Depending on who you ask, owning rental real estate can be the best (or only) thing in the entire world or the worst idea that should be avoided like the plague. This post is going to take the eyes wide open approach and discuss some items that should be thought through when considering rental properties.
First my cynicism: many advisors are paid for managing assets, Winding Trail Financial included, so there's at least a conflict of interest in that assets and corresponding fees are typically reduced to pay for rental properties. Less cynically, rental properties typically require the involvement of CPAs, attorneys, and often property managers. Therefore, many advisors are at least inadvertently left out of the conversation and there can be a tendency to not have the familiarity with the intricacies of rentals in the same way the other players mentioned would have unless they own rentals themselves. We tend to recommend what we know (and get paid for). Many advisors, especially those attached to broker-dealers or insurance companies, are prohibited from giving tax and legal advice which are basically the two main drivers of a rental property business.
I think rental properties can make sense for people that are taking an eyes wide open approach, are taking a long-term view, and have checked a lot of the required boxes: adequate emergency fund and cash reserves, filling up tax advantage accounts, etc. Let's discuss at least a few topics that need serious consideration when mulling over getting into the rental real estate game.
Liquidity
Purchasing a property requires cash for the down payment if not the whole thing, transaction and due diligence costs (typically smaller on the buy side than sell side), and any costs to get the property into rental condition. This can and usually does add up to thousands of dollars. You can easily buy shares of stock or a mutual fund or ETF with substantially less outlay. You'd be hard pressed to get into the rental game for less than $100 like you can with some other investments. Depending on your financial position, it may not make sense to tie up that much liquid cash into a traditionally illiquid asset such as real estate.
Selling a rental property isn't something that can be easily done overnight. I discussed in a previous post that friction can be a great behavioral incentive not to sell a property. But sometimes, you need to cash out part of your investment whether it's time to pay for a planned expense or due to an unexpected circumstance. It's difficult to immediately liquidate a rental property or only a part of a rental property. With an investment portfolio comprised of mutual funds, ETFs, and widely traded stocks, you can sell as much or as little as you want with the click of a few buttons or call into your advisor.
Diversification (or lack thereof)
You're buying one property in one location which is predicated on one micro-economy. While we've recently seen above average real estate growth in markets such as Denver, Seattle, and parts of California, other areas haven't seen the same growth. There are also pockets within those hot markets that haven't performed as well. Having real estate ties you to one very specific area for better or worse. If you're looking at a rental property for the long-haul then it's a good idea to get a sense of the long-term prospects of your interested area.
Alternatively, you could purchase an index fund that could provide global diversification and exposure to real estate baked in. Furthermore, you could consider purchasing a Real Estate Investment Trust (REIT) mutual fund or ETF that would be professionally managed and provide diversification within the real estate market or submarkets. This can also help solve the liquidity issue above while still giving you exposure to the real estate market. (Note: not all REITS are created equal and some, such as private REITs, can have restrictions. A REIT is not a perfect substitute for actual real estate. It's recommended that you work with an investment advisor that can help recommend the appropriate tool for you if you decide to go this route.)
Potential for Legal Exposure
Because you're dealing with tenants and leases and other vendors, this can open up to different legal exposure that aren't necessarily there with just owning a portfolio of stocks and bonds. Certainly these exposure risks can be at least partially mitigated with the help of legal counsel and insurance but they don't go away entirely. It's at least worth being aware that you're potentially adding a target to your back especially if you are a higher earner and/or have a sizable amount of assets.
Unknowns That Could Require Cash
Anyone that's lived in a home or apartment (and that would probably be all of us) know that things pop up. In the rental business, there are expenses that directly require cash and those that indirectly require cash.
Repairs and maintenance and HOA assessments are a couple of big ticket items that typically require cash directly. It's a good idea to think about the property you're considering and factoring in those costs. It's better to budget for that new roof replacement or that HOA assessment that's been discussed at the board meetings than to be surprised with a big bill later on and scrambling for cash. You can't exactly tell a tenant that they'll have to wait a week or two for the furnace to be repaired in the middle of February.
What about expenses that require cash indirectly? For example, it's expected that you'll have tenant vacancies. You may experience a longer than expected vacancy from time to time as well. The lender will want their money regardless which you'll have to come out of pocket. If you've paid cash for the property but are relying on the rental income then you'll have to go without for that time. Again, you'll want to bake that into your projections and have some cash reserves if things don't go according to plan.
A portfolio of stocks, bonds, and mutual funds doesn't typically require additional capital at no notice (unless you have shorts out there which are outside of the scope of this discussion). Psychologically, it can be very frustrating to have to write a five-figure check to cover a large HOA assessment or new HVAC system and watch years of profits disappear rather than holding tight to an investment portfolio and waiting for the recovery which doesn't require writing a check.
Complexities
The potential tax benefits are one area that gets a lot of attention - non-cash depreciation and potential for tax-deferred or tax-free exchanges are two examples - but it's a double edged sword. Rental properties have their own tax rules that are quite nuanced. Property taxes can be different in certain areas is the property is a rental rather than being used as the owner's primary residence. Owning the property with other people or entities, especially related parties and closely-held businesses, can get complicated very quickly and the tax consequences detrimental. Owning rentals is one area where I recommend bringing in a tax pro.
Passive ≠ Hands-off
It's easy to find great stories either from friends and family or the internet about the benefits of passive income and the seemingly little you have to do. Just collect a check! But it's a bit like Vegas, you only hear about the winners.
Someone has to manage the day-to-day operations of the property including the repairs and maintenance - do you want to fix the heat at 2:00 AM? - finding tenants, marketing the property, getting the property ready for a new tenant, and possibly dealing with the unpleasantries of an eviction, to name a few of the tasks. All of the above points can be addressed and it's not as if it happens all day, every day but it's going to require at least some attention on your part even if you use a property manager.
In wrapping up, for many, the potential upside outweigh any of the negatives - they believe it will outperform the stock market, they like the "hands on" aspect, they like the control, the learning opportunities, or that it at least compliments a well thought out investment plan, etc. My take is to treat rentals like a business rather than a hobby; there are a lot of professionals out there in this arena that take this stuff very seriously. Keep your eyes wide open!
If you're considering rentals, let's chat! Schedule a call here.
Disclaimer:
The above is for general information only. Consult with competent investment, tax, or legal counsel to best understand your unique circumstances before implementing any strategy. There is no assurance that working with a financial professional will improve investment results. All information above is subject to change. Read our firm's disclaimer here: https://www.windingtrailfinancial.com/disclaimer.