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Deeds, Sunday, July 26, 2015

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The Advantages and Disadvantages of Owning a Rental Property

Photo: turkeychik

When I was a little kid, a cousin of mine owned several rental properties in the small town near my home. This was basically his livelihood, as he spent his time taking care of the properties as needed, collecting rent, and so on. He spent about 20 hours a week on his collection of properties that was spread around the town.

I always thought that this guy kind of had things figured out. He only had to work about 20 hours a week, after all. He was constantly receiving income from the properties, plus he owned all of those houses that he could sell if he wanted to.

But the reality was different. When I visited his house, it often seemed like it was held together by duct tape. It was easily in worse shape than some of the houses he rented out. In 1993, a flood wiped out most of the houses and trailers that he rented and it turned out that the insurance money he collected wasn’t enough to rebuild.

Instead, he wound up dying with very little money left and a decided hand-to-mouth existence during the final years of his life. In fact, looking back on it, it was fairly obvious that he never had a whole lot of money, even when his rental “empire” was in great shape.

This left me with something of a dual view of owning rental properties. On the one hand, they seemed like they could earn you a lot of money, plus you’d own the properties. On the other hand, it looked like there were more costs than I expected and there were other big risks, too.

It was something I might consider someday, when I could “afford it.”

Over the last several years, that day has slowly arrived. Right now, Sarah and I could purchase a rental property or two as a way to earn some direct income and to diversify our investments. It’s also something that many readers have written to us about.

As Sarah and I always do when we’re thinking about a big decision like this, we make a big list of pros and cons and then use that to guide our decision…

The Advantages

The advantages to owning a rental property are relatively few, but they’re powerful. To put it simply, if everything lines up well, you can make a lot of money from a rental property.

Income from Renters

The biggest benefit of owning a rental property is that the renters will provide you with a direct income stream. Those monthly rent checks go straight into your business account, ideally more than offsetting any expenses for the month.

For example, if you own a house that you rent out for $1,000 per month, that house when fully occupied will put $12,000 per year back into your accounts.

It’s hard to argue with a direct income stream like that. It is worth nothing, though, that those kinds of figures are optimistic ones and you shouldn’t just dive in expecting those results. Still, even partial results can be very good. If you can keep the property rented for just 75% of the year, that’s still $9,000 a year in income, after all.

Income from Property Value Growth

In addition, since you own the property, you stand to gain from an increase in the property value over time due to changing demands in the area, even if the property doesn’t undergo any changes.

This is obviously going to be a variable thing, as it depends heavily on the area where your rental property stands. In some areas, the value may rise significantly over the course of a few years, while in other areas it may remain flat. Ideally, this value growth holds pace with inflation at a minimum. If you happen to be in an above average area, you might find that you can beat inflation; on the other hand, a really stagnant area may not even keep with inflation.

Sweat Equity

The other factor that you should consider is that your sweat equity is likely to add additional value to the property as you maintain and upgrade it. Doing things like repainting the home, adding new siding, refinishing the inside, doing some basic landscaping to the yard, and so on will add value to the home without significant financial cost.

Not only will this allow you to charge more for rent, it will also increase the value of the property itself should you choose to sell it in the future.

If you enjoy home improvement projects, this should be a major attraction for buying a rental property. You’ll have the opportunity to fix it up upon acquisition as well as in between tenants, which will return very nice dividends for you.

The Disadvantages

On the other hand, there are a number of disadvantages to owning a rental property. Individually, these disadvantages are relatively small, but they add up to a significant cost.

Concentration of Assets

One drawback to investing in a rental property is that for most people, owning a rental property is a serious concentration of their assets. It would take a significant portion of the average American’s net worth to fully own a rental property.

The problem with that concentration is that it’s not diversified at all. That investment is in a specific house on a specific block in a specific neighborhood in a specific city. If that neighborhood goes downhill, you lose a lot of money. If that block goes downhill, you lose a lot of money. If something unfortunate happens to that house that insurance can’t handle, you lose a lot of money.

Like it or not, by owning a rental property, you’re tying yourself to the local real estate market in a very tight way.

