A co-worker told me she bought a house as a rental property in Las Vegas (we are nowhere near Las Vegas). She said a few other co-workers thought it was a great idea and bought there too.
Clark Howard, a consumer advocate and personal finance guru on radio, also says now it’s a great time to buy a home, either to live in or as a rental property.
So far all my investments are in stocks and bonds. I’m not sure if the home I live in counts as an investment in real estate. Suppose it doesn’t, should I diversify my investments with a rental property?
Diversification
On one hand, more diversification is good. A rental property receives a stream of rent payments. Allowed depreciation makes the rent income more tax efficient. If the value of the property appreciates when I sell, that’s another source of income. All these probably have low correlation with stocks and bonds. It seems my investments would be more diversified if I add rental real estate.
On the other hand, I will have just one property, in one specific neighborhood, in one specific part of the country. It would be very much like buying a single stock — be it Apple, Exxon Mobil, or Wal-Mart. It smacks of speculation to me. After being bitten by speculation some years ago, I swore I would never do that again. It seems adding a rental property would actually make my investments less diversified.
I’m not sure if it’s actually more diversification or less diversification if I add a rental property to the mix.
Liquidity
A rental property is clearly not as liquid as stocks and bonds. If I want to be out of some mutual funds or ETFs, all it takes is a few mouse clicks. I would get the true value less a negligible amount. If I ever want to be out of a rental property, it would take so much longer and cost so much more.
That’s also a reason an illiquid investment such as a rental property can give a good return because it has to sell at a lower price multiple in order to attract buyers.
I’m tolerant of illiquidity to a certain extent. I invest in I Bonds, muni bonds and CDs instead of Treasuries when I trade illiquidity for a higher return. But we are talking about a magnitude of difference here. Compared to a rental property, I Bonds, muni bonds and CDs are super liquid.
Carrying Costs
Besides the initial investment, say I buy a rental property outright, I will still have carrying costs such as property tax, insurance, and maintenance, whether the rent is able to cover them or not. With stocks and bonds, the worst case would be that they don’t pay me anything; I will never be cash flow negative. Not so with rental real estate.
Property Management
How do I find tenants, collect rent and manage the property when I’m far away from Las Vegas? My co-worker said don’t worry, a property manager will take care of all those for you. I just sit back, relax, and collect rents (after paying a cut to the property manager).
I somehow doubt it would be that easy. I imagine many decisions will still have to come to me. Investments in stocks and bonds don’t require much involvement at all. Dividends and interest come automatically without me lifting a finger. If I’m away for a month, nothing would happen. I like that.
I think adding a rental property would add stress to my life. With a busy work schedule, I don’t need any more stress. It could be very profitable though. I know people who retired in their early 40s because they made a lot of money from rental properties. From listening to Clark Howard, I got the impression that investing in rental property is quite widespread. I tried to look for census data for what percent of the population owns a rental property. I haven’t found any. Does anyone know?
Maybe it’s a great opportunity. I will leave it to others.
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Helixso says
I would think that investing in a residential REIT would be an attractive alternative, much like investing in a mutual fund is an alternative to investing in a single stock. You get exposure to the asset class without the possibility of losing your entire investment due to problems with a single property. The upside is likely smaller, but so is the downside.
Dan says
Warren Buffet commented on what a great opportunity it is now to buy rental property. Property values are really low, interest rates are really low, and rents are rising because the demand for rental property has increased. That being said, rental properties can add stress to your life. If you don’t manage it yourself, you may pay 10% to a property management company. They can make filing your taxes more difficult. We own two and they give me headaches at times. Part of me wants to sell them and be done with them. Another side thinks it would be best to just hold on to them since the market for selling them is not favorable to the owner right now. More people are becoming landlords as a result of moving recently and being unable to sell their previous home. We are in that category and several of our friends and new neighbors are also.
Ken says
To me a rental property is like starting your own business and not the same as investing in stocks and bonds.
Financial Advice for Young Professionals says
You bring up some good points. In the ideal situation, you buy a rental property, you’re able to get around 10% or more cash on cash return, you have ideal tenants(think old couple) that keep the place spotless, never bother you, etc. But you can also have the opposite and that’s where it can become stressful.
Right now is without question a great time to buy, with low housing prices, low interest rates and high rents. But it does take some research/effort, as the commenter above mentioned, I think it definitely is akin to starting your own business.
nickel says
One of the “advantages” of individual properties over REITs is that you can easily use leverage to amplify your gains (or your losses, of course). You don’t pay 100% for one property. Instead, you put down 20% on five properties and mortgage the rest. I guess you could achieve something similar if you bought REITs on margin, though I certainly wouldn’t do that myself…
Wai Yip Tung says
I have a stronger opinion on property as personal investment. Don’t do this. It is a all or nothing investment. There is no liquidity. You can’t sell 10% of a house when you need money. The recent real estate downturn is a good lesson to learn.
