5 Factors to Consider Before Investing in Rental Real Estate

While stocks and bonds are, for most investors, the key components of their investment strategy, some turn to rental real estate as a source of asset growth and income.  In many cases, this arises from circumstances (e.g. an individual moves out of a condo or starter home and retains it as an investment property), but in other cases, investors seek out opportunities to invest in rental real estate in order to diversify the type of assets they hold or because they plan to eschew the stock market altogether.  Is this a good financial move?

Unfortunately, there is not a clear answer.  For long-term financial planning purposes, we generally assume that a balanced stock and bond portfolio will grow 8% annually over time, whereas real estate will appreciate approximately 3% annually.  However, in any given period of time, both the stock market and the housing market can behave very differently than their long-term averages, especially over the short-term (less than 5 years).  The 3% figure for home appreciation also doesn’t take into consideration potential positive cash flow from rental income.  There are many factors—both quantitative and qualitative—to consider in comparing these investment choices.  We discuss some of the key issues below.

1. Leverage: In terms of cash needs, rental real estate requires a more significant sum to get started given the down payment and closing costs needed to acquire the property. A cash cushion is needed for repairs and to cover expenses in the event of vacancies.  (Also, keep in mind that you generally need a larger down payment—around 25% to 30% down—to get the best interest rates on a rental property.)  However, the benefit of that cash outlay is that by financing the rest of the purchase, you can use leverage to increase your potential gains over time.  You may only put down 25% in cash to buy the property, but you keep 100% of any appreciation in value (before taxes, at least).  Of course, you could use leverage with your investment portfolio by taking a margin loan. However, most investors are not willing to take on the additional risk.

2. Taxes: There can be tax advantages to rental real estate, since you can deduct the mortgage interest, property taxes, depreciation, and other expenses to offset much or even all of the income received from rent. If the depreciation and expenses are high enough, you may even be able to deduct “losses” from rental real estate against your earned income (note that special rules and limits apply).  However, when you sell a rental property that has increased in value, unless you have lived in it for two of the last five years, you will have to pay capital gains tax (likely 15% for federal, plus state taxes) on the appreciation as well as depreciation recapture (25%) on amounts that you depreciated on your taxes.  Furthermore, if you do have to report positive rental income on an annual basis, it will be taxed as ordinary income, rather than facing the more favorable capital gains rates.

3. Transaction Costs: In comparing the growth in value between real estate and stock/bond assets, investors often neglect to take transaction costs fully into account. While stock and bond mutual fund purchases generally cost around $10 per trade, regardless of size, closing costs for a real estate transaction will likely cost approximately 1% to 3% of the purchase price for a buyer and 5% to 7% for a seller.  Furthermore, if you don’t plan to manage the property yourself, you will need to hire a property manager, which typically costs around 10% of the monthly rental income.  Finding an excellent property manager is not always easy to do.

4. Being a Landlord: Having a rental property impacts your lifestyle more than simply investing in stocks and bonds as well. Some individuals enjoy this choice and are well-suited to be a landlord.  They have the time, energy and skills in home repair, live close to the rental property, and do not mind finding and managing tenants.  However, especially if you opt not to hire a property manager, you should consider whether you really want to be a landlord when deciding to purchase (or retain) a rental property.

5. Adjusting Risk: As mentioned above, neither the housing market nor the stock market produce predictable returns in any given time period. However, with stock/bond investment portfolios, you can generally decrease the volatility of returns by diversifying holdings and/or adding more bonds into the mix.  Therefore, you can reduce volatility as you approach the time that you need to access the funds—e.g., if you are saving for kids’ college expenses or for retirement.  This is not possible in the same way with a rental property.  If you are planning to sell the property and use the equity for college or retirement, there is a chance that the housing market might be down when you need the cash, thereby restricting your options and forcing you to possibly sell when the market is down or take out additional loans on the property in order to accomplish your goals.

If you are considering purchasing or retaining a rental property as part of your investment portfolio, give us a call so that we can talk through your options and help you weigh the relevant factors in making this big decision.