking to sign up for, consider hiring a property manager. There are also tax and accounting tasks that will require time.
Cash Flow Lower Than Expected – This can happen for a variety of reasons – for example, vacancies greater than expected, rents lower than expected, legal costs to evict non-paying tenants, bathroom flooding and roof leaks. These are just some of the items that may weigh on your cash flow. Using conservative assumptions when running the numbers on an investment and budgeting proper reserves should prepare you to weather the storm, although your assumptions may turn out to be wrong.
Transaction Costs – Compared to buying a typical publicly traded investment like a stock or mutual fund, higher transaction costs to buy and sell a property are much higher. These can include broker commissions, title fees, transfer taxes, loan fees, appraisal fees, and attorney fees, among others. In certain circumstances, these may have a silver lining as they encourage holding onto property for the long term; none the less, you should be sure to include these costs in your analysis.
Reduced Liquidity – Unlike investing in real estate through a publicly-traded vehicle like a REIT, making an investment into a hard asset comes with liquidity constraints. If your rental property is not performing well and you would like to sell it, it could be difficult to find a buyer and sell the property at a reasonable price.
As you look into investing in rental properties, these are some key factors to consider:
Do you plan to manage the property yourself or to outsource the management? Hiring a property manager could save a lot of headaches. However, this will also eat into your cash flow. If you are comfortable swinging a hammer or unclogging a drain, you may choose to manage the property yourself to improve the profitability of your investments, at least for a small number of properties.
How much risk are you comfortable with? You may be able to borrow a significant portion of the funds to purchase a rental property. However, in the same way that leverage can boost your returns if things go well, it can also exacerbate your problems if your property is performing poorly. Putting a reasonable amount of equity into the property and keeping cash reserves to cover unexpected expenses and vacancies can lower your risk.
Have you run the numbers? It is crucial to model out your investment and see what the cash flows look like under different scenarios. These can include lower rent rates, vacancies and unexpected expenditures. Are you able to cover your expenses in these scenarios? Make sure that you understand what the costs may be and how they may impact the profitability of your investment.
How does this rental property fit in your portfolio? Just as investing in one stock brings company-specific risks, investing in a single property or area comes with property-specific and geographic risks. What happens a significant employer in the area relocates their facilities, reducing the number of renters in the community? What if your property doesn’t generate income for six months? These are some of the risks that may accompany a single rental property or smaller portfolio of rentals. Therefore, it is important to look at the rental properties in the context of your total portfolio and decide what level of concentration in these properties you are comfortable with.
Rental properties can be a powerful component of an investment portfolio. Their potentially strong cash flow, attractive tax characteristics and ability to leverage the investments can all contribute to strong returns. However, this type of investment does not come without risks and can turn into a second job for investors. If you would like to discuss how rental properties could fit into your overall financial picture, please schedule a call with us here.