I have some exposure to REIT. It is fine if I do not leverage my REIT investment. I do not leverage my stock investment either. I like to hear how does it compares to actually invest in a house.
joe says
I inherited a house from my grandmother 15 years ago. Since there were tenants in the house already, I just kept renewing the lease. The house today is worth about 250k and I rent the house for 2k/ month. The tenants fix anything less than $500/ month.
These tenants are great and this has been very easy, but it never involved me putting any money for the investment. I think if these tenants ever leave I’ll sell the house for whatever I can get.
babar says
REIT would be low-headache way of getting exposure to real estate. 4% of my investable assets in REITs. I wish to increase it to 8-10%.
Purchasing rental properties now looks like opportunity of lifetime (low interest rates, buyers’ market, improving employment scene). But unlike purchasing stocks (buy and forget), rental property is a constant hassle (find tenants, deal with tenants, fix things).
I weighed what would give me higher returns for my time investment (work longer hours, get that promotion, new job/ role etc) vs. work with realtors, property managers, tenants and wait for a decade to realize fruits of labor. I chose the former.
Janith Randeniya - Let's Learn Finance says
As crucial as diversification is in any investment portfolio – the jump from stocks/bonds to real estate can’t be considered as a simple “alternative”. It’s a whole different ball game with different risks associated with it. Instead, buy a house – rent it – then invest in stocks/bonds! Since we are all have abundant reserves of extra cash.
Heidi says
TFB, thank you for the article on rental property!
I have some strong views on this topic as well, but they are mainly opposite those posted above. I believe that a reasonably priced, well-researched, well-managed investment property is an excellent investment. It can yield a return three ways: through good cash flow, through tenants buying the asset for you (by paying down your mortgage) and through market appreciation. Most importantly, the rental property investment is under your control, which is more than I can say about investments in stocks and bonds.
I’ve read a variety of books on the topic, and years ago, I developed a rental property model, consisting of a series of spreadsheets, to estimate profitability, cash flow, return on investment, etc. for rental property. There’s a summary tab that indicates whether the benchmarks meet my high expectations for an investment property. Not many properties meet the model, and unless they do, I don’t waste my time (or that of the realtor or tenants) by going to see it.
Of the 4 investment properties I currently own, 3 of them were purchased 11 years ago, which was the last time my rental property model indicated that there were “deals” to be had. I just purchased the fourth property in January 2012, which is when my model indicated real estate prices and interest rates had come down far enough to meet my stringent requirements again.
I manage the 2012 investment myself. The other 3 are in another state, but have been managed for several years by a trusted relative, who needed the management fee to supplement early retirement, and who has become an excellent property manager.
For those interested in rental property as an investment, I will share some valuable lessons I have learned though experience. They are (in no particular order):
1. Invest where you know the neighborhood. In other words, don’t buy a house in Las Vegas unless you live in Las Vegas!
2. Prepare a stringent model through which you will run all potential rental properties. If the property, no matter how much you may like it, does not meet the criteria in your model, do not even entertain the thought of purchasing it.
3. Be a tough negotiator on price, shop around for the best mortgage terms, and never compromise on location. Never be in a hurry to buy a property.
4. Interview your own tenants and perform credit/background checks. Even if you hire a property manager, have them narrow it down to the top 2 or 3 tenants based on ability to pay the rent, then interview them yourself. In the past 11 years that I’ve been invested in rental property, I have only lost one month’s rent to a tenant that did not pay. By the way, that tenant came with the house when I bought it. I chalk that record up to a thorough screening process.
5. If you aren’t handy or don’t have a handy spouse, do not invest in rental property unless you are sure you can get quick access to a reasonably priced handyman. Even if you or your spouse is handy, it always helps to have the numbers of one or two people on speed dial in case something unexpected arises while you are on vacation.
6. Make sure you increase your emergency fund, so you will not be strapped for cash in case an unexpected expense develops, or in case someone moves out and you decide to make some improvements before you market the apartment to new tenants.
7. Analyze rents compared to the competition in your local market at least annually, so you are not leaving money on the table.
8. The best tenants are not your friends, they are your customers. It is your job to keep your customers happy by keeping the house well maintained, in exchange for a fair rent and an adequate security deposit.
9. The best rental properties are not in high end neighborhoods. Rather, prices are better and tenant retention is higher in blue collar neighborhoods.