The possibility of investing in rental real estate has been a hot topic with clients of late. Entering the world of being a landlord is a not a decision to make lightly, with many factors to consider and ins and outs of the business to understand.
Calculating income or loss on rental real estate for tax purposes differs in some important ways from the cash flow realized; and both calculations are important to know. When looking at income potential for a property, the cash in or out of your pocket has the most immediate impact. Will the expected rental income cover your expenses such as property taxes, insurance, maintenance, a mortgage if you have one, and still set aside funds for the inevitable future large repairs or improvements? How many months of rental income are required to cover those expenses, and how likely is it that you will have a paying tenant for those necessary months? Operative word there is “paying;” eviction is brutal and expensive. No one wants an investment that drains money, but it happens. Do you have the funds to cover months on end without income?
As with any investment, positive return is the goal. Potential return on rental real estate comes from two components, much like a stock investment: income it produces plus the growth in value of the building itself. So even if your income is only covering your expenses, you may see a return on your investment via appreciation in the building, and growth of your equity as you pay down the mortgage, if you have one.
A rough way to evaluate the return would be to take the amount you would be laying out to purchase the property- your down payment, or the whole nut if you are not financing – and compare the return on that to what you might gain on that money if it were invested elsewhere. Let’s say you purchase a building for $100,000, putting $30,000 down and financing the rest. Further, let’s assume you take out a 20-year mortgage for 5 percent (and a monthly payment of $500). At the end of year one, if the property value has not changed, you have gained about $2,000 in equity through paying your mortgage. Even if you break even on the income vs expenses, that’s a 6.5 percent return on your original investment of $30,000. Not bad, but there are some caveats.
First, selling the property to get your hands on that $2,000 in equity will cost you- in the time and effort of finding a buyer, and especially the costs associated with the sale. Clearly you would not want to sell until the gain in equity outweighed the selling costs. And in years of high repair costs, your return can easily turn negative. But owning rental property is a long term proposition, so let’s look at 20 years out. At this point the mortgage is paid off and all of the equity is yours. At a modest 2 percent growth rate, the property is worth $150,000.
Even if your income and expenses continued to net to zero each year and it cost $15,000 to sell, your original $30,000 investment is now worth $135,000 in your pocket, or $105,000 more than when you started. That’s again about a 6.5% annualized return over those 20 years.
If you keep the property beyond this point, the $500 a month you were paying on the mortgage is now potentially cash in your pocket. That $6,000 a year represents a hefty 20 percent return on the original $30,000 you put down, plus any growth in property value. The potential for that kind of return is what draws investors to rental properties. It’s important to remember that those returns are what you get when all is going according to plan- and life doesn’t often go according to plan. You can be sure there will be things like broken pipes, bad tenants or periods of no tenants, carpets to replace, and upgrades to make, and those will all eat into your return, not to mention the personal effort on your part it will take to manage the property.
Another risk to consider is that the property might in fact lose value, rather than grow. I’m sure we’re all aware now that property values can go down significantly. If you are realizing a positive cash flow on a property that may not be a concern until and unless you want to sell; again like a stock investment, it’s a paper loss until you cash out. But if you’re sitting at a break even or negative cash flow, banking on appreciation to make your money is not a guarantee.Another reason given for wanting to invest in real estate is that it is tangible; something you can touch and have more control over than an investment in the stock market. Rental property is perceived as more stable than stock investing, and with a greater potential return than putting money in the bank. However one advantage that is lost by purchasing real estate is the ability to access your money. Certainly it is easier to get cash out of the bank if needed, or even to sell a mutual fund (although possibly needing to sell in a down market is a risk in itself). That is why before tying up money in real estate you must first cover liquidity needs for emergencies, job loss, or other potential expenses, even positive ones like vacations or weddings.
Those considering real estate investing often look forward to saving money on their taxes by claiming a rental loss. However those losses don’t always help the way you might expect. I’ll cover those details in a future column.
Real estate investing can be a profitable endeavor. I know many folks who have made a nice living that way. But I’ve known just as many who have incurred great losses. You can’t always control which way it will go, but you can make sure you know what you are getting into and be as prepared as possible before taking the leap.