If you’re interested in owning rentals (and you should be) let me share a very important fact:
Owning rentals is expensive.
I hear over and over from investors that they plan to own rentals for the cash flow. Fabulous plan! I agree! But, in the beginning of your investment career, Warning: owning rentals is typically more of an expense than an income. They really only cash flow well when paid off. Even if they appreciate in value over the years and you’re able to raise rents and pay down your mortgage, your taxes and interest payments go up and your monthly mortgage payments do not decrease.
Now don’t think I’m anti-rental – quite the opposite! In fact, I own a bunch of rentals and I believe that EVERYONE should own rentals. Yes, property upkeep and dealing with tenants can be a hassle, but the rewards FAR outweigh the hassle.
So what makes holding rentals an expense?
Some of the expenses of holding include:
- Vacancy – tenants move out and you begin paying mortgage, taxes, insurance, utilities, yard maintenance, etc.
- Repairs – when tenants live there as well as when they move out.
- Face lift (carpet, paint, appliances, etc.) when tenants move out and you prepare for new tenants.
Some of the main advantages of holding rentals:
- Monthly income for later in life – especially retirement income (no need to rely solely on government assistance)
- Tax write offs for now – if you plan to do flips and wholesales, you need write offs or Uncle Sam will take a huge chunk of your rehab profits. Even if you’re not a real estate investor, holding rentals gives great tax advantages to offset your W2 income.
- It’s a wonderful thing to provide housing for the public. Public assistance is one of the reasons Uncle Sam encourages providing housing (rentals) by offering tax write offs to property owners.
Finally, to get the most out of your rentals, a primary fact to focus on is the same as for any other investment property:
DON’T OVER PAY FOR THE PURCHASE
We will pay more for a property we plan to hold long term than for a property we plan to renovate and resell immediately, but we still need a significant discount off of the retail price so that our rental can be as profit performing as possible right from the start. Also, being able to reduce rents yet still cover all/most of our monthly property costs was one of the things that helped us survive the 2008-2010 market downturn.
During the economic downturn, many of our tenants found themselves needing a less expensive place to live. We never want to lose a good tenant, so being able to reduce rent to keep them was often better than having that tenant move out. Don’t forget, a vacant property will cost you (see “expenses of holding” above) and rather than spending $1000-$2000 (or more) for the vacancy, we could lower rent by, for example, $50 per month to keep the tenant and still come out better over a 12 month period. Plus, when a good tenant moves out, you run the risk of a not-so-great tenant moving in!
Yes the 2008-2010 years are behind us, but an economic downturn will hit again. Real estate is very cyclical.
How much do I recommend paying for rentals? My personal rule-of-thumb is that, after purchase and repair, I don’t want more than 80 percent of the retail value in the property. Having at least a 20 percent discount off the retail value also protects you when market values drop again. You never want your house value to drop below your purchase amount.
In summary, own rentals. They’re the long term cash flow we all need and want. But plan on the cash flow advantage down the road so you’re not disappointed when you can’t quit your W2 job after purchasing a few rentals. For today, love your rentals for the tax breaks they provide. True cash flow comes later.
And when you do have rentals, be sure to check out my book The Essential Handbook for Landlords.
What can you add to the pros / cons of owning rentals?