Why You Should Or Shouldn't Buy a Rental Property
Published on Jul 14, 2023Landlords
As rent has increased nationwide, people are increasingly interested in investing in real estate. More specifically, they are interested in investing in both short-term and long-term rental properties as a long-term investment. Housing construction still hasn’t recovered from the Great Recession, and the housing shortage has caused rent to increase rapidly nationwide. With minimal signs of housing construction increasing, those looking to earn passive income or even switch careers as looking towards investing in real estate.
What makes investing in real estate so attractive is its versatility. It can create cash flow and passive income. It can be used as collateral for future investments. With land and housing scarcity, the revenue will likely increase long-term and help with a more comfortable retirement. More importantly, the land itself has value; even if the home needs to be sold, the value of the land will increase over time.
7 Reasons Why You Should Buy a Rental Property
1. Steady Income Generation
Investing in rental properties is a great way to generate a passive income that steadily increases. Even in a healthy housing and rental market with a surplus of homes, you can increase rent to keep up with inflation over time. If there is a housing shortage, you will be able to increase rent at much faster rates.
While owning a rental property investment doesn’t guarantee substantial profit immediately, It will generate steady cash flow early and likely be profitable. The profit margins may not be significant early on, but real estate is generally a long-term investment. The monthly rent will increase over 10-20 years as mortgage payments remain unchanged. As long as the property is kept in good condition, that could lead to a steady source of income down the road.
Investing in dividends vs. real estate isn’t an apples-to-apples comparison, and those looking to invest would be wise to diversify and not put all their eggs in one basket. However, one thing to consider is the massive advantage of investing in real estate: Equity. Equity in real estate can be converted into cash, giving the investor greater flexibility when handling emergency expenses or growing an investment portfolio.
2. Property Appreciation
Buying a rental property isn’t just about purchasing the home, which depreciates over time. It’s also about buying the land, which is limited. Most of the suburbs across the country, especially in states like California, have developed all the land that can be developed. The vacant land left is much less likely to be developed because of fire or flood risks. This is why even a burnt-down home in San Diego will still sell for over half a million dollars, and in some regions, the land value is up to 80% of the purchase. With homes and land at a premium, even homes in poor condition will increase their value over time.
Supply and demand aren’t the only determining factors regarding housing costs. The local economy and job market are significant factors regarding how much a landlord can charge. An extreme example is the Bay Area in California. After decades of a booming tech market, housing prices have become the most expensive in the country. Part of the reason is the high number of high-paying jobs. When you combine the growing number of high-paying jobs with minimal housing construction, you see a rapid rate in housing costs. For example, San Mateo added 70k jobs in a decade but only built about 3k homes.
Owning a rental property in a region with high-wage jobs, a growing population, and a low housing supply can be a great hedge against inflation. The value of homes in these areas will likely increase much faster, even in high inflationary times.
3. Tax Deductions and Benefits
Contrary to popular belief, landlords can’t just write off everything and turn losses into profit. It’s not a money-printing machine; you still need to generate revenue. Like all businesses, some costs and losses can be written off. For example, the depreciation of the home can be written off. This allows you to spread the cost of purchasing and managing a rental property over time. It isn’t a cash giveaway, though, and if you sell the property for more than the depreciation value, you will have to pay it back as a depreciation recapture tax.
Tax write-offs can help spread your costs out over the property's lifetime, decreasing the monthly amount of your operating expenses. This will help your cash flow as you manage your rental property over the years.
4. Diversification of Investment Portfolio
Investing in real estate is a great way to diversify your portfolio, and it’s the kind of investment that can grow over time. It doesn’t need to start with purchasing a 4-bedroom single-family home and converting it into a rental property. There’s a housing ladder that you can climb as your housing needs change over time. For example, you may buy a studio condo as your first home. As your needs change over time, you buy a one-bedroom and lease the studio, and so on. This can be done as you age and alongside any stock market and retirement plans/
Generally, investing in real estate is much safer than investing in individual stocks. Very rarely have housing markets completely collapsed. Even during the Great Recession, home values in regions with strong economies didn’t decrease in value much. They have also since recovered and then some. Investing in rental properties is similar to a mutual fund, where individual investments can have ups and downs, but value will increase over the long run.