Concentration of assets is not a wise investment strategy. However, the more wealth you have, the less this becomes a factor and the more that property ownership becomes a tool for diversification rather than something you’re concentrated in.

Tenant Risk

Tenants are never a guarantee to pay their rent. Even in the best of times and even with the (seemingly) best tenants, that revenue stream is far from guaranteed.

Sure, sometimes you’ll get a great tenant that pays their rent on time for years and years and years, but that’s never a guarantee. Some tenants won’t pay regularly, and others won’t pay at all. You’ll be out several months of rent and also the time spent dealing with their non-payment and eviction.

• Related: What I Wish I Knew Before Buying Rental Properties

Some tenants may also cause more property wear than others. Sure, you’ll have that security deposit, but that’s still a cost and a risk.

There’s also the risk of not having a tenant at all, which means that you’ll have periods where the property generates no rental income.

Taxes and Fees and Insurance

Regardless of whether you have people in the house or not, you’ll still be facing the cost of property taxes, the cost of insurance on the property, and the cost of any homeowners association fees associated with the property. Those bills will come in regardless of whether there is a tenant in the property or not.

This is a pretty steady cost that you’ll clearly know about in advance, but no matter how you slice it, it’s a cost that cuts into your profits. It’s especially painful if you don’t have someone renting the property, as that means that such costs are going to be coming directly out of your pocket.

These costs are not insignificant. For example, insurance on a rental property is usually around 25% higher than it is for a normal homeowners’ policy and property taxes are nothing to laugh at. If you’re caught without a tenant or with a tenant that’s not paying up, this will have a direct and fierce negative impact on your finances.

Active Involvement

Even in the most “hands off” of situations, you’re still going to be devoting notable time to this rental property. Eventually, it will need repair. Eventually, you’ll have to check on it. Eventually, you’ll have to interact with the tenants. Eventually, you’ll have to do paperwork of some kind or another.

You can do away with this problem by hiring a management company – something we’ll discuss below – but in doing so, you eat away at the profits from renting out that property.

Other Options

What options do you have if you want to mitigate some of the downsides of owning and renting a property without getting rid of all of the upsides? Here are two alternate strategies.

REITs

REIT stands for Real Estate Investment Trust. A real estate investment trust is simply a company that owns and operates income-producing real estate. Individuals can invest in REITs through the stock market, as they are often publicly traded, and they enable a person to take a relatively small amount of money and invest in income-generating real estate.

REITs pay out income in the form of dividends. They tend to pay out a healthy dividend each quarter, but their price is high in accordance with those dividends. In other words, the individual shares of reputable REITs are fairly high.

Buying some REITs along with your other investments can be a way for investors without a lot of money to diversify. It’s worth noting that very broad-based index funds, like the Vanguard Total Stock Market Index, already have some REITs rolled right into them.

Managed Properties

Another strategy worth considering is managed properties. A managed property is one that you own and rent out, but which you pay another company to handle the day-to-day management of on your behalf. The net effect is that you hand over some of the rent you take in to that management company.

What this does is reduce the amount of time you have to spend dealing with the property in exchange for a reduced income stream.

This can be a good idea for someone who wants to try owning a property, but has no interest in day-to-day property management and can live with a reduced income stream to save themselves the headache.

Joining a Residential Investment Firm

Another option might be to pool your money with some other interested parties and launch a residential investment firm. This is a small business that buys and sells properties, usually within a local area, with the purpose of renting them out and earning a profit from them.

This does require some initial legal work as you set up a business structure that works for all involved, but once this is done this can be a great way to earn steady income. Such businesses often employ a property manager who takes care of the actual on-site tasks, allowing the partners in the business to instead focus on business decisions which are mostly done in a passive fashion.

The only drawback here is that it does require partners, which means that you need to know people in the community with the business acumen and the financial strength to be willing and able to enter into this kind of arrangement.

What We’re Doing

Given all of this, what are Sarah and I doing?

We have some of our money invested in a REIT. How? As we’ve mentioned many times before, Sarah and I have some of our money invested in the Vanguard Total Stock Market Index, of which a portion is invested in real estate via real estate investment trusts. So, as of right now, we do effectively own a small amount of highly diversified real estate.

