Should you rent properties?
One of the most common pieces of financial advice our clients hear is to invest their excess cash in rental properties. Unfortunately, this is terrible advice for all but a lucky few. There are four big reasons for this: it likely won’t generate the income you expect, it’s hard to generate a compelling return, a lack of diversification is likely to hurt you in the long run, and real estate is illiquid, so you can’t necessarily sell it when you want.
Before you buy a rental property as an investment, consider the reasons you’re unlikely to come out ahead.
Are you thinking about purchasing an investment property? Real estate has produced many of the world’s wealthiest people, so there are plenty of reasons to think that it is a sound investment. Experts agree, however, that as with any investment, it’s better to be well-versed before diving in with hundreds of thousands of dollars. Here are the things you should consider and investigate.
Investing in rental properties is a great starting point for real estate investors. Rental properties can provide cash flow and generate value from appreciation. Investors also get tax incentives and deductions from owning real estate.
While it can be a lucrative method of real estate investing, there’s a lot to know before investing in rental properties. This comprehensive guide will show you how to start investing in rental properties as a beginner. We’ll go over what it takes to invest in rental properties, common mistakes to avoid, and things to know before you buy your first rental.
What is the rental property?
A rental property is a residential or commercial property that’s leased or rented to a tenant over a set period of time. There are short-term rentals, like vacation rentals, and long-term ones, like those under a one-to-three-year lease.
Residential rental properties are one- to four-family homes, which include:
- single-family homes,
- triplexes, and
Types of commercial rental properties include:
- multifamily (apartment complexes),
- industrial (such as a warehouse or self-storage),
- office space,
- retail space, and
Residential rental properties are often more accessible to beginners because they’re less expensive. Less money is required upfront, and that often means that it’s easier to get financing. While there are exceptions, residential rental properties are also typically easier to manage. In most cases, managing one tenant is easier than managing twenty.
For these reasons, this comprehensive guide to investing in rental properties is focused on residential rentals.
Most investors buy a rental property with the goal of producing positive cash flow — earning more income each month than they spend on expenses. Not every rental has a positive cash flow at first, but building up to one is a common goal of rental investing.
Owning a rental property is an active form of real estate investing and requires time, dedication, and involvement. Being a landlord isn’t for everyone. As you’ll see, there’s much work involved in identifying, analyzing, buying, and managing a quality rental property.
The advantages of owning a rental property are relatively few, but they’re powerful. To put it simply, if everything lines up well, you can make a lot of money from a rental property.
Income from Renters
The biggest benefit of owning a rental property is that the renters will provide you with a direct income stream. Those monthly rent checks go straight into your business account, ideally more than offsetting any expenses for the month.
For example, if you own a house that you rent out for AU$1,000 per month, that house when fully occupied will put AU$12,000 per year back into your accounts.
It’s hard to argue with a direct income stream like that. It is worth noting, though, that those kinds of figures are optimistic ones and you shouldn’t just dive in expecting those results. Still, even partial results can be very good. If you can keep the property rented for just 75% of the year, that’s still AU$9,000 a year in income, after all.
Income from Property Value Growth
In addition, since you own the property, you stand to gain from an increase in the property value over time due to changing demands in the area, even if the property doesn’t undergo any changes.
This is going to be a variable thing, as it depends heavily on the area where your rental property stands. In some areas, the value may rise significantly over the course of a few years, while in other areas it may remain flat. Ideally, this value growth holds pace with inflation at a minimum. If you happen to be in an above-average area, you might find that you can beat inflation; on the other hand, a stagnant area may not even keep with inflation.
The other factor that you should consider is that your sweat equity is likely to add additional value to the property as you maintain and upgrade it. Doing things like repainting the home, adding new siding, refinishing the inside, doing some basic landscaping to the yard, and so on will add value to the home without high financial cost.
Not only will this allow you to charge more for rent, but it will also increase the value of the property itself should you choose to sell it in the future.