One of the most unique benefits of investing in rental properties is the flexibility it gives the investor. It provides the owner equity and opportunities for future investments. It gives the owner flexibility when it comes to where they live. A rental property can eventually become your retirement home or give you a place to live in between homes. Most importantly, it provides you with consistent cash flow.
5. Control Over Your Investment
Unlike investing in the stock market, you have control over your investment when you invest in a rental property. This means you get to make all the critical business decisions making yourself the master of your destiny. You’ll get to choose how you screen tenants. You’ll get to decide how much rent you to charge. While there can be some limitations on business decisions that can be made depending on which state or city your property is in, you are still in control of all significant business decisions.
With owning rental properties, how much you earn is all on you. You don’t have to worry about the advice you’re getting from fund managers or stock brokers. You don’t have to keep watching how your stocks are performing. More concrete measurables determine your business as a landlord and will perform with more certainty than individual stocks.
6. Potential for Property to Pay for Itself
Even if you’re only breaking even regarding rental income and your mortgage payment, you’re still coming out ahead as you own a property that appreciates. Ultimately, the property pays for itself over time as the rental income covers mortgage payments, and you can profit if and when you decide to sell the property.
The most likely scenario is you do much better than just breaking even with mortgage payments. While you may break even initially, increasing rent by a few percentage points yearly will generate profit from your rental income. If you own a rental property in a market with a shortage, you can increase your rent even faster.
7. Opportunity to Build Equity
As you pay off your mortgage, you increase the percentage of the property you own outright. This means you grow your property equity every month you make a mortgage payment. This means that your income which goes towards the mortgage payment, is growing the equity you have in your property.
The more equity you have, the more flexibility you have in leveraging that equity when investing in a new property. This can help you grow your business faster. If you aim to turn being a landlord into a full-time job, leveraging equity is one of the quickest ways to reach that goal.
8 Reasons Why You Shouldn't Buy a Rental Property
1. Significant Upfront Investment
Unfortunately, not everyone has the opportunity to become a landlord. It requires a lot of cash upfront. Unlike purchasing a primary residence, you don’t want to forgo a full down payment. You want your monthly mortgage payments to be as low as possible. You’ll also need a cash reserve to deal with any speedbumps and delays you may have to deal with early on. Most Americans struggle to find a home they can afford as a primary residence, so becoming a landlord isn’t for everyone. One way to help with upfront costs is to pool your resources with a group of real estate investors.
You’ll also need a high credit score to obtain financing at lower rates. When buying an investment property, you aim to keep your operating expenses as low as possible. Higher interest rates and mortgage payments will eat into potential long-term profits.
2. Real Estate Market Fluctuations
Local economic factors will have the most significant impact on the housing market. While an increase in interest rates can negatively impact the value of your property, it isn’t nearly as important as the local economy and housing laws. Regions with colleges, high-paying jobs, and growing populations are likely to see rents and demand increase over time. Regions with restrictive zoning policies and slow growth in housing development will also see steady growth in value and rent so long as the local economy is strong.
The downside to areas seeing rapid increases in housing prices and rent is that they tend to be established, which means you need more cash upfront to invest in those regions. The alternative is to bet on emerging regions seeing early signs of economic growth and population boom. This can be risky because prices may depend more on speculation of long-term growth that may never come to fruition. Some regions are more dependent on a handful of large employers; if those employers decide to leave or go out of business, the entire housing market in the region can crater.
3. Maintenance and Repairs Costs
There are a lot of costs associated with managing a rental property. Depending on the type of tenant you want to attract, those costs can increase or decrease. If you’re looking to rent out a luxury property to a high-end clientele, you’ll need to maintain that property to the highest levels. There is a lower standard if you’re looking to rent a home as just a basic market-rate home. Most repairs can be routine maintenance, like repainting cabinets and walls. There will also be costly, unpredictable repairs like water damage, electrical work, and structural repairs.
If you are renting out a unit in a multi-family property, many basic repairs and maintenance may be managed by your HOA. This will make budgeting for maintenance and repairs easier as your HOA will cover much of it. The downside of dealing with HOAs is all the rules and restrictions they can put on your property. They can restrict the type of rental or even the total number of rentals within the complex.