We constantly watch the local real estate market. We are simultaneously looking for land to build on or a house for ourselves as well as potential low-end properties to invest in. This does means we’re looking at foreclosure listings and estate auctions, too. We haven’t found anything that wasn’t either quite expensive or in need of extensive work, however, at least in terms of a property to rent. It is worth noting that we don’t see buying a property to rent as a high priority, but it is something that we would jump on board with if the opportunity arose.

So, will we become landlords in the future?

At this point in my life, buying a rental property just for the sake of buying one isn’t the right move for me.

For starters, I have little interest in taking on the tasks required of a good landlord. While I enjoy home improvement tasks, I’m not as interested in answering the phone in the middle of the night to deal with a crisis. I also don’t relish the interactions between myself and a tenant if there is trouble.

If I were able to be in a situation where I could hire a management company to take care of the property, I would consider it, but for that to be a good financial move, I would need to find a very good deal on a property.

For me, at least, it makes sense to diversify into real estate by buying into a REIT, and I already do that with my personal investments. I feel as though my personal investments are very diversified right now.

If I were at a different stage in my life, I might relish the experience and challenge of taking on a rental property, but it’s just not a good fit right now.

Who Would Make a Good Landlord?

As I studied the ins and outs of becoming a landlord, it began to occur to me that some people are personally predisposed to be more likely to effectively manage – and enjoy the management of – a rental property, while others are not so predisposed. Here are a few traits that a good rental property owner might find desirable. The more of these traits you have, the more enjoyable and lucrative owning a rental property may be for you.

You enjoy small home improvement projects. Do you enjoy doing things like installing carpets, painting walls, fixing minor dings and dents in cabinets, doing minor plumbing tasks, installing and patching drywall, and so on? Some people really enjoy these tasks, particularly when doing so rewards their sweat equity with more rental income and a higher property value. Other people don’t enjoy home improvement tasks much at all, which will make this part of the gig into painful drudgery.

You have spare time. You’ll be responsible for things like backed-up toilets in the middle of the night, basement flooding, and so on in another home besides your own, where the tenants see you as a landlord who will be fixing such problems. Are you up for that? If you’re on a tight schedule, it might be very tough. Even if you hire a management company, owning a rental property will still eat up at least a little of your spare time. If you choose to go without one, it can eat up a lot of time.

You don’t mind occasionally dealing with difficult situations with people. Being a landlord sometimes means dealing with tenants with overinflated demands and expectations. It can also mean dealing with tenants who don’t pay their rent. Those types of interactions can be difficult and, if handled poorly, they can escalate into progressively worse problems. Are you willing to occasionally deal with these kinds of difficulties?

You have significant liquid assets to invest right now. It’s generally a poor idea to take out a loan in order to buy a rental property because of the financial risk it introduces into your life. If you don’t have the financial wherewithal to pay cash for a rental property – or you don’t have an established business that can handle this via a business loan – you shouldn’t be in the rental property business yet.

Investing in a rental property won’t absorb the majority of your net worth. This is all about concentrating risk and putting all of your financial eggs in one basket, which is never a good idea. If you’re going to have the majority of your net worth tied up in a rental property, you may want to reconsider your plans.

Final Thoughts

For some people, owning a rental property might be a brilliant personal financial move. If they’re in good financial shape already, have some spare time on their hands, and don’t mind handling home maintenance emergencies, a person who puts in some patient time finding the right property to rent can make a very nice profit on a rental property.

However, not everyone is in that group. Some people might not relish the interaction between tenant and landlord from the landlord’s side. Others may not be in a financial position to take on a rental property quite yet. Still others might not feel confident in their local real estate market.

That’s okay. If those things describe you, you can still diversify into real estate by investing in a REIT with some of your investment funds.

The important thing to remember is that investing in rental properties is definitely one of many options on the table, and it is a good option for some people. Take into consideration your own financial state, your personal strengths, and your interests and make up your own mind about whether rental property ownership is the right move for you.

The post The Advantages and Disadvantages of Owning a Rental Property appeared first on The Simple Dollar.

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