In this article, I discuss some pluses and minuses of buying and owning a rental house. Most of these observations come from my own experience being a landlord over the last 10 years. There are some additional observations in To Sell or Rent the Parent’s House.
Disclaimer
I am not a financial professional. Please consult one before taking any action on the ideas presented below.
Potential Income & Growth With Low Volatility
The appeal of owning rental property is readily apparent. Rental property can provide positive cash flow. Over time, you may be able to raise the rent for more income and the value of the property will likely increase. Also, real estate values are typically less volatile than other investments like stocks or bonds. All this can make it easier to sleep at night while the cash just rolls in.
Acquiring Rental Property
My friend Joe has talked to me a few times about investing in rental property. He is considering buying a house and renting it out. For now, let’s assume Joe is paying all cash and won’t be needing any loan approval for the house. Purchasing such a property happens in the same manner as buying a home to live in.
Once Joe owns the property, he could fix it up a bit to appeal to potential renters. He could then advertise it at a competitive rate and evaluate potential applicants to find a renter or he could hire a property manager to take care of that as well as fielding issues with the property.
Let The Money Roll In
Let’s take my son’s recent home purchase as an example of what the finances could look like. I will use rounded figures for simplicity. The house was purchased for $190k. He did about $5k in refurb for a total cost of $195k.
The market where he lives would support him renting it out for $2000 per month or $24,000 per year. Prior to expenses, that would provide a Return On Equity (ROE) of the rent/total investment or 24,000/195,000 = 12.3%, pretty awesome. Moreover, he can expect rental rates and the property value to raise a couple of percent per year. Nice.
Costs To Be Expected
Let’s assume Joe buys such a property. He will be responsible for maintaining, insuring, and paying related taxes, all of which will eat away at that $2k/month he gets in rent.
Joe can avoid the cost of paying a property manager by choosing to manage it himself, provided he doesn’t live too far away to be able to respond in a timely manner. Still, he’ll need to have the landscaping kept up so the property doesn’t lose value from neglect.
Likewise, appliances and fixtures periodically break or need replacement. Or worse, the house needs a new roof. He needs to think of all the typical expenses of homeownership and subtract them from his rent to arrive at a realistic income.
Also, he can’t count on having the place always rented. Renters are often transient. Every transition in occupants costs in refurb, advertising, and lost income.
It’s All About Cashflow…
For Joe, the focus has been on cash flow. Even with the cost of ownership, management, and tenant turnover, he can get a pretty good supplemental income so he can enjoy a bit more of the good life.
Joe’s monthly costs would $375 in property tax, $150 for a property manager, $325 in insurance, gardening, and repairs allocation for a total of $850. His monthly cash flow after expenses is then $2000 – $850 = $1150 or $13.8k/yr.
…And Return On Equity
Given the $195k investment from above, the ROE including expenses is now $13.8k/$195k = 7.1%, still not bad. Again, Joe can expect the property value to raise a couple of percent per year.
What Could Joe Make In The Market?
Different analyses of the stock market lead to different answers about what kind of return Joe could expect. As such, I suggest comparing what you believe versus the total return on renting his house, that would be 7.1% based on rent + 1.9% gain in value for a total of 9%
Therefore, if you think the stock market will return more than 9% annually, the stock market would be a better place for Joe to invest.
Liquidity
Another key consideration is access to funds. It could take months for Joe to get his money out of his house if he had to sell it for other needs. He could access his funds in days if he held it in stocks.
Being A Landlord Is Not Fun
Even if he hires a property manager, the management decisions are ultimately his. Should broken items be repaired or replaced? Which flooring, carpet, paint, blinds, and appliances to use? How much rent will the market bear?
Rent control may be in a place where he buys. If the occupant chooses to stop paying rent, it can take months to go through the eviction process (depending on location), if it is even possible. During that time, he will still have to pay all the of the expenses while receiving no income. He may even need to pay a lawyer to assist with the eviction.
Going In With Eyes Wide Open
All in all, investing in real estate is a time-proven way to grow wealth. It can be a great way to diversify investments and get income with less volatility than stocks. I feel it is important that Joe have realistic expectations of what it means to own rental property in terms of responsibilities, returns, and liquidity so that he can balance his allocations versus other investment options.
Are you ready to be a landlord?
