WHY INVEST IN RENTAL PROPERTIES

Many think that investing in rental properties is more difficult and risky than it actually is and you need to be a real estate expert to do so. I’m here to let you know that’s not true. Although you should not go in overconfident and under informed the fact is anyone can do it as long as you have the right mindset, realistic expectations, a willingness to learn and don’t mind putting in the work. Since there’s a ton of information I can provide on this topic I’m going to break it up into a series of posts. This post will focus on why you should consider investing in rental properties while future posts will address the details around how to do so as well as some of the downsides and risks.

CASH FLOW

One of the most obvious benefits and most popular reasons people acquire rental properties is the additional cash flow it provides. To keep it simple, Cash Flow is the difference between the rent you’re collecting and your expenses for the property. Expenses can include regular maintenance, insurance, repairs, loan interest, HOA, commissions and utilities. This additional cash flow can be used to pay living expenses, supplement retirement or invest in additional properties. Although it’s critical to accurately calculate your expenses (many new investors underestimate their expenses) when determining cash flow we will see that even if you don’t have great cash flow there are other benefits to owning rental properties.

PRINCIPLE PAY DOWN

One factor that leads to less than desirable monthly cash flow is having a loan on the property. Most of us aren’t walking around with hundreds of thousands of dollars to drop on a rental property, therefore we need to take out a loan to acquire it. That will eat into your monthly cash flow but don’t worry, that doesn’t mean it’s a bad investment. In fact, I would argue that using debt to acquire investment properties is better than buying with all cash in most cases and results in a much higher ROI. Please see my post titled “The Power of Leverage”. So although your monthly cash flow might be reduced, your tenant will be paying down your mortgage.

For a quick example. If you purchase a property for $300k, using a mortgage with today’s average rate of 3.6% and putting down 5% your tenant will be paying down $440 of the principle each month. That’s basically money in your pocket, you just can’t access that pocket until you sell the house. But wait, it gets better. Due to the way loans are amortized, the amount of principle paid down increases over the life of the loan. In this example by the end of year 10 the tenant will be paying $630 of the principle per month. I don’t know about you but I think that’s pretty awesome!

APPRECIATION

Although price appreciation cannot be guaranteed (especially in the short-term) over the long term if you make wise investment decisions you can pretty much count on at least some appreciation. Depending on your goals and investment approach this might be a minor or major factor. For example if you believe a certain area is ripe for new development and going to take off you might put more weight on price appreciation than cash flow. However if your main focus is supplemental income, you might look for properties that provide stable cash flow but might not appreciate much. That being said outside of a catastrophic event if you have a long enough outlook you are almost guaranteed to experience some level of appreciation. Consider the housing crash of 2008. That was the worst market most of us have ever seen and now in 2020 many areas have seen prices double since the peek of 2008. The beauty of owning a rental property is even if there is a short-term dip in prices, collecting rent allows you to ride the wave to recovery.

TAX ADVANTAGES

Without getting into all of the various tax advantages of owning rental properties I’d like to touch on the one that I consider the most significant. That’s depreciation expense. Using the example above, when you purchase a $300k investment property you are allowed to deduct that amount over the course of 27.5 years. That’s what the IRS considers the life expectancy of the house. This results in an expense of $10,910 that can be used to offset your income. EVERY YEAR!! If you earned $10,910 in rental income (after expenses) for that year, guess what. According to the IRS you made $0 since your income ($10,910) - depreciation expense ($10,910) = $0. In a nutshell you will pay no taxes on your rental income. But what if your renal income was less than your overall expenses (including depreciation)? Well you can offset the additional expenses against your personal income. For example, if you made $5,000 of rental income then the remaining $5,910 can be deducted from your personal income resulting in a lower effective tax rate. There are restrictions for the amount of depreciation expense you can deduct so please consult a tax professional.

RECESSION RESISTANT

Although I’m not going to say rental properties are fully recession proof they come very close. If you look at average rent in the US over the past 50 years you will see a steady upward trajectory. Even during the housing crash in 2008 average rental rates continued to increase. That doesn’t mean during a recession you can’t run into problems because your tenants might not be able to pay the rent due to job loss. That can certainly occur. Then again that can occur in great economies. However, overall, even when the economy is terrible and the housing market takes a hit, rents remain stable. One reason for that is during periods with weak economies and/or bad housing markets people still need a place to live and are even more likely to rent than buy a new house.

SCALE UP

The last reason I’ll discuss in this post for acquiring rental properties is that is allows you to, what I call “Scale Up”. To put it simply, acquiring one rental property will help you acquire a second. Acquiring your second makes it even easier to acquire your third and so on. There are a couple of different ways to do this, I’ll explain how I did it in a separate post. The first thing you should know is when acquiring a new rental property, lenders will count a portion of the future rent from the new/subject property as income if you have at least 2 years experience owning/managing a rental property. This is extremely powerful!!

Let’s look at an example to illustrate this concept. When you purchase your first rental property you will need to quality for the loan based on your current income. So if you already have a house with a mortgage this could be difficult. Your income would need to cover both loans (based on the lenders requirements). Let’s assume you purchased the house in the example above 2 years ago and have been renting it out since. Now you would like to purchase a second rental with an estimated market rental rate of $1,000/month. The lender will add a portion (typically 60%) to your income even though you haven’t purchased the property yet. This makes is much easier to continue to build your portfolio of rental properties and “Scale Up”.

FINAL THOUGHTS

There are many benefits to purchasing rental properties but I think these are the most important and illustrate why everyone should at least consider it. Being in the rental property business is definitely not for everyone and to be successful you need to take it serious and treat it as a business. If you have the right mindset, take the right approach and have a trusted Realtor who knows your market and can guide you through the process I believe this is one of the best ways to build wealth.