There can be something particularly gratifying about buying and owning real estate. For investors who feel nervous about the stock market or who struggle with the abstract nature of stock investments, it may feel reassuring to own something tangible, a real asset.
Becoming a landlord is often touted as a key strategy for building wealth and financial independence among financial influencers and the so-called "FIRE" community (which stands for financial independence, retire early). For millennials and other cohorts who still remember the volatility of the Great Recession, there may be an appeal to building a portfolio that's less affected by decisions made on Wall Street or in corporate boardrooms.
Investing in rental properties is an opportunity to provide an alternative source income, while building equity in a property over time. It may also provide a way to diversify your cash flow. However, buying rental properties isn't for everyone. In addition to requiring a substantial up-front commitment of cash, it comes with a unique set of risks and rewards that prospective investors need to understand. Here are some factors to keep in mind.
Potential risk: Cost of ongoing time and effort
While rental income is sometimes referred to as "passive income," there's nothing passive about becoming a landlord. In addition to finding and vetting tenants, you have to manage ongoing relationships with those tenants, maintain and periodically upgrade your property, and make sure you're abiding by any applicable laws or regulations. If your portfolio expands to multiple properties, management duties can become a full-time job.
You essentially have 2 options for handling management. You can either commit time to doing it yourself or pay a management firm to do it for you. Even if you hire a firm to handle the day-to-day, you'll still have to make key decisions.
Short-term vacation rentals can add another layer of management complexity. Vacationers expect sheets, towels, soap, and other hotel-like items for the duration of their stay. If you take bookings online, you may also have to worry about cultivating a steady stream of 5-star reviews.
Potential reward: Unique tax advantages
While rental income landlords collect is generally taxable as ordinary income, there are deductions for a wide range of items, which can help reduce the tax bill.
Deductions for income from rental properties can include:1
- Mortgage interest
- Property taxes
- Repairs
- Insurance
- Utilities
- Depreciation (i.e., a property's gradual loss of value as it ages)
Costs for renovations aren't deductible the same way that maintenance costs are, but they can still provide tax benefits. Money you put into improvements of the property can be added to your cost basis and factored into your depreciation. A higher cost basis can also reduce the taxes you owe if and when you sell.
If you eventually sell your rental property at a profit, you'll generally have to pay capital gains tax on the full amount of any appreciation over the adjusted cost basis. That's because you won't be eligible for the capital gains exclusion (which applies to sales of primary residences) for properties that you've exclusively used as rentals.
If you're getting serious about real estate investing, consider consulting with a tax professional to better understand the potential tax implications.
Potential risk: Lack of diversification and liquidity
Buying even just one rental property can often take a significant commitment of cash. Because properties are so high value in many high demand areas, it can be challenging even for wealthy investors to build a diversified portfolio of properties. That can mean you're heavily exposed to the risks of the individual properties you own, and a few strokes of bad luck—if your investments aren’t broadly diversified.
It’s important to ensure that you not only have a financial safety net to handle repairs and ongoing maintenance, but to look at real estate as part of your overall financial strategy and in context of any other investments you have such as stocks, bonds, retirement, or other assets.
Additionally, unlike traditional financial assets that are generally easy to sell, it takes time (plus effort and money) to sell a property if you ever need to raise cash or rework your portfolio. Your ability to sell quickly, and at a good price, may also heavily depend on the dynamics of your local area at a given point in time.
Potential reward: Inflation protection
Rental properties have the potential to hedge inflation with rising rents and property values. Rental income can provide a particularly good inflation hedge if you have a fixed-rate mortgage on the property. Rent generally go up over time, but the payment on a fixed-rate mortgage stays the same, and your payments go towards paying down the principal balance over time.
Although it's never guaranteed that a given property will increase in value over any specific period, real estate values on average tend to keep pace with inflation over the long term. The significant ongoing expenses for owners—from taxes, to repairs, and improvements—also tend to rise with inflation over time.
Treasury Inflation-Protected Securities and exposure to commodities can also potentially help provide an inflation hedge. (Learn more about protecting your money from inflation.)
Pitfalls to avoid
If you're serious about getting into direct real estate investing, beware of these common beginner mistakes:
Not keeping enough cash on hand
Plan for recurring costs, such as your mortgage payment and regular maintenance, and also for unexpected expenses like repairs. Make sure to create enough of a buffer in your cash flow so you can ride out periods of high expenses.
Not researching the local area
It's imperative to understand the dynamics in your local market, compare similar properties, and choose locations that appeal to prospective tenants. For instance, if you plan to rent to vacationers, is the property near the highway or public transit? Understanding their desires will help you select a property they'll find appealing.
Alienating tenants
Tenants are your customers. They can make or break your business, so it's essential to maintain healthy relationships with them. You should avoid creating an adversarial dynamic, such as charging more than the agreed-upon rent and work to tactfully resolve any issues.
Additionally, being disciplined about checking credit and references may also help prevent problems before they occur. The more reliable and responsible your tenants are, the less likely the friction.
Make sure you research and understand your local landlord/tenant laws so that you can follow applicable regulations accordingly and not put your income or business at risk.