There are a vast array of pros and cons of owning rental property. It’s become more and more popular of an investment strategy, particularly in recent years as people are seeking havens from wall street investing. A little known fact is that upwards of 70% of rental properties are owned by individual investors, like you and us here at 40PlusFinance.com.
Even though the market itself can be volatile with housing prices and the demand for rental property can go up and down, depending on the real estate market.
Residential rental properties come in all shapes and sizes. There are many different types of real estate investment opportunities, from single-family rental homes to condos and coops, townhouses and mobile homes, small multifamily properties with 2 to 4 units, fractional ownership shares of a home, crowdfunds and REITs.
That’s one of the best things about real estate. There is a rental property available for every type of investor.
While here at 40PlusFinance.com, we are huge fans of owning rental property, it is not the right investment for everyone. Let’s take a look at some of the biggest pros and cons of owning a rental property today.
- 1 Top 10 Benefits of Owning Rental Property:
- 2 10 Disadvantages of Owning Rental Property:
- 3 Final Word
Why Invest in Rental Properties?
There is more effort required to invest in real estate directly than to manage paper assets. An investor will need to have more money available to get started, and less money that can be quickly turned into cash.
Famously, Robert Kiyosaki, author of Rich Dad Poor Dad, counts owning rental properties of all kinds as a core part of his wealth building strategy. Starting with a small, single family home purchased completely with debt and then progressing to owning large, multi-family apartment complexes, he continually talks about rental properties and the benefits of owning them.
So let’s dig into some of the benefits and advantages of participating in this financial freedom strategy.
Top 10 Benefits of Owning Rental Property:
1. Ongoing Income
If you were to invest in an index fund that tracked the S&P 500, you would see dividend yields that fall somewhere between 2-3%. Most of the returns come from long-term growth.
Bonds cannot be relied on to provide income for your portfolio. In the current economy of low interest rates, bonds don’t provide much income.
Rental income on the other hand can provide ongoing income in the form of what is known as “cash flow”. This is essentially your net earnings after paying for a mortgage, property management, maintenance, taxes, etc.
A typical measure of a single family rental income potential is what is known as “cash on cash return” and in the first year, it can range anywhere from 0 to 10%. Our own goal is, at a minimum to have the rental properties pay for themselves starting in the first year.
2. Inflation Protection
Not only do rents go up when the cost of living goes up, but rising rents also contribute to inflation. Over the past 30 years, inflation has caused the value of the dollar to decrease by about 50%. Rents have increased threefold over the past 30 years. This means that in 2020, the median rent was approximately 3.5 times higher than it was in 1990.
With each year that goes by, it becomes more expensive for renters to keep up with their landlords. Landlords can raise rents to keep pace with or even surpass inflation, meaning that renters have to pay more just to keep up with the cost of living. A currency’s value may change, but that doesn’t affect the real value of housing. The worth of an item is dictated by how much people are willing to pay for it. This makes rental properties an excellent hedge against inflation.
Another way to look at rental properties helping with inflation protection is that the selling price of properties generally goes up at least with the rate of inflation. You can tap into that increase in equity through either selling or a refi-cash out.
3. Leveraging Other People’s Money
Typically, investors can put down only 15% to 25% of the total cost of a rental property and finance the rest with other people’s money.
You can buy an asset and keep it, but you don’t have to pay the entire cost yourself.
In this case, the debt is “good” because it brings cash flow from the asset back to the investor. If you borrow $80,000 to buy a $100,000 rental property and your average cash flow is still $1,500 per year, then the debt has helped you become wealthier.
Meanwhile, your tenants pay down that debt for you. If you are able to pay off your debt entirely, your cash flow will increase significantly.
4. Predictable Returns
When you buy a stock, you are gambling that the stock will go up based on historical returns and your research about the company. However, it is impossible to predict the exact results it will bring.
