As an investment, residential real estate offers some great benefits: income, tax breaks, long term appreciation, and a hedge against inflation. However, it’s not for everyone, and there are some major downsides to be aware of. Here we’ll discuss the benefits and pitfalls in more detail.
Benefit #1: Income
Perhaps the most desirable benefit of investing in a residential rental property is the potential for it to generate steady income. To enjoy this benefit, however, your property has to be “cash flow positive.” This means you earn more in rent than the expenses you have to pay out. Those expenses can be substantial, especially if you have a large mortgage on the property. Properties with large mortgages may be cash-flow negative, meaning they cost more than they produce in rent, for years until the mortgage gets paid down enough to reduce the payments.
Benefit #2: Tax breaks
Another very desirable benefit of rental real estate is the tax deductions. The federal government offers some pretty significant tax advantages for owning real estate. You get to shelter some of your income using the depreciation expense and any interest of your mortgage is deductible, as are most expenses of owning the property. In some cases, you can shelter all the income, so that none of it is taxed in the year it is earned. Other tax advantages like tax-free exchanges and the step up in basis at death can make the income truly tax-free.
Benefit #3: Long-term appreciation
Real estate can come in many forms and there may be a host are unique things about any particular property. However, historical returns on real estate in general are generally in between that of stocks and bonds. The use of leverage (borrowing) can magnify your returns greatly. As an example, if you put $100,000 down on a $500,000 property and borrow the rest, 8% appreciation on the property means your equity has increased by $40,000, which is a 40% return on your investment.
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Benefit #4: A hedge against inflation
Real estate values tend to grow more than inflation. If you are earning rental income that is also increasing by at least as much as inflation, your property can be a great hedge against inflation over the long-term.
Now for the pitfalls of investing in real estate:
Pitfall #1: Risk
Investing in a residential rental property comes with plenty of potential risk. Any number of things can go wrong: damage from fire, flood, etc., drops in property values, lost income due to repairs, problems with the property, or problems with the tenants. Risk is magnified when you are using leverage. Consider our previous example: if the property value goes down by 20%, the investor’s $100,000 investment is worth zero: a 100% loss. If this is coupled with negative cash flow, the investor may experience distress and may even have to allow the lender to foreclose on the property.
Pitfall #2: Illiquidity
Real estate takes time and expense to sell. Also, if you have to sell a property because you are in financial distress, you may have to take a larger-than expected loss on the sale.
Pitfall #3: Work and complexity
Owning and renting (and managing) your property is one of the more complex ways to invest. Buying real estate is a relatively complex transaction and managing the properties can become a full-time occupation on its own.
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Pitfall #4: “Realness”
There are a lot of things that make real estate real. One of these is being a landlord. In California, tenant rights are strong, and landlords may be forced to deal with bad or ugly situations, loss of income, or unexpected costs (due to “real situations” on the property.)
I’ve had a few conversations with friends and clients who own rental properties recently. Here are some paraphrased quotes from these conversations:
- “I don’t dare raise the rent; I have to live next to these people and I don’t want to make them angry.”
- “I haven’t raised the rent on my tenants because it took me so long to find a good one and I don’t want to lose him.”
- “The property was so beat up it took us months to fix it up again and get it back out on the market.”
- “That guy’s dogs are destroying the place and he’s not even supposed to have pets!”
These quotes illustrate some of the downsides to owning rental properties.
Professional management can help mitigate some of these risks, but at a higher cost (and thus lower income). You should also build in estimates for vacancies and maintenance when you plan your rental purchase, to help evaluate whether the price you pay for the property represents a reasonable return on your investment.
A rental property can be a great investment, and its benefits can increase over long periods of time. You can also invest in residential real estate in other ways, such as a limited partnership that owns multiple properties, a publicly traded REIT, or a mutual fund that invests in residential properties.
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