Rental Real Estate: Everything you should know about the hottest fad that isn't
On this week’s blog, we’re extending our previous post’s theme of alternative assets with a deep-dive into considerations around rental real estate. It’s no secret that rental real estate is a white-hot topic in American finance right now, with its popularity being driven by a number of factors, including social media marketing, ease of online purchasing, tax advantages, surplus wealth, and peer pressure! But no matter the motivation or inspiration, pretty much everyone wants the same outcome from a rental real estate purchase: passive income. Passive income is a sexy idea that often gets treated like the holy grail of personal finance (and to be fair, what could be better than increasing your net worth by doing “nothing”?). If you’re a rental-savvy reader, you might already be calling the bluff here. If you’re rental-curious and optimistic, you might not be fully aware of the risks involved. At Mana, we recognize that rental real estate is not a one-size-fits-all investment - it’s a personal decision that should be made based on your unique financial situation. It can be a fantastic idea, but it shouldn’t be treated like a fad or considered over a short term (though some other alternatives can work nicely as quicker investments). Rental real estate works best as a long-term commitment that you are not relying on for short-term yield (secret’s out: it’s usually not a great source of passive income). To help illustrate these thoughts further, we’ve outlined the benefits, risks, and key considerations that should be taken into account with rental real estate below.
The benefits of rental real estate
As we mentioned above, rental real estate is super hot right now, but here’s why it absolutely shouldn’t be a fad.
Real estate as an asset class can provide cash flow, tax benefits and diversification, but in our view, these benefits take time. A common anecdote you’ll hear from us is “if you want to become a rental real estate investor, the best thing you can do is become a rental real estate investor for life.” In this week’s blog, we’ll tell you why.
Real estate is an attractive asset class, because it has historically generated cash flow and appreciated in value. This dual benefit has made it one of the best performing asset classes over the past 