Investors get involved in real estate for the appreciation, tenant-paid mortgage, cash flow, and more. However, be wary of bad tenants, tied-up money, and unexpected costs.
Pros of Rental Property Ownership
Many investors consider owning real estate the greatest investment you can make. There are plenty of reasons why Andrew Carnegie said that 90% of millionaires join the seven-figure club through real estate.
Appreciation
Perhaps the best part of long-term real estate ownership is that your property is almost guaranteed to go up in value significantly. Property values have increased by an average of 4.3% annually since 1991.
While that may not sound like much (stock market growth is around 10% per year), think about it like this:
You’re not gaining 4.3% on your cash; you’re gaining 4.3% on the entire value of the home!
For example, let’s say you bought a $500,000 home but only paid $100,000 in cash and borrowed the rest. If the property increases in value by 4.3%, the home is now worth an extra $21,500. That’s a 21.5% increase on your money because you only paid $100,000!
No Mortgage Payment
For most people, the single biggest cost each month is a mortgage payment. Your personal residence can be a great investment over time, but you also have to sink significant resources into paying your mortgage each month.
Furthermore, you can’t just sell your home and pocket the cash—you need another place to live.
That isn’t the case with a rental property, where you can experience all the financial benefits of home ownership—such as appreciation—without having to put any more money into the asset.
Cash Flow
In addition to no mortgage payment, rental property owners who have invested wisely should have a source of cash flow each month.
While a new rental may not cash flow much, over time it will. Your mortgage payment is locked in (minus small tax adjustments), but you’ll be able to significantly increase rent over the next few decades.
Eventually, you’ll have the mortgage paid off, and the monthly rent payment is cash in your pocket. That’s a tremendous investment.
Tax Benefits
Rental property owners experience the following tax benefits:
- Deducting Operating Expenses – Any costs that the owner incurs while running his business can be deducted. For example, advertising, property manager fees, supplies, repairs, and much more can be deducted from income.
- Deducting Depreciation – Any part of the home that wears out over time (i.e., everything but the land) can be considered a depreciation expense. For example, if you provide a fridge that costs $1,500, you can deduct $300 per year for the next 5 years, which is the assumed life of an appliance. You can even deduct depreciation expenses on the cost of the entire home, which adds up nicely.
- Deducting Mortgage Interest – Anything you pay in interest can be deducted.
- Deducting Owner Expenses – Other costs not directly associated with property upkeep can also be deducted, such as traveling for business or continuing education.
- Avoid FICA Taxes – Generally, when a self-employed business owner earns income, they must pay FICA taxes of 15.3%. That doesn’t apply to rental income.
Asset Control
Rental property owners have complete control over the asset, which isn’t the case with many other investments. Buying a stock in a company like Tesla gives you a very small piece of ownership, but you have no control over how the stock performs.
On the other hand, your decisions with the property greatly affect how profitable the asset is. These decisions include renovating, hiring a property manager, advertising openings, screening tenants, and more. You can even decide exactly when you’d like to sell, which many investment classes don’t allow you to do (e.g., fractional ownership in a property, bonds, or CDs).
You Can Return to Your Home
One of the most common ways new investors get their first rental property is to rent out their current home! They buy a new home without selling their current home and rent it out. This gives the investor more flexibility if they want to return to live in that home later.
Of course, the owner must wait until the tenant’s lease is over before resuming residency.
Cons of Rental Property Ownership
While many argue that owning a rental property is a simple decision, it’s not for everyone. There are certainly downsides to running a rental property business.
Illiquid Money
While you can choose to sell whenever you want, it’s unlikely that you’ll get the money within the next few months. In a cold market, your property might not sell for several months, or not at all if your pricing doesn’t match the market.
This can cause you to miss out on other investment opportunities. If a friend comes to you with a great investment idea, but all your cash is tied up in rental properties, you’d likely have to pass.
Frequent Upkeep
While most investors refer to rental properties as “passive income,” that’s only partly true. Yes, as long as you have tenants you will get paid each month (in theory). However, it’s not totally passive because maintenance can be overwhelming on a house.
If you manage the property yourself, you may have to handle frequent calls to fix issues. Even if you hire a property manager, upkeep costs money, and you’ll still have to make larger decisions such as replacing carpet or painting the walls.
Unexpected Costs
Most investors are savvy enough to set aside a piece of their monthly rental income to pay for expected upkeep. However, sometimes large, unexpected costs may arise that can sink your rental business.
A few of these items could be:
- Roof needs to be replaced
- Water heater dies
- Unhappy tenant trashes the apartment
- Long vacancy
- Fines from the city
You don’t realize that your tenant hasn’t kept your property up to code, and the city fines you $100 per day. Before you realize what’s happened, you could have a serious bill that you weren’t expecting
Tenant Management
While some rental owners choose to hire a property manager, others take on the task themselves. These DIY owners are the first call for emergencies, regular maintenance, and complaints.
In addition, landlords must establish processes for collecting and recording rent, screening new tenants, and taking care of landscaping (unless it’s the tenant’s responsibility).
Owners who hire property managers lose some of their monthly cash flow, and still often have to make decisions with emergencies and larger upkeep items.
Neighborhood Changes
Have you ever returned to your old neighborhood and been astonished at how different it was? This happens all the time—for good or bad. If the neighborhood becomes rundown, grows more dangerous, or converts into a high percentage of rentals, it will affect your rental property’s value.
Tax Changes
Investors can generally expect that their mortgage payments (including insurance and taxes) will stay relatively the same while they can regularly raise the rental price.
But there’s certainly no guarantee, as property taxes and insurance premiums are subject to change. State governments can decide to significantly raise property taxes.
For example, Hawaii has the lowest property tax rate at 0.29% of the property value while New Jersey is at 2.47%. There’s nothing stopping Hawaii from deciding to raise their tax rate by 5x (and they’d still be well below New Jersey).
Real Estate Cycles
While the real estate market has consistently increased over time, there are hills and valleys along the way. For example, while property values have since recovered from the Great Recession of 2008, it wasn’t easy for property owners at the time. If an owner needed to sell, they were likely listing their property 30% lower than they could have gotten just a year earlier.
While holding property generally makes financial sense, owners still have to be patient with unloading their properties at the right time.