Why rental properties make good investments
If you talk to anyone who is currently investing their money, you won’t be surprised to hear that rental property is one common avenue by which people invest. Real estate investing can be pursued in many different ways and what method works best for one individual may not be the best option for another. The flexibility in real estate investing is what makes it powerful and adaptable for anyone. In this post I’m going to discuss why rental properties can be the best investments one can have in their portfolio.
You have control over it (for the most part)
The world economy is large and it can be easy to get lost in all the details regarding unemployment, government spending, corporation mergers, interest rates, debt and so on. These are things an individual cannot control. In regard to personal finance however, luckily there are many things one can control. Specifically, there are many aspects to owning property that can be controlled. A property is an asset, meaning it will generate cash flow and increase your net worth over time.
When a property is purchased at a set price and then improved through repairs and renovations, the value of the property is increased. When a stock or commodity is purchased, its value is its value at that point in time and there isn’t much the owner can do to increase the value. The property is a physical standing building owned by a single party and its fate isn’t determined by others.
This is different from ETFs and mutual funds that are dependent on fund managers as well as the management of companies that make up the fund. Real estate is perceived as a less risky investment for this reason. With real estate, more of the responsibility is on the owners shoulders for whether a property is a good or bad investment.
If you are renting a unit or house to a long term tenant, the property owner has a say in who is able to rent the space. For a short term rental such as an Airbnb, the owner can put together a list of conditions the visitor must meet before accepting the rental. Real estate investors create the leases and terms for any potential tenant. They create the rules for how much money will be paid per month, how long the tenant will be living there, and who is responsible for which procedures and bills during the tenant’s time in the property. There is an agreement established between the tenant and landlord that is negotiated so that both parties are satisfied.
Long term appreciation
What is something that cost more in 1990 than it does today? Well, for most things it’s the other way around – you need more dollars to buy things today than you did in 1990. This is due to inflation. Home prices tend to rise over the years with an average appreciation of 4-5% for the United States. If a property is rented out and breaks even with income to expenses, the property will still gain in value if held onto long enough.
Some may argue that house prices could crash again like they did in 2008. There may be a housing crash at any time, but the current average real estate prices are still higher than they were just before the crash of 2008. If you spend your money on things that go up in value rather than down, you will automatically put yourself into a much better financial situation in years to come.
The property’s increase in value correlates to an increase in equity which is the amount of money the house is worth minus how much is still owed on it. As the property increases in value and the loan is paid down, the equity grows yearly. This equity can be used to pay down high interest debt, fund other deals, or improve the property. There are a few ways to extract equity from a property. One way is to apply for a HELOC or home equity line of credit. A HELOC is essentially a second mortgage that you take out against your home based on how much equity there is in it. Let’s say the house is worth $500k and you owe $300k on the mortgage. This means there is $200k in equity. A HELOC allows you to borrow $100k with the house as collateral. There is typically a draw period where money can be withdrawn from the credit line and the payback period which is enacted after the draw period. Some draw periods are 10 years, meaning one does not need to pay any of the principal for the first 10 years. However, the interest still needs to be paid monthly based on the interest rate and total balance borrowed.
Another method for tapping into the home’s equity is with a cash out refinance. This is done by getting a new mortgage on the property. Lenders allow investors to take a portion of equity out of a property in cash to then restart a new mortgage with a loan to value ratio of around 80%. This can be very powerful if refinancing to a lower interest rate but depending on the market, it may or may not make sense at a specific time.
Tax advantages
Nobody likes paying taxes but believe it or not, there are still taxes to be paid when owning any type of rental property. The good news though is that there are certain expenses that can be deducted to lower taxable income. The government tends to award individuals and businesses with tax breaks for things they cannot do well on their own. Creating jobs, providing shelter, and maintaining older homes so they look neat and function safely are some tasks that get rewarded by the government.
The first tax break comes to both owner occupants and investors who own rental properties – the mortgage interest deduction. Interest that is paid monthly based on the interest rate can come off the top when computing taxable income. This is a greater reduction at the start of a 15 or 30 year loan when the interest payment is higher.
Operating expenses from running a rental property are also tax deductible. These expenses come from advertising costs to get the units rented out, leasing commissions, property management costs, miscellaneous supplies, and repairs and maintenance to name a few.
The IRS allows rental property investors to depreciate the property over the course of 27.5 years. This depreciation expense is to account for wear and tear on the building over time. Only the property value can be calculated toward the depreciation expense because the land will not suffer wear and tear like the property will.
Another tax advantage is the deferral of capital gains tax. When a rental property is sold, the owner has to pay capital gains tax on how much the property gained in value since the time it was purchased. To avoid this tax, some investors use a 1031 exchange. The 1031 exchange allows the investor to sell a property and buy another one at an equal or greater value without paying tax on the sale of the prior property. This defers tax until the time the next property is sold. There are certain rules to the 1031 exchange and a tax professional will be able to provide the details on a per case basis.
Let’s say an investor holds shares of stock or mutual funds and they want to sell some to take profits. They don’t want to sell the entire portfolio but just some of the profits from the most recent 5 years. Taxes need to be paid on these profits as a form of income. Real estate, on the other hand, allows you to withdraw profits in the form of equity. This can be done with a HELOC or cash out refinance.
Cash flow
Cash flow is arguably the greatest aspect of owning rental properties. When tenants pay their rent and after expenses are accounted for, whatever is left over is positive cash flow. This income is what allows investors to purchase more property, retire early, and have the funding to pursue anything else that requires money. As time goes on, the cash flow of a property tends to increase since the mortgage balance is shrinking while the rent rises over time. The loan can be refinanced to a better interest rate or re-extended to reduce the monthly payment. Once there is enough cash flow from properties, a 9 to 5 desk job is no longer necessary.
Although there is interest paid on any mortgage, the income generated from the property will ideally cover the principal, interest, real estate tax, and expenses to run the property. We know that the total amount of money paid into a mortgage over 30 years is much higher than the price of the property because of interest. However, if the cash flow figures are good enough, the property is still a great investment.
One last thought about cash flow – cash flow is what gets you your time back. Even if you live in a paid off million dollar home, drive a paid off car, and have no debt, you still need money coming in monthly to live. The home will need repairs. Property tax and energy bills are always going to exist. The car needs gas to work. You and your family need to eat. Because of this, you can have a net worth of millions of dollars but still need to work to pay the bills. Cash flow provides you financial freedom and freedom of time while equity in property provides you with wealth. Real estate is capable of creating both.
Loan paydown
Rental properties allow investors to buy residential and commercial buildings that tenants pay for over time. If a property is purchased with a 30 year loan and tenants are in it for 30 years, the rent income would go towards paying the principal, interest, tax and insurance. At the end of the time period, the investor is left with a paid off asset. Every month when the mortgages are paid, the equity is increased and the net worth of the investor continues to increase.
Savvy real estate investors like to take on more debt by purchasing more properties. If there is one paid off rental property generating income from 3 units each month, this is a nice situation to have. However, many investors opt to have more homes with mortgages on them than fewer homes that are fully paid off. This strategy allows investors to open themselves up to more loan paydown since the income is three times as much. (Given 3 houses with mortgages vs. one house fully paid off).
These are just a few of the many reasons why rental properties are great investments. If done properly, this asset class can help build wealth faster and with less risk compared to other investments. It is a more hands on and active investment but is worth it in the long run.
