A few weeks ago I was in Washington, D.C., attending a seminar. One day I enjoyed lunch with a longtime real estate investor from Florida, a prospective realty investor from Philadelphia, and another prospective real estate tycoon from New York City. Because two of us were realty investors, the discussion soon turned to the pros and cons of investing in rental houses.
We all noted houses are currently the best long-term real estate investments. Most homeowners will agree their best financial investment has been their personal residence.
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But then the topic eroded into the negative but very realistic topic of how to earn enough rental income to pay rental-house carrying costs while, hopefully, the house appreciates in market value.
ADVANTAGES OF INVESTING IN RENTAL HOUSES. The primary advantage of owning sound, well-located rental houses is they usually appreciate in market value just as fast as nearby owner-occupied houses. According to the National Association of Realtors, average annual appreciation of houses is just over 5 percent annually. But, frankly, that doesn’t sound very exciting.
However, most rental-house investors don’t pay all cash. They use leverage to control a property but invest as little of their own cash as possible. Leverage increases return per dollar invested.
For example, suppose you buy a $100,000 rental house for cash and it appreciates a typical 5 percent in market value during the next 12 months. That’s not a great investment to just earn 5 percent annually on your $100,000 cash, is it?
However, instead suppose you bought the same $100,000 rental house for $10,000 cash down payment, obtained $90,000 financing, and it appreciates 5 percent in market value during the next 12 months. Now, thanks to the magic of leverage, you earn a 50 percent return on your invested dollars (presuming the rent income pays the expenses).
Are you excited yet? You should be.
An additional rental-house advantage is the depreciation tax deduction to shelter the rental income from taxation. Depreciation is a non-cash “paper loss” tax deduction for estimated wear, tear and obsolescence.
Still another advantage is you can deduct up to $25,000 of your real estate “passive loss” deductions from your other taxable ordinary income, such as job salary, interest, and dividends if your annual adjusted gross income (AGI) is $100,000 or less. If your AGI exceeds $100,000, the deductibility of investment property tax losses gradually phases out to zero when you reach $150,000 AGI.
But unused rental-property tax losses can be saved or “suspended” for future tax use. However, if you are a qualified real estate professional, such as a real estate broker, there is no limit to the rental-property tax loss you can deduct against other ordinary income.
DISADVANTAGES OF RENTAL-HOUSE INVESTMENTS. While your sound, well-located, rental-house investment is hopefully appreciating in market value, there might be some potential problems to anticipate.
The biggest rental-house problem I’ve encountered is not being able to obtain enough rent to pay the mortgage, property taxes, insurance, repairs, and other expenses.
Local markets for rental houses vary widely. The national standard for rent used to be a rental house should command at least 1 percent of its market value in monthly rent.
For example, using our rental house purchased for $100,000, it should rent for at least $1,000 per month. Inexpensive rental houses often meet this 1 percent rent standard. However, investors in more expensive rental houses usually are unable to obtain rent that meets this 1 percent per month profitability test.
The result can be negative cash flow. That means the rental income is less than the expenses for the house.
However, many rental-house investors can handle a mild case of negative cash flow. They reason the house is appreciating in market value at a faster rate than the negative cash flow. If the investor can afford to pay the negative cash flow, perhaps $100 to $500 per month, rapidly appreciating rental houses can be a great investment.
If you can’t afford the negative cash flow each month, investing in rental houses might not be a smart investment for you. Instead, you might wish to purchase bargain-priced fixer-upper houses for quick resale. That’s called “flipping” instead of “keeping” for long-term rental-house investment.
THE PRIMARY RENTAL-HOUSE DISADVANTAGE. But the primary disadvantage of rental-house investing is known as “tenants and toilets.” In other words, property management can be the biggest drawback of owning rental houses.
Over my 35 years of investing in rental houses, apartment buildings, and other types of properties, I’ve had my share of mostly wonderful tenants who enabled me to earn substantial profits, plus a few “bad apple” rotten tenants.
Which ones do I remember most? Which tenants do I discuss with my fellow investment property owners? The “bad apples,” of course. We never talk about our boring, uninteresting, great tenants.
Some rental-house investors think they will solve the “tenants and toilets” management problem by hiring a professional property manager. But the big drawback is most so-called professional managers charge at least 10 percent of the gross rent. The result is little or zero cash flow.
Long-distance property management is even worse. To illustrate, I recently talked with the president of our local property investor’s club. He and his wife own several rental houses about 1,000 miles away.
We commiserated about his “lousy” property manager who can’t keep his rental houses rented. I hated to remind him that nobody has as great an interest in properly managing his property as the owner. That’s why I don’t recommend long distance rental-house investments.
WHY INVEST IN RENTAL HOUSES RATHER THAN APARTMENTS? At this point, you’re probably thinking apartment buildings might be better investments than single-family rental houses.
But there is a huge drawback to apartment building and other commercial property investments. They usually don’t appreciate in market value as rapidly as single-family house investments.
The reason is apartments and commercial building investments are valued by their “cap rate.” That means net operating income divided by the property value.
For example, suppose a small apartment building or commercial property produces $10,000 annual net operating income (excluding mortgage payments) and its seller is asking $100,000 for the property. That is a 10 percent “cap rate.” Grab it! That’s a bargain.
Instead, suppose the seller of the same property is asking $150,000. Now the “cap rate” return on cash sales price drops to a 7 percent capitalization rate.
The rule is the higher the cap rate, the lower the property value. Your goal when buying apartment or commercial property should be to buy at as high a cap rate as possible.
By contrast, single-family rental houses have nothing to do with a “cap rate.” Regardless of rental income, sound, well-located rental houses frequently appreciate in market value at the same rate as nearby owner-occupied houses. For this reason, rental houses are usually a much better investment than are apartment buildings and commercial properties.
AN EXTRA TAX BENEFIT OF OWNING A RENTAL HOUSE. For many investors, a rental-house investment is the first step to pyramiding their way to a real estate fortune.
Thanks to the tax-deferred exchange benefits of Internal Revenue Code 1031, it is possible, after the rental house has appreciated in market value, to make a tax-deferred trade up for another investment or business property.
However, your personal residence is not eligible for an IRC 1031 tax-deferred exchange. For full details on tax-deferred exchange benefits, especially “Starker delayed exchanges,” please consult your tax adviser.
SUMMARY. Rental-house investments can be more profitable than your principal residence because the rent from your tenants will pay all or most of the expenses while the rental house, probably, appreciates in market value. But there are potential drawbacks such as managing the tenants and understanding that long-term profits come from appreciation in market value, not from the rental income.
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