Rental properties can provide a steady income and cash flow if they are managed correctly. The purchase price, market rent, and estimated expenses are all known.
You can figure out how much each of these expenses will be for any property you’re considering. Want to know the property taxes? You will need to look up the local tax rate and then multiply that number by the purchase price. Curious about the neighborhood vacancy rate? Get in touch with landlords, property managers, and real estate agents in your area to see if they have any recommendations.
A general guideline in the industry is that your non-mortgage expenses are usually half of your monthly rent. You must remember that there are always going to be unpredictable expenses when you own rentals, such as repairs, maintenance and vacancies. While natural disasters don’t happen every month, they can cost a lot of money when they do occur.
The potential for appreciation for rental properties is less predictable but just as valuable in the long term.
Over time, real estate usually becomes more valuable. Appreciation is when the value of an asset goes up over time. So if you own a rental property, the appreciation of that property can help you grow your net worth, even as the mortgage balance on the property shrinks each month.
You earn money on rental cash flow. You earn money on appreciation. This means that you pay less in taxes for both options than you would for other investment options.
6. Tax Advantages
There are tax benefits to rental properties that you can take advantage of even if you don’t itemize your deductions.
If you’re a real estate investor, you can deduct a whole host of expenses, like property management fees, mortgage interest, maintenance costs, some closing costs, insurance, and even travel expenses to and from the property. You can also deduct paper expenses like depreciation, which is really the big one.
This means that you can make money while still appearing to have lost money on your taxes. The tax shelter of depreciation begins to look attractive For example, if you make $2,000 from rental cash flow, but after deducting for depreciation, you show a loss on your tax return of $3,500, the tax treatment of depreciation begins to look attractive. If you earn a profit, that amount will be deducted from your taxable income, which will lower your tax bill.
This can effectively make your cash flow from any property tax-free.
If you sell the property, you can avoid paying taxes on your profits by doing a 1031 exchange. This allows you to keep investing in properties that will provide passive income without having to pay taxes on your capital gains.
7. Diversification Of Assets
Although stock returns are usually positive, they can suddenly drop during a stock market correction. The average investor then makes emotional decisions that result in them losing half of their stock returns.
Real Estate allows for it’s own, unique way of diversifying. For example, let’s say that you decide to invest in single family homes, specifically through Turnkey Rental Properties.
You can bring diversity into your rental property portfolio by buying in different neighborhoods, different classes of neighborhoods, homes with 2 bedrooms vs homes with 4 bedrooms, etc. One final great example of rental property diversity is through owning in different states and cities with different economic conditions.
8. Hard Asset
Rental property falls under the category of being a “hard asset”. This means that it is something physical and tangible that a person can see & hold.
Compare this with other assets such as Bitcoin, EFTs, or stocks, none of which are anything physical. Famously, some Bitcoin in 2022 has gone down to zero value.
Contrast that with rental property which almost always will retain some value because it is an actual “thing”.
9. Multiple Ways To Earn
Rental properties generate earnings in multiple ways for the investor. These include cash flow, appreciation, amortization (the tenant pays down mortgage) & tax advantages.
If, for example, your property doesn’t appreciate in any given year, more than likely your other profit centers will stay steady and you will generate income from those. It’s always good to win at financial freedom in multiple ways.
10. Outsource Debt
One unique advantage of rental properties is that you can essentially outsource the debt or mortgage to your tenant. As long as they pay the rent, they will in turn be paying the mortgage.
You get to reap the benefits of the rent income paying the mortgage down and accumulating equity in the house over the course of many years.
10 Disadvantages of Owning Rental Property:
1. Capital and Credit Required
Lenders who offer loans for rental properties typically require a down payment of at least 20% – 25% of the purchase price.
Borrowers who are looking to purchase a secondary home can expect to pay a higher interest rate than on a primary residence, by 0.5% to 0.75%. Investors are required to have a credit score of at least 620 out of 850 and have cash reserves to cover loan payments for up to six months.
