By David McClellan
It’s difficult to turn on the television without coming across a house-flipping show where people appear to be making money. According to Gallup, more people believe real estate is a better long-term investment than the stock market, despite data showing that real estate underperforms stocks over the long term.
We understand the allure of having rental properties that generate “mailbox money,” where a rental check arrives every month in the mailbox. But make sure to use realistic assumptions and think through the pros and cons. This article assumes you’re in your prime earning years. The pros and cons may differ a bit if you’re a retiree looking for passive income who is also willing to work as a landlord.
- Passive income. The concept of "mailbox money” can feel reassuring, especially when you compare it to gains in your portfolio, which may not be as easy to see. But will you actually reinvest the check you receive so you build wealth over time, or would you spend it? Over the long term, does the passive income exceed what you would have made from your portfolio?
- Limited supply means big returns. The thinking here is, "They’re not making any more land!" As population and demand for land grows, prices are likely to rise. While it’s true that land has limited supply, in most cases, the majority of your investment is tied to the building and not the land.
- Diversification. The real estate market generally isn’t correlated to a traditional stock portfolio, so investing in real estate can provide valuable diversification. But do you already have exposure to real estate in your investment portfolio (e.g., via REIT or real estate funds)? And how much exposure is enough? Does a 5% to 10% allocation to real estate provide enough diversification? I frequently find clients who have 50% or even 90% of their portfolio in real estate, which doesn’t provide effective diversification.
- Depreciating asset. Many investors confuse the value of the land and the value of the building. Land is arguably not a depreciating asset. They really aren’t making more of it. But the building you own on top of it is absolutely a depreciating asset. It may hold value better than a new car when you drive it off the lot, but it still depreciates.
- Maintenance. As a result of depreciation, eventually you need to sink more money into it. One year it’s carpets, the next it’s the AC compressor. Or window replacement. Or a roof. The older the decor and amenities, the harder it is to get premium rents. At some point, you’re remodeling the kitchen and bathrooms in order to be competitive. If you’re not budgeting for this, the economics can quickly turn negative. A reasonable assumption is that maintenance costs about 1% of property value annually.
- The handyman. You have to either be the handyman or pay the handyman. Who’s on call 24x7 when something breaks? Does the renter call you to fix the toilet, or the fridge or a burst pipe, or do they call a management company? If it’s you, is the rental property close enough to you so that it’s convenient to get to? Do you have handyman skills and like being a handyman? When something breaks, you’re on the tenant’s schedule; it’s not a “fun project when I have time for it.” A management company typically charges about 10% of rent.
- Hidden expenses. There can be lots of hidden expenses beyond just maintenance. A client recently told me his rental property was profitable the first year until he paid a CPA to file a K1 tax return for the LCC, which consumed his entire first-year profit. Property taxes can rise suddenly. If you have a mortgage with a variable interest rate, your mortgage payments may increase as interest rates rise.
- Rent utilization. Many landlords assume they’ll rent the building 12 months a year. But what if you can’t? If a tenant leaves, how long does it take to clean the unit, complete repairs, and find a new tenant? One month? If so, your rental income is 8.3% lower than expected. What if it takes longer? When you look at the economics, be sure to build in rent utilization that’s less than 100%.
- Tax impact. I rarely find a client who has thought of this, but generating passive rental income typically increases your taxes. Rental income is taxed at your ordinary income marginal rate. For example, if you’re married and have modified adjusted gross income between $165,000 and $315,000, you’re in the 24% federal tax bracket, which is the rate at which your rental property income would be taxed. If you left your investment in your traditional portfolio (in a taxable account), most of your investment gains would be taxed at your long-term capital gains tax rate of 15%. And that ignores additional taxes such as state income taxes or the Medicare surtax.
- Local concentration. Real estate market dynamics are highly localized, e.g., what’s going on in the L.A. rental market usually has very little to do with your rental property in suburban Chicago. Most investors reasonably want to buy property in a market they know well, which typically means close to where you live. But if you do that, you’ve doubled down on the market where you live. If the local real estate market falls, your rental property and your residence are likely to fall together.
- Lack of liquidity. Investment properties generally aren’t as "liquid” as traditional investments like mutual funds. If you need to sell the property because you need the money, it can take months to prepare the property for sale and then actually sell it.
- Headache for heirs. What happens if you die and your spouse or children inherit the property? If they don’t want to manage rental property, they’ll be faced with an additional headache of disposing of it. What happens in the event of divorce where you have to split assets?
When you net out the pros and cons, investing in rental properties can be a risky proposition. Hidden expenses can wreck the economics. It often boils down to the hope that the property will continue to appreciate in value while you pay principal on the loan and grow your equity. But since the majority of the mortgage payment in the early years is allocated to interest, it may take many years to build significant equity. A highly diversified investment portfolio, which can include mutual funds that invest in real estate and capture the diversification benefit, may be a more effective strategy to build wealth.
Before investing in rental properties, be sure to consider the economics and risks in detail so you make a thoughtful and informed decision.
For more from David McClellan, see his bio.
By clicking on a third-party link, you will leave the Forum website. Forum is linking to this third-party site to share information in a different format and is for informational purposes only. However, Forum cannot attest to the accuracy of information provided by this site or any other linked site. Forum does not endorse the site sponsors or the information or products presented there. Privacy and security policies may differ from those practiced by Forum.