Knowing the pros and cons of owning rental property can help you make an informed decision about whether or not to invest in this type of real estate. I have been investing for over 15 years and have experienced most of the cons firsthand. After building an investment portfolio with more than 70 properties, I am finally realizing the pros. Now I’ll give you the list that I learned the hard way.
|Monthly Income||Management Hassles|
|Wealth Accumulation||Lack of Liquidity|
|Tax Advantages||Effect on Personal Finances|
|Ease of Leverage||Risk of Making Mistakes|
This article will explain the pros and cons of rental property investment. I will explain each of them, giving you the tools to decide if investing in rental homes is for you. If you move forward, study the cons closely, and devise a risk mitigation strategy, investing in residential real estate is a great way to accumulate wealth.
Pros of Owning Rental Property
Owning a rental house can provide a steady stream of passive income, as tenants pay monthly rent. When done correctly, this constant cash flow will cover rental property expenses and provide you with a monthly income. As rent rise, your mortgage payments often stay the same, providing additional monthly cash flow. In addition, rental rates rise with prices acting as a hedge against inflation.
Maintaining a long-term positive cash flow to cover the property’s operating expenses is essential. In addition, you need extra income above the operating expenses to have a monthly passive income. Ensure tenants pay rent on time; if they don’t, follow my guide for handling a tenant that doesn’t pay their rent.
The paper, Rental Yields and HPA: The Returns to Single Family Rentals, looked at rental real estate in the 30 largest metropolitan statistical areas over 28 years. This study found that, on average, properties appreciate at the rate of 3.3% to 6% annually. As a real estate investor, you must cultivate the skill of finding properties with a purchase price that is a significant discount to market value. Doing this will amplify the appreciation gains, pushing your net worth higher.
As the property owner makes monthly payments, the amount allocated to mortgage interest decreases. As a result, each month, the investor buys equity in the properties. Over the long hail,
An additional benefit is increasing your equity as you pay down the mortgage on your rental property. It is simple to borrow against this equity to finance future real estate investments and snowball your wealth accumulation.
There are several tax benefits associated with owning a rental property.
Rental property owners can often claim depreciation on the property, which is a tax deduction that allows them to recover the cost of the property over time. This depreciation deduction acknowledges that properties will lose value over time due to normal wear and tear. Thus their value must be depreciated or reduced over their useful life. In some cases, depreciation can lower the taxable income from other sources, making it one of the best tax deductions available.
Deferring Capital Gains
A 1031 exchange, also known as a like-kind exchange, is a provision in the U.S. tax code that allows property owners to defer paying capital gains taxes on the sale of certain investment properties as long as the proceeds are reinvested in a similar property within a specific time frame. In a 1031 exchange, the property owner sells their investment property and uses the proceeds to purchase a like-kind property within a specific time period. When appropriately used, the gain on the sale of the property is not taxed. Instead, the existing depreciation and any taxable profit are transferred to the new property.
By deferring the payment of capital gains taxes, the property owner can reinvest the proceeds into a new property, generating more income or appreciation. This can be a powerful tax planning tool for real estate investors, as it allows them to defer paying taxes on the sale of a property and keep more money invested in their business.
Ease of Leverage
Leverage in real estate investing typically refers to using borrowed money to finance the purchase of a property. Using leverage, investors can increase their purchasing power and acquire more rental properties than they could with their own cash. This can help diversify their portfolio and spread their risk across multiple properties.
Using leverage with real estate is easier than with most other investments. For example, you must have a margin account to use leverage when investing in the stock market. Even then, you can face a margin call and be forced to liquidate your investment at an inopportune time. With real estate, your loan stays in place for an extended time and doesn’t change based on property values.
Additionally, leveraging a rental property can increase the potential return on investment if the property appreciates over time. For example, if an investor purchases a rental property for $100,000 with a 20% down payment of $20,000 and the property appreciates to $120,000 over several years, the investor would have made a return of 100% on their initial investment of $20,000, not including any rental income earned during that time.
Cons of Owning Rental Property
Managing a rental property can be time-consuming and require significant effort. Tasks may include finding and screening tenants, responding to maintenance requests, and handling lease agreements and rent collection. In addition, these rental properties require regular maintenance and repairs, which can be costly and time-consuming.
Rental house maintenance costs can be a significant financial burden for landlords. Regular repairs and maintenance tasks such as fixing plumbing issues, repairing electrical systems, or replacing appliances can quickly add up and impact the landlord’s bottom line. It can be incredibly challenging for landlords with limited budgets or tight cash flow, as unexpected maintenance expenses can disrupt financial planning and strain resources.
Tenant issues such as late payments, property damage, and complaints can be stressful and time-consuming. The rental property owner often became a de-facto debt collector. Occasionally, this results in an eviction, which can be a lengthy and costly legal process.
Lack of Liquidity
One of the potential drawbacks of owning rental property is the lack of liquidity. Liquidity refers to how easily an asset can be converted into cash. Compared to other assets such as stocks or bonds, rental property is typically less liquid because it can take time to sell and find a buyer.
If a rental property owner needs to sell their property quickly, they may have to lower the sale price or offer incentives to attract buyers, which could result in a lower return on investment. If you want to make your rental portfolio more liquid, check out my article on the liquidity of residential real estate.
As the real estate market fluctuates, it can affect rental property owners in terms of property value, rental rates, demand for rental properties, financing options, and overall profitability. A booming property market can result in higher property values, increased rental rates, and high demand for rental properties, leading to greater profitability for rental property owners. On the other hand, sluggish market conditions can result in lower property values, reduced rental rates, and decreased demand for rental properties, which can negatively impact the profitability of rental property owners. Over the long haul, a real estate investor is subject to the whims of their local market and the national market.
Effect on Personal Finances
When investing in real estate, the owner usually has complex tax returns. As a result, this may cause problems obtaining a mortgage on their primary residence. Often, banks that make conforming mortgages are not experienced with the intricacies of rental house finances. These banks will have difficulty correctly calculating metrics such as the debt-to-income ratio, which could result in your loan application being denied.
Rental property expenses can also impact personal credit and financial health. If landlords struggle to meet their financial obligations related to the rental property, such as mortgage payments, property taxes, or maintenance costs, it can result in late payments, defaults, or other negative impacts on credit scores. This can, in turn, affect personal financial health and make it challenging to obtain credit or loans in the future, impacting the overall economic well-being.
The lending environment, which includes factors such as interest rates, lending standards, and availability of financing options, can significantly impact rental real estate. The lending environment influences the cost of borrowing money to purchase rental properties, particularly interest rates. When interest rates are low, it can make financing more affordable for rental property owners, resulting in lower monthly mortgage payments and potentially higher cash flow. Conversely, with a higher interest rate, borrowing costs increase, which can impact the profitability of rental properties and reduce cash flow.
Owning rental property can be a lucrative investment strategy. It can provide you with a monthly income and massive wealth through property appreciation. On the other hand, investing in rental houses requires hard work and dedication. The owner must deal with many hassles while holding an illiquid investment.
This article has presented the pros and cons of owning rental property. Is it worth it? Only you can answer that question. The best advice is to study the pros and cons and make an informed decision before you embark on a career as a landlord.