There are several other factors involved, including your debt to income ratio, credit history, etc.
Screening tenants is the best way to avoid problem tenants, but even with the best screening process, landlords may still end up with a problem tenant. Renters who don’t pay their rent on time, damage the property, or do something illegal can break their lease.
Although collecting a security deposit from tenants can help to reduce financial risks for landlords, most states have laws limiting the size of deposits that landlords can require.
3. Landlord Responsibilities
Some investors decide to self-manage a rental property. Many people choose to hire a professional property manager to take care of the everyday details like communicating with tenants, collecting rent, coordinating repairs with vendors, and following landlord-tenant laws and fair housing laws.
The investor is responsible for the success or failure of the investment, no matter what option they choose. There are still decisions that need to be made regarding issues such as when it is appropriate to make a costly capital repair (like replacing a roof or the HVAC system), or when and how to evict a tenant.
Our recommendation is to outsource the day to day responsibility of managing properties to a property management company who has experience with these tasks.
4. Property Taxes
There are a few things an investor can do to control rental property expenses, but two of the more difficult ones to predict are annual property taxes and the cost of insurance.
For example, the amount of taxes paid on property varies widely from state to state. The taxes may increase significantly from year to year due to the local government’s operating budget. Some states have property taxes that are based on the value of the property, which may change depending on when the property is sold. This is something that some investors may not take into consideration when creating a profit and loss pro forma before purchasing the property.
5. Constant Maintenance
A rental property needs to be regularly maintained and repaired in order to keep it livable and stop the value of the property from going down. Although some investors use the 50% Rule to estimate the operating expenses of a rental property, maintenance costs will vary from month to month. It’s possible to have negative cash flow in a month where repair costs are unexpectedly high.
6. Neighborhood Changes
The value of a rental property can be affected by the neighborhood it is located in. The neighborhood can change over time, which would in turn affect the value of the property. As the CDC points out, when gentrification happens, low-value neighborhoods become high-value ones.
Unfortunately, the opposite can occur as well. There are a few signs that may indicate a decline in a neighborhood. These include an increase in property taxes, poor ratings for nearby public facilities, and an increase in “For Rent” signs.
7. Tax Code Changes
At present, the tax code is favorable to real estate investors, and has been for some time. But that doesn’t mean that tax laws won’t change. The Trump administration has proposed raising the top capital gains tax rate from 20% to 39.6% for people making more than $1 million a year.
8. Lack of Liquidity
Even though real estate markets are doing well currently, it can still take a month or more for a home to sell. If you need to sell your property quickly, you may end up selling it for less than it’s worth. The selling price of a property may be significantly lower than its fair market value if the property requires a lot of repairs.
This can be one of the most difficult challenges when you need fast cash. You can’t simply sell a rental property quickly and closings on a property generally take at least 30 days and often longer.
We recommend mitigating this with having adequate financial reserves available to you. Both 3-6 months of mortgage payments and roughly $5k per property for any make-ready expenses.
9. Real Estate Market Cycles
Home prices generally increase over time, but the real estate market goes through cycles that last about 18 years, even though it might not seem like that today. Since the late 1800s, real estate has gone through periods where there was too much supply, recession, recovery, and growth. If you’re thinking about buying a property solely as an investment, it’s important to remember that you may not see any ROI for several years. In fact, the value of your investment could drop in the short-term before eventually beginning to rebound.
10. Profit Isn’t Guaranteed
You will not make a guaranteed profit from owning a rental property. Though home prices can sometimes dip, operating expenses can often be higher than anticipated, and it can sometimes take a while to find a tenant who is willing to pay a reasonable rent.
Rental properties can offer high returns, low volatility (fluctuations), income that keeps up with inflation, tax breaks, and a way to become financially free.
In fact, most millionaires today became wealthy though real estate investing. You can read more about our preferred method of owning rental property in “What is Turnkey Real Estate“.