Rental properties

For Rent Real Estate Sign

Up to this point, the main way I have discussed investing for the future is with stocks and bonds.  That leaves out one of the major vehicles that people use for investing—owning real estate.  Actually, stocks, bonds, and mutual funds are newcomers to the world of investing when you compare that to owning property.  Being a landlord has been around for millennia, while trading stocks and bonds as we know is about 100 years old.

Full disclosure: Foxy Lady loves the idea of investing in rental properties while I am opposed.  We talk about it all the time and at this point we have not jumped in the pool yet.  So what is my take on it all?

 

The pros

There are a ton of really great reasons to invest in rental properties.  I had a coworker who once told me: “real estate is the only way to build real wealth.  Stocks and stuff are great, but to really become wealthy, you need to buy property.”  I don’t really agree with that, but there are a lot of people who do, and there are a lot of people who have become super wealthy following that line of thinking.

Rental income:  Obviously the main reason to go into rental properties is for the rental income.  Of course this will vary greatly depending on a ton of factors, but I just did some quick research on www.zillow.com and you can get about 7-10% of the property value in rent each year.  That tends to be lower for more expensive markets (LA or Chicago compared to St Louis or Birmingham) and it tends to be lower for more expensive properties (free-standing homes compared to condos).  And of course, any expenses you incur come out of that, but 7-10% is an awesome return for an investment.

Property appreciation:  In addition to that 7-10% rental income, you’ll also enjoy the potential for the property to increase in value.  This similarly varies greatly, with periods of huge price appreciation and other times where the market crashes, but on average home prices do tend to go up.  So this is an added bonus.  If you’re savvy about which properties you buy with an eye towards which neighborhoods will become popular or buying fixer-uppers, this can be a major portion of your profits.

Leverage:  With rental properties, you often buy the home with a mortgage.  This gives you leverage which can really juice up your profitability.  Take for example a home that costs $300,000 and you can rent for $2000 per month.  Using the basic calculation, you would have a return of 8% ($2000 rental per month x 12 months / $300,000).  But what if you bought the property for $50,000 down and then financed the remaining $250,000 with a 5% mortgage?  The calculation is a little more complex—your revenue is $11,500 ($24,000 annual rent – 12,500 interest on mortgage), but then you divide that by your $50,000 investment.  That’s a 23% return!!!

Tax advantages:  In the US the tax code can be tricky on this (and I’m not an accountant) but in some circumstances, the interest you’re paying on the mortgage can be tax deductible.  That 23% return from above can be even higher because Uncle Sam is letting you deduct some of that interest from your taxes.

Economies of scale:  All these calculations on returns are assuming you have no expenses.  Of course, you will have some (finding renters, maintenance on the property, improvements on the property, etc.) so that 23% return will definitely be lower when you take those expenses into account.  But as you do more and more rentals, you will start to have serious economies of scale.  Especially if you do some of the handyman work yourself, you’ll learn to do these things like fixing plumbing and electrical, installing appliances, etc.  That can lead to lower costs for each property unit you have, and that can make a major impact on your returns.

Best option:  I’ve always said you should be investing your money, but what if you live in a country where investing in stocks isn’t very easy (as we saw was the case in Russia)?  Without those other options, that makes real estate investing even more attractive.  After all, you need to invest your money somehow.

 

The cons

Wow!!!  A 23% return plus property appreciation and tax benefits.  All that seems pretty sweet, and there’s no way you’re matching those returns with the stock market.  So what’s the downside?  Stocky Fox, why aren’t you seeing with wisdom of what Lady Fox wants to do and start buying rental properties?

It’s a job:  Make no mistake that owning rental properties is a job.  If you own mutual funds you literally have no work for your investment.  When you manage rental properties, there is real work involved—finding renters, getting documents signed, fixing the place, dealing with renters, etc.  Maybe you set it up so it’s not much work, but it’s still always some work.  Also, you can have a property management company do all that work for you, but then they’re eating into your profits.