If you enjoy home improvement projects, this should be a major attraction for buying a rental property. You’ll have the opportunity to fix it up upon acquisition as well as in between tenants, which will return very nice dividends for you.
On the other hand, there are a number of disadvantages to owning a rental property. Individually, these disadvantages are relatively small, but they add up to a high cost.
Concentration of Assets
One drawback to investing in a rental property is that for most people, owning a rental property is a serious concentration of their assets. It would take a significant portion of the average Australian’s net worth to own a rental property fully.
The problem with that concentration is that it’s not diversified at all. That investment is in a specific house on a specific block in a specific neighbourhood in a specific city. If that neighbourhood goes downhill, you lose a lot of money. If that block goes downhill, you lose a lot of money. If something unfortunate happens to that house that insurance can’t handle, you lose a lot of money.
Like it or not, by owning a rental property, you’re tying yourself to the local real estate market in a very tight way.
The concentration of assets is not a wise investment strategy. However, the more wealth you have, the less this becomes a factor and the more that property ownership becomes a tool for diversification rather than something you’re concentrated in.
Tenants are never a guarantee to pay their rent. Even in the best of times and even with the (seemingly) best tenants, that revenue stream is far from guaranteed.
Sure, sometimes you’ll get a great tenant that pays their rent on time for years and years and years, but that’s never a guarantee. Some tenants won’t pay regularly, and others won’t pay at all. You’ll be out several months of rent and also the time spent dealing with their non-payment and eviction.
Some tenants may also cause more property wear than others. Sure, you’ll have that security deposit, but that’s still a cost and a risk.
There’s also the risk of not having a tenant at all, which means that you’ll have periods where the property generates no rental income.
Taxes and Fees and Insurance
Regardless of whether you have people in the house or not, you’ll still be facing the cost of property taxes, the cost of insurance on the property, and the cost of any homeowners association fees associated with the property. Those bills will come in regardless of whether there is a tenant in the property or not.
This is a pretty steady cost that you’ll know about in advance, but no matter how you slice it, it’s a cost that cuts into your profits. It’s especially painful if you don’t have someone renting the property, as that means that such costs are going to be coming directly out of your pocket.
These costs are not insignificant. For example, insurance on a rental property is usually around 25% higher than it is for normal homeowners’ policy and property taxes are nothing to laugh at. If you’re caught without a tenant or with a tenant that’s not paying up, this will have a direct and fierce negative impact on your finances.
Even in the most “hands-off” of situations, you’re still going to be devoting notable time to this rental property. Eventually, it will need repair. Eventually, you’ll have to check on it. Eventually, you’ll have to interact with the tenants. Eventually, you’ll have to do paperwork of some kind or another.
You can do away with this problem by hiring a management company – something we’ll discuss below – but in doing so, you eat away at the profits from renting out that property.
So you shouldn’t buy an investment property if:
You’re buying a property to pay less tax.
Many naïve investors think negative gearing is an investment strategy.
A property is negatively geared when the costs of owning it – interest on the loan, bank charges, maintenance, repairs and depreciation – exceed the income it produces.
In my mind, this is not an investment strategy – it’s a short term funding strategy, which only makes sense when used to purchase high capital growth investment-grade properties.
These tend to be established houses, townhouses or apartments in desirable streets in top locations in the inner and middle-ring suburbs of our three big capital cities.
You’re buying because you’re disappointed you’ve missed the recent property boom
Have you heard of F.O.MO? – the Fear Of Missing Out.
It usually happens at this stage of every property cycle when people read of the windfalls made by those who bought the property a few years ago. However, this is the time of the property cycle you need to be more cautious in your investing rather than over-optimistic.
Of course, it’s an understandable emotion, but investing with emotion leads to bad judgement.
And it is exactly this type of emotion that makes you easy prey for the property marketers and spruikers who will offer you a way to get rich quickly.
You want to get rich quick money coin
Many beginning investors want to “get rich quick.”
However, property investing is a long-term endeavour.
I’ve found it takes an average property investor 30 years to become financially free.
Often it takes ten years to learn what not to do – we all make investment mistakes when we start.
Then it takes three to five years to undo the mistakes of the first decade, often selling off underperforming properties.
Then it takes two good property cycles to build a substantial asset base of investment-grade properties.
Warren Buffet said it well when he said ‘Wealth is the transfer of money from the impatient to the patient.”
You don’t understand how property investment works
Many people mistakenly believe they understand property investment because they own a house or have lived in one.
So they end up buying a property close to where they want to live, where they want to retire or where they holiday.
Again, these are emotional reasons to purchase a property rather than selecting based on sound investment fundamentals.
On the other hand, successful investors have formulated a sound investment strategy that suits their risk profile and helps them achieve their long term goals and one which has stood the test of time.
If you’re not financially fluent money
If you haven’t learned how to budget, spend less than you earn and save or if you’re not good at handling debt, then property investment may not be for you because a large amount of debt you’ll take on for your investment will either get you into financial trouble or keep you awake at night.
Of course, if you’re scared of debt, and many people are because they don’t fully understand the difference between bad debt and good debt, then steer clear of the property until you better understand the power of leverage, compounding and time have on well-located properties.
If you want a multipurpose property data
If you are buying your property with the aim of creating wealth but also as your future home, or as a part-time holiday home or somewhere to retire in the future, then perhaps you want that one little property to achieve too much.
I’ve never found that a mixed-use property delivers premium investment returns – something has to give.
For one, there are too many emotional factors at play.
Of course, adhering to a proven investment strategy will mean you’re more likely to buy an investment-grade property and not make this type of mistake.
If your finances are not in order
Property investment is a game of finance with some real estate thrown in the middle.
To get into the property you should have a stable job, profession or business with a steady income and need to be attractive to the banks, so they lend you money plus you should have sufficient stashed away in a financial buffer to see you through the inevitable rainy days ahead.
You don’t have enough money
If you can’t afford an investment-grade property, either because you haven’t saved a sufficient deposit or you can’t service the loan repayments, then rather than buying money savings secondary property, in my mind it’s better that you wait and buy an investment-grade property.
One of the reasons that around 50% of those who get into real estate sell up in the first five years and the main reason around 90% of investors never buy more than one investment property is because the first property they buy underperforms and they lose confidence.
In my mind, less than 5% of the properties currently on the market are “investment grade” – the type of property that will outperform the averages with wealth-producing rates of return and stability of price when the markets eventually turn.
This means you need to buy the right property in the right location (remembering that the correct location will deliver around 80% of your property’s performance.)
So, if you can’t afford this type of property, sometimes the right thing to do is “nothing.”
You make your money when you buy your property, not because you buy it cheaply, but because you buy the right property.
You’re trying to time the market or find the next hotspot location map house suburb area find
Sure property markets move in cycles, and it would be great to buy near the bottom or find a location that will be the next hotspot, but the landscape is littered with investors who tried to time the market and failed.
Instead, the right time to buy real estate is when your finances are in order, and you’ve got the ability to purchase an investment-grade property.
Remember, there is no one property market in Australia, so there will always be opportunities.
Rather than wait and buy real estate; you buy real estate and wait.
For some people, owning a rental property might be a brilliant personal financial move. If they’re in good financial shape already, have some spare time on their hands, and don’t mind handling home maintenance emergencies, a person who puts in some patient time finding the right property to rent can make a very nice profit on a rental property.
However, not everyone is in that group. Some people might not relish the interaction between tenant and landlord from the landlord’s side. Others may not be in a financial position to take on a rental property quite yet. Still, others might not feel confident in their local real estate market.
That’s okay. If those things describe you, you can still diversify into real estate by investing in a REIT with some of your investment funds.
The important thing to remember is that investing in rental properties is one of many options on the table, and it is a good option for some people. Take into consideration your financial state, your strengths, and your interests and make up your mind about whether rental property ownership is the right move for you.