Should I Invest in Rental Properties?
Owning rental properties is one of the keys ways to drastically increase your wealth. Many people know that Real Estate investing has been part of many millionaire’s investment portfolios, but many times the average person is wondering why should I invest in rental properties? Hopefully, at some point, you have thought about investing in real estate or at least owning your own home. Find out if investing in a rental property, especially a single family home, is right for you.
Housing Market Keeps Growing
It is a common trend for Millennials in their 20s and mid-30s to stay in rentals. In the past 10 years, there has been an increase in renters as well in the baby boomer era. All of these factors show that the U.S. rental market is thriving.
The old American dream that most of our parents had of purchasing a home and raising the family there is no longer quite as applicable today. People move on average every 7 years or around 11 times in their life most of the time it’s because of a school or job change.
Because of the flexibility renting provides people tend to rent when they arrive at a new location until they have a better idea of how long they will stay in their current job and position. With job-hopping becoming so much more normal than it was years before, it doesn’t make sense to move to a new location and buy a home only to turn around and sell the home to move somewhere else.
Small Families Are Looking to Transition
There are plenty of social reasons to live in an apartment complex especially if you are single or living with roommates, but as you start a family you need more room to expand and more privacy.
I remember when I was recently married and we had our first child we lived in a smaller complex that only had 10 units. We were upstairs in #8, but we never felt like to were on our own still, we could hear the kids playing outside or the neighbors playing their music all day long that we felt as though we could never be at rest. As we started to have kids we moved into a smaller home (which had a rental in the basement) and as we continued to have more kids we moved to a larger home on a quiet street.
Families are looking for a transition and that smaller starter home is perfect for many who would consider buying or still renting until they make that next step forward. As they rent they can provide you with some income.
Steady Cash Flow
Passive income (cash flow) indicates recurring income that needs no effort to maintain. Though there is always some sort of maintenance and management with a rental property they are usually an excellent source of steady cash flow, though not entirely passive.
Owning a rental property only makes sense if it’s earning positive cash flow. If the mortgage expenses are more than you are receiving in rent than you are losing money on the deal, and banking entirely on appreciation and equity in the property. Negative cash flow should only be considered if you have the reserves to wait until the property appreciates in value quickly in a hot market.
Consider earning at least a 25% spread on rental expenses vs the rental payment. For example, if the mortgage and expenses are $750 a month, the rental income should be at least $1000 a month. This is to make sure you have a good buffer should something need to be addressed in the property.
Also to be considered is if you are looking to purchase another home (either primary residence or investment property) the lender will most likely reduce your rental income by 25% before offsetting the mortgage payment, if you already are above that then you will be more likely to be approved for another mortgage on a new property.
Property Value Appreciates – Loan Paydown
As the rental property owner generates cash flow, their investment property gradually gains more value. Conduct extensive research to find out the rates of appreciation at different potential neighborhoods and cities because the location of the rental property varies drastically with how much the property itself will appreciate.
This goes back to basic economics and if the supply is low and the demand is high than the price of the same house will be much higher than where there are a plentiful supply and low demand for living there.
An added benefit of owning a rental property is the low down payment needed to own and rent out the property. Typically 20-25% down-payment is all that is needed to sure a non-owner occupied (investment) mortgage. As you pay down that mortgage (with the rent payment) than the amount you owe becomes less and less and the equity you receive become more with each payment.
Real Life Example
If you are looking at a rental property worth $100,000 at a 5% interest rate and 20% down, your repayment will look like this.
Your initial payment (Principal, Interest, Home Owner’s Ins and Taxes) would be $629.46
The first payment would have $333.33 applied as interest and $92.12, applied as principal, but every payment afterward would reduce the amount applied to interest and increase the amount applied to principal.
Now without 25% rule, you would want to rent it out for at least $787. That difference of $157 dollars could then be applied back into principal to pay off the loan faster, saved up for potential repairs and upgrades, or received as additional income.
