After accumulating significant assets in the typical financial accounts (401(k), IRA, brokerage, etc.), it is common to think “what’s next” on the journey of building and protecting wealth. As part of this process, many of our clients have considered owning a rental property as an investment to complement their overall financial picture.
Our clients are not alone. Approximately 70% of rental properties are owned by individual investors, according to Census estimates.
Discussion around investing in rental properties tends to increase during times of stock and bond market volatility. During these volatile times, investors feel anxious about the public markets and look for alternative ways to diversify their wealth.
There are strong opinions both in favor and against owning rental investment properties. The purpose of this article is to provide a balanced and objective view of the pros and cons.
We believe that this decision is unique to every individual, and that it should be discussed alongside your financial, tax, and legal advisors.
For high-net-worth individuals looking for a steady stream of income (especially in retirement), rental properties can be an attractive consideration. Monthly rents are collected and often delivered electronically, just like a paycheck.
The champions of real estate investing will often point to the diversification benefits. The core of the argument is that real estate “behaves” differently compared to other investments. Stock prices fluctuate for seven hours a day, 5 days a week, while real estate prices are updated much less frequently (typically when a transaction or comparable sale occurs).
This creates the appearance of a “smoother” ride for real estate investors but is mostly just a behavioral benefit. Regardless, for some investors it feels better not actively seeing the price swings of their real estate holdings and makes them more inclined to hold the investment through tough times.
Credit: St. Louis Fed FRED Economic Data
Aside from the rental income being generated, most properties also experience price appreciation over time. Case-Schiller measures various data points related to housing and estimates the average annual growth rate of a home in the U.S. to be just under 5%.
These growth rates will vary significantly based on factors such as location, the condition of the property, and other housing trends.
In addition to the benefits listed above, rental real estate also has several tax perks available. The most widely known tax benefits include:
These benefits are unique to each taxpayer and should be researched by a qualified tax professional but can significantly enhance after-tax returns for a rental property investment.
The term “passive income” is often used by internet gurus to describe rental property investments, but this is often far from the case. Rental properties need to be carefully managed to preserve the benefits listed above.
These management responsibilities include vetting and finding new tenants, interacting with the tenant, and ongoing property repairs and maintenance. If outsourced to a property manager the fees can be significant (usually between 5-10% of the rent collected).
Rental markets (both property values and rental income) can vary based on economic and other market factors. In stock investing, portfolios are diversified and hold many positions to avoid single company risk, while with rental investing these risks can be magnified based on the unique characteristics of the property and location.
Owning a rental property in an area with deteriorating economic conditions or unemployment can quickly devalue the investment and rental attractiveness.
The rental income payments provide monthly cash flow but the equity in the property is less accessible and can usually only be accessed if a loan is taken out or if the property is sold.
It’s important to consider your short and long-term liquidity needs as part of the decision-making process to invest in a rental property.
Investing in rental properties can be a viable way to build wealth, but it requires careful consideration of the pros and cons.
Discuss your specific situation with financial, legal, and tax professionals to determine if rental property ownership aligns with your goals and risk tolerance.
With proper planning and execution, rental real estate can be an effective component of your investment portfolio.