It could be a nightmare:  This is what keeps me from wanting to get into the rental property business.  If things are working well the returns for rental properties are super attractive, but that can all go up in flames in a hurry, and there seem to be so many things that could go bad.  What if you tenant is a real pain in the butt and is constantly badgering you to fix things or upgrade things?  What if they trash your place and you need to do major repairs (you could take them to court, but then that’s a whole other headache)?  What if they stop paying rent (you could evict them but there are a lot of laws protecting renters so that could be a really long and painful process)?  Any one of those things could cancel out months or years of rental profits.

Low diversification:  Rental properties by their nature aren’t diversified.  When you buy a single property for let’s say $300,000 you’re putting a lot of eggs in one basket.  Maybe the neighborhood turns bad or something like that.  When you invest in mutual funds you’re buying tiny slices of thousands of different companies, but with a rental property you’re exposing yourself to much higher idiosyncratic risk.  The closing of a factory could have a devastating impact on the local rental market, but it wouldn’t register a blip on your mutual fund.

Low liquidity:  When you have rental properties you lose a lot of liquidity and flexibility.  If you needed cash for some reason (maybe an emergency) it would be super easy with mutual funds.  Sell some shares and you have the money in a few days.  With a rental property it could take months to sell it and get the cash.  Similarly, if you decided to move away from where your rental properties are that’s a monumental undertaking; once you start with rental properties you’re somewhat tied to that area.  With mutual funds, you change your address with Vanguard  and you’re done.

 

Lots of pros and lots of cons.  So where do we stand?  Certainly rental properties have tremendous upside, much more than stocks.  I always use 6% as my long-term expectation for returns on the stock market; if you do the calculations of your rent less your expenses and divide that by the property’s value and come up with a value greater than 6% you should seriously consider it.  Also, if you can avoid some of the pitfalls—you know some trustworthy people who can be renters, you’re handy and can fix things, and you don’t plan on moving for a long, long time—that makes it all the more attractive.

So what do you think?  I don’t think rental properties are a good idea for the Fox family (Lady Fox just flipped me off), but what about you?

6 thoughts to “Rental properties”

  1. I don’t know how you argue with those numbers. Yes, it represents real work but you’re not going to get a return like that without some effort. And given your previous post, the lack of liquidity shouldn’t be a major consideration.

    1. Thanks for the thoughtful post Stocky. The one thing you didn’t really put numbers behind is risk. Risk of no renters and risk of no appreciation in particular. Of course this must vary by market but do you have any idea how that compares to a mutual fund in the long term?

      (Enjoyable and informative blog, by the way)

      1. Brian–I totally agree. The risk is what keeps me away.

        To your question, just one month of vacancy would lower your return in the example where you own the property outright from 8.0% to 7.3%. Maybe that’s not a big deal. But then if you look at the leveraged example where you have a mortgage, a one month vacancy lowers your return from 23% to 19%. So things can start to turn south in a hurry if you have vacancies.

        The other big risk is what if you have a problem tenant and they cause damage or refuse to leave. Something like can drain away your profit in a hurry and possibly have you with a negative return. I don’t know how likely those types of things are, but things like that scare me to death. I have a neighbor whose has rental properties: there was black mold in one of her properties. She took care of it immediately but the tenant is now suing for $1 million because she says it has affected her health and now she can’t work. Who knows if any of that has any merit, but no thanks.

  2. We had friends who did very well buying up small cheap homes that were in disrepair and remodeling them and then renting them out. But this was a full time endeavor for both of them. The man owned a kitchen remodeling business and was very handy and able to fix just about anything in the houses. So he had all the tools and know-how. His wife did the bookkeeping and legal end and communicated with the tenants. But they admitted it took them years to learn the secrets of running things successfully and it definitely was a full time job. If you’re young and have lots of money and patience, I guess this might be a good way to go.

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