Tqpwrjfisecwqlq8gxb7+twitter_ws_pic_2

Wall Street Steward Blog

The Lowdown on Rental Real Estate

About 5 years ago, this game was E-A-S-Y. 

Save up a little money, buy a home (financed 100%), rent it out and pay the mortgage payment with the rental income.  Then, over a period of time…raise the rent to create a larger difference between the income the owner receives and the mortgage payment they must plunk down.  Finally, after 5-10 years, sell the home for a nice capital gain because sarcastic we all know that real estate can never go DOWN in value sarcasm.

Welcome to present day…and REALITY.

Real Estate values have steadily declined all across the U.S. over the past 3 years. 


Gee, thanks Columbo—-  “King of the obvious” lives!

Imagine for a second that you are one of those unlucky people that decided that real estate speculation was a good idea.  You bought a home for $100,000, financed it all, and rented it out in late 2007.  Your rental payment was $800 and your mortgage payment was $600.  Life is good errr….life WAS good.  Now, your home is worth $65,000 (and you owe approximately $85,000), and your tenants are unemployed and cannot afford to pay their rent.  Uh oh…

The best of times….the worst of times.  Normally, the reality is somewhere in between these two extremes.  With that in mind, let us examine the pros and cons of owning rental property.

PROS
Growth Potential:  Although the long term annual average return for real estate is modest (between 4-5% per year according to the Case-Schiller Index), it can produce large gains due to the leverage aspect.  If someone has $100,000 to invest, instead of buying just one home for $100k, they could buy 10 homes by placing $10,000 down on 10 homes each costing $100,000 each.  Looks like this:

($100,000 sale price = $10,000 down payment + $90,000 in financing) x 10

Total dollars invested is $100,000, but the total amount of assets under control is $1 million.  If the real estate appreciates by 20%, the owner’s equity has appreciated by $200,000.  So, in essence, the land owner has tripled their money.  That formula works.

Income Stream:  This is the money that is left over after collecting rent, paying the note and the expenses, etc.  Assuming that the tenant is reliable and able to make their payments, the cash flow is consistent.  Having an additional stream of income is never a bad thing.

Tax Benefits:  The rental income can become tax-free if there is none left over.  I know, it sounds weird.  Basically, if the expenses of maintaining the properties eat up all of the rent collected, then there is not a NET positive cash flow.  In this case, the rent collected is not taxable.  However, the owner still enjoys the benefit of using the money to make the mortgage payments, which means they are gradually increasing their equity in the property. 

CONS
Loss Potential:  See the paragraph above after the “Columbo” comment.  If you own property during a period of time that includes falling real estate prices, then you will lose equity (aka…money).  Depending on how much leverage is used, this can possibly lead to an “upside down” situation.

Liability:  The possibilities are endless.  What happens if a tenant is hanging Christmas lights on the roof and it gives way?  What if the tenant is taking a shower and gets scalded because of a hot water heater malfunction?  Ultimately, the owner of the property must take every precaution to make sure that every aspect of the property is safe.  This can be a large expense, and speaking about expenses….

Expenses:  Owning a home is expensive.  There are expected expenses (maintenance), and then there are the surprise expenses.  What if there is a mold problem inside the walls of the home?  It is the owner’s responsibility.  HVAC unit quits?  The owner gets to write that $5,000 check.

Tenant Problems:  Ask yourself if you have the heart to kick out a deadbeat tenant with his wife and 3 small children because they cannot pay the rent.  It is not that they do not WANT to pay you, but they CAN’T right now.  Once he finds another job, they will pay their overdue rent…..get the picture?  It would be TOUGH for me to be responsible for making a family homeless.  The only thing worse than bad tenants is….

No Tenants:  Vacancy.  No rental income.  This means that the owner must pay the mortgage out of their own pocket, which can be especially tough if the owner also owes money on their primary residence.  Can you say “multiple mortgage payments?”


FINISHING TOUCHES

Suffice to say that rental real estate is a high risk-high reward business.  There are several steps that a prospective investor can take to mitigate these risks, but that conversation is for another day.  It is NOT easy to be Donald Trump

However, I think that we can all agree that real estate is not the “gravy train” it used to be.  If it is an area that you have an interest in, then be very patient and do your research.

Investing in real estate involves special risks such as potential illiquidity and may not be suitable for all investors.  All examples provided in this article are hypothetical and are not representative of any specific situation.  Your results will vary.