Should you rent properties?
It’s very common in the financial advisory to tell people to invest their cash into rental properties. However! There are four reasons it’s never quite as easy as this. Firstly, it likely won’t generate the income you expect. It’s also difficult to develop a strong return. Then, its lack of diversification may hurt you in the long run, and real estate is not liquid, meaning you can’t always sell it when you want.
Before buying a rental property as an investment, consider why you are unlikely to come out ahead.
Thinking about purchasing an investment property? Real estate is responsible for many of the world’s wealthiest people, so there are plenty of reasons to believe it is a solid investment. That said, experts suggest that, as with any investment, it’s better to be well-versed before diving in.
It’s true; investing in rental properties is a great starting point for real estate investors. Why? They can provide cash flow and value from appreciation. Investors also get tax incentives and deductions for owning properties. But there are risks.
There’s a lot to know before investing, so this blog will cover everything it takes to invest in rental properties, mistakes to avoid, and things to know before you take the plunge. Here is what you should consider and investigate:
What is the rental property?
A rental property is either a residential or commercial property leased or rented to a tenant over a set period. Short-term rentals, like vacation rentals, differ from long-term ones, like those under a one-to-three-year lease.
Residential rental properties include:
- single-family homes,
- triplexes, &
Types of commercial rental properties include:
- multi-family (apartment complexes),
- industrial (warehouse or self-storage),
- office space,
- retail space, &
Residential properties are often more accessible to beginners because they’re less expensive. They require less money upfront. That typically means that it’s easier to get financing. With exceptions, residential rental properties are also easier to manage; managing one tenant is easier than overseeing thirty.
Most investors buy a rental property to produce positive cash flow, earning more income each month than they spend on expenses. Not every rental initially has a positive cash flow, but building up to one is the common goal.
Owning a rental property is considered an active form of real estate investment. It requires dedication, time and involvement. Being a landlord isn’t for everyone; a lot of work is involved in analysing, identifying, buying, and managing a quality property.
The pros of owning a rental property are few, but they’re powerful. If everything ends well, you can make a tidy profit.
Income from Renters
A huge benefit of owning rental properties is that renters provide a direct income stream. Monthly rent checks go into your banking account, more than offsetting any monthly expenses.
Suppose you own a house you rent out for AU$2,000 monthly. That house, when fully occupied, will accrue AU$24,000 per year.
It is worth noting that those kinds of figures are optimistic, and no one should expect those results from the beginning. Even if you keep the property rented for just 75% of the year, you will still accrue a tidy $18,000 per annum.
Income from Property Value Growth
Since you own the property, you will gain from any increase in property value over time due to changing demands in the area. This is even if the property doesn’t change.
This will be a variable thing, as it depends heavily on the area where your rental property stands. In some regions, the value may rise significantly over a few years, while in others, it may stagnate. If you are in a hotspot area, you might find that you can beat inflation; however, a static suburb may not even keep up with inflation.
Something to consider is that your sweat equity will likely add additional value to the property as you maintain and upgrade. Repainting, adding new siding, and basic landscaping will add high value to the house with a low financial commitment.
This will allow you to charge more for rent and increase the value of the property itself should you choose to sell it down the track.
If you enjoy home improvement and DIY, you’ll have opportunities to fix it up upon acquisition and between tenants, which will return very nice dividends for you.
There are some disadvantages to owning a rental property. These disadvantages are relatively small but can be costly when added up.
Concentration of Assets
For most Australians, owning a rental property is a significant commitment and concentration of assets. It takes a substantial portion of the average person’s net worth to own a rental property fully.
Plus, it’s not diversified at all. Investment in a specific house on a specific block in a particular neighbourhood in a specific city means that if the community goes downhill, you lose a lot of capital. If the block gets caught up in red tape or something unfortunate happens to the house that insurance can’t handle, you again stand to lose a lot of money.
Like it or not, you’re quickly tying yourself to the local real estate market by owning a rental property.
The concentration of assets is not considered a wise investment strategy. That said, the more wealth you have, the less this becomes a factor, and the more property ownership becomes a tool for diversification.
Tenants are never guaranteed to pay their rent. That revenue stream is far from guaranteed even with the best times and the (seemingly) best tenants.
If lucky, you’ll get a great tenant that pays their rent on time for years, but that’s not a guarantee. Some tenants will fail to pay regularly, and others won’t pay, leaving you to deal with their non-payment and possible eviction.
Some tenants may also cause property degredation more than others. You’ll have that security deposit, but it’s still a cost and risk.
There’s also the risk of not having any tenant at all, which means you’ll have periods when the property generates zero rental income.