You should always have a reserve of funds for unexpected events. You can never predict when an appliance will decide to stop working or when insects start to invade or the tenant has to unexpectedly move out. But you can prepare to set aside funds to handle those situations, typically six months worth of rental income is a decent buffer to cover you to make a repair or find a new tenant
Self vs Property Management
The debate of self-management vs property-management has always seemed to come up when it comes to rental homes. I say each has its place and can be utilized when appropriate.
Self-Management can be considered when you are local to the property, want to market in various ways and you are handy are minor maintenance. People tend to self-manage to avoid paying a property manager when they feel they can provide a similar service. They will show the rental unit, and receive calls and complaints about repairs needed and typically try to resolve the problem them self first before contacting a professional.
We did this when we rented our basement and again when we had moved out, but still lived locally. Luckily with some of our tenants, they were quite handy themselves and were only contacting us to receive reimbursement for supplies as they fixed the problems themselves. But I would say those are rare cases.
Property Managers can be an excellent choice if you are not living near the rental property, as the management company is there to market the property, receive rent payments and make sure that the property is kept to high standards. Good ones will only charge a flat % of the rent, typically 10%, while others will also charge a coordination fee (finder’s fee for the first tenant) or a reserve they can draw upon when repairs are needed.
Should tenants become bad tenants and stop making payments or taking care of the property the question is would you personally be the one who wants to address and resolve the issue or would you like a management company do it for you? Especially in the worst case scenarios and you are trying to evict them out of the house, arguments get heated and sometimes it’s best to leave it to the professionals for that added piece of mind.
Flexibility with Selling or Refinancing
Owning rental property provides you with flexibility in selling or refinancing. As you continue to rent out the home you can ride the appreciation up until the market no longer feels it climb as much. At this time you can either sell and find a new rental property, taking the equity you have received while owning the property, or you can look to refinance and pull out equity and apply it to another property.
One of the ways you could sell without dealing with added expenses in property management and Realtor commissions is by selling the home to your tenant or a new tenant with a Lease Option contract.
During the time of rental, a rental agreement is in place as well as an option to purchase the home after a certain period. The tenant then becomes responsible for all maintenance required on the home removing the need for a property management company. At the end of the term if the tenant is ready to qualify for the purchase of the home you will apply a portion of their rent payments as additional down payment and move onto the purchase agreement of the home.
This typically allows you to demand a higher rent (so that additional portion can be considered toward future down payment as well as receive an initial down payment to hold the purchase agreement in place.
However, to receive money from your home you don’t need to sell it. If you have equity greater than 25% typically you can refinance or request a Home Equity Line of Credit (HELOC) to tap into the equity that is available to you, this can help provide access to money for repairs, upgrades or even as a down payment for your next rental property.
Keep in mind that becoming over-leveraged can become extremely dangerous should the market turn and your equity position decreases. Make sure you have enough reserves and are willing to sell your properties if necessary.
Taxes – Minimizing Them
Taxes should always be considered and consulted with a tax professional, that said there are always various tax advantages. Keep in mind that owning a rental property provides expenses that are tax-deductible (mortgage, taxes, insurance, repairs), or can be applied as business expenses.
When selling the home keep in mind that if the home was your primary home for at least 2 years in the last 5 years you may be able to sell the home without any tax liability. If you haven’t lived in the home the past 5 years than you would be eligible for a 1031 exchange which would let you roll your real estate investment from one investment into the next, kicking the tax liability down the road similar to an IRA.
Another benefit that retirees like is that rental income will not be counted against social security benefits. Also, net rental income is not taxed the same as ordinary income and keep in mind that even if your cash flow is minimal every rental payment continues to pay down the mortgage.
Rental Properties can be a lot of work but also a great source of income and wealth. Should you invest in rental properties still, the answer is yes. As with every investment keep in mind your vision for the investment. How long do you see yourself holding it? Who will manage it? When do you plan to sell it? What are the plans for the income it will provide?
Finding partners who currently own rental properties is a great way to start. If you’re ready to own a home on your own, you may want to look into Roofstock which is a market for owners and sellers of rental properties. Or if you’re not quite ready for a full home purchase you could consider investing in a Real Estate Investment vehicles such as Fundrise or Groundfloor.
What are your lessons from owning rentals? Are you looking at expanding your investment portfolio?