4. Dealing with Tenants
An eviction is one of the more difficult situations a landlord may have to deal with. Even if a landlord is within legal rights to evict a tenant, the process can be time-consuming and costly if the tenant refuses to leave voluntarily. The eviction process is one a landlord should want to avoid at all costs. If a tenant refuses to leave, forcefully removing them will cost money, which goes with the tenant's unpaid rent period.
There’s only so much that can be done regarding screening tenants. There is no way to guarantee a perfect tenant that will not require eviction. Risks can only be mitigated. That being said, it is best to do your due diligence when screening your tenants by looking at their rental history and running credit checks.
5. Property Taxes and Insurance Costs
Depending on your location, property taxes, and insurance rates will vary. For example, states like California may have lower property tax rates but higher tax bills due to high housing costs. Due to legislation like Prop 13 in California, your property tax bill can be locked in based on the purchase price and not the asset value in the future. This means that your tax rate will actually decrease over time as your property value increases. Like capital gains tax, higher property tax rates can reduce the property's value.
Homeowners’ insurance costs can have a similar impact as property tax. States like Florida have increasingly high property tax and insurance rates. This can make purchasing an investment property in these regions less attractive. It is also becoming increasingly difficult to obtain insurance in areas of natural disasters. State Farm has left California and Florida because of high hurricane and fire risks, respectively. All these accumulated costs can harm your rental income.
6. Property Management Costs
Typically, property management fees will be around 8-12 percent of your monthly rental income. This will be the fee regardless of what your profit margins are. If you don’t have the time or knowledge to manage your rental property, you may need to hire a property management company for professional help.
Property management fees can eat into your profit margins and make your rental property unprofitable. Before purchasing a rental property, you want to be sure that you have the time and ability to manage the property in the early stages, or you need to be sure you can afford a property management company right from the start.
7. Difficulty Selling Property
If the market goes sour, you might find yourself stuck with a property that is difficult to sell. Unlike stocks, real estate is not a liquid asset. You must consider exit strategies before making your initial investment.
In an ideal world, you only sell your property during favorable market conditions. Unfortunately, life doesn’t work that way, and situations may arise where you must sell your rental property in unfavorable market conditions. With any business, you can find yourself in unforeseen and unfortunate circumstances. Family issues, personal health issues, economic downtown, and many other unpredictable events can leave you in a lurch and forced to sell your property at a loss. The best you can do is try to plan and mitigate any disasters, but the best-laid plans of mice and men are still at the mercy of unforeseen events.
Investing in rental property isn’t for the timid. It requires a lot of capital, intricate planning, and a palate for high-risk and unpredictable investing. It requires some knowledge about the local real estate market and patience. Before jumping into business as a landlord, first, determine if you are ready to do all the work that is necessary to manage the business.
1. Is buying a rental property a good investment?
Buying a rental property can be an excellent investment. It won’t necessarily be a life-changing investment, but it can be a great way to generate passive income and build a nest egg for a comfortable retirement. Generally speaking, depending on local markets and economic conditions, property values typically increase over the long term.
2. What are the advantages of owning a rental property?
There are plenty of advantages to owning a rental property. You can generate a passive income through rental income. There are tax benefits. You can increase your equity and net worth, creating more investment opportunities. It can help you diversify your investment portfolio and plan a comfortable retirement.
3. What are the disadvantages of owning a rental property?
Owning a rental property isn’t without its disadvantages. Real estate investing requires substantial upfront costs and depending on mortgage rates and rental property condition, significant operating expenses. There are high costs for maintenance and repairs. Managing a rental property also involves a lot of time in dealing with and finding tenants. If you can’t have the bandwidth or desire to manage the property yourself, there are also property management costs.
4. Is it better to invest in real estate or stocks?
There’s no either-or when investing in real estate or stocks. Both have their pros and cons. Stocks can offer higher returns and are easy to buy and sell, but they can be more volatile than real estate. Investing in rental properties allows you to have a little more control over your financial future.
5. How much money do I need to buy a rental property?
There is no set cost required for buying a rental property. The down payment will depend on the purchase price and lenders' requirements. Closing costs and necessary renovations and repairs may be required to bring your property up to code or competitive rental market standards. Each investment will have different upfront costs so it’s best to invest in a property well within your means.