Taxes and Fees and Insurance
Whether you have tenants or not, you’ll still face costs, such as property taxes, insurance on the property, and any homeowners association fees coming in regardless of having a tenant on the property.
These costs are not insignificant, where insurance on a rental property is usually around 25% higher than it is for normal homeowners’ policy. If you’re stuck without a tenant or have a non-paying one, this will directly impact your finances.
Even in the most ‘hands-off’ situations, you’re still devoting considerable time to a rental property. Eventually, it will need repair. You’ll have to check on it. And you’ll have to interact with the tenants. There will also be paperwork.
A management company can assist with this active involvement, but you will need to research.
So you shouldn’t buy an investment property if:
You’re buying a property to pay less tax.
Most beginner investors believe negative gearing is an investment strategy.
However, a property is negatively geared when its costs: interest on a loan, bank charges, maintenance, repairs and the all-important depreciation exceed its produced income.
Take note; this is not an investment strategy. It’s a very short-term funding strategy, which makes sense only when used to purchase high-growth properties considered investment-grade.
Investment-grade properties include established houses, apartments, or townhouses in desirable locations in the inner and middle-ring suburbs of Australia’s three major capital cities.
You’re buying because you’re disappointed you’ve missed a recent property boom
‘FOMO’, aka Fear Of Missing Out, happens when people read of the success of those who bought into property a few years ago. However, this is the time you need to be cautious in investing.
Of course, it’s understandable, but investing with emotion leads to poor judgement, making you easy prey for any property marketers offering you a way to get rich in a hurry.
You want to get rich quick money coin
Don’t be fooled; property investing is a long-term endeavour.
It takes 30 years on average for a property investor to become financially free, and it can take ten years to learn what not to do.
To build a substantial base of investment-grade assets, it can take another three to five years to undo those mistakes before experiencing two ideal property cycles.
Warren Buffet summed it up well: “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 know property investment because they own a house or have lived in one.
They may buy a property close to where they want to live, where they want to retire or where they holiday.
These are all emotional reasons to purchase a property rather than deciding based on sound investment fundamentals.
Successful investors have developed sound investment strategies that suit their risk profile to help them achieve their long-term goals.
If you’re not financially fluent in money
If you haven’t learned how to budget, spend more than you earn or are not adept at handling debt, then property investment may not be for you. Why? The debt you’ll take on through investment will either get you into financial trouble or cause great stress.
You may not understand the difference between bad debt and good debt, which can bring fear. If you’re scared of debt, steer clear of investing until you know the power that leverage, compounding and time have on well-located properties.
If you want a multipurpose property data
If you are buying your property to create wealth and as your future home or holiday home, perhaps you want that little property to achieve too much.
It’s hard for mixed-use property to deliver premium investment returns, as something generally has to give because too many emotional factors are involved.
Following a robust investment strategy will mean you’re more likely to buy an investment-grade property and less likely to make this kind of mistake.
If your finances are not in order
To get into property, you need a stable job, profession or business with a steady income. This makes you attractive to banks, so they lend you money. You should have sufficient funds in a financial buffer to see you through rougher periods.
You don’t have enough money
Suppose you can’t afford an investment-grade property because you haven’t saved a sufficient deposit or can’t service the loan repayments. It may be better to wait and buy an investment-grade property.
About 50% of those who get into real estate sell in the first five years. Most investors never buy more than one investment property; if this first property underperforms, they lose confidence.
Only a small percentage of on-market properties are ‘investment grade’. This type of property will outperform the averages with wealth-producing rates of return and stability of price when markets eventually turn.
This means you must buy the right property in the right location to deliver around 80% of your property’s performance. And if you can’t afford this type of property, it may be best to do nothing.
You’re trying to time the market or find the next hotspot location
Property markets move in cycles. It would be ideal to buy near the bottom or find the next hotspot, but thousands of investors who tried to time the market have failed.
So what can you do instead? Buy real estate only when your finances are in order. Australia has more than one property market, so there will always be purchase opportunities.
For some, owning a rental property might be the best personal financial move where they’ve found the right property and are enjoying the profits. These people may also have spare time and don’t mind handling maintenance emergencies.
However, not everyone fits that group. They may not enjoy the interaction between tenant and landlord as a landlord. Others may not be financially stable enough to take on a rental property, while others might not feel confident in their local property market.
It doesn’t mean you shouldn’t invest, as you can still diversify into real estate by investing in a REIT with some of your funds.
It’s important to remember that investing in rental properties is one of many options on the table, and it is a viable option for some people. Consider your financial state, strengths, and interests and decide whether rental property ownership is your most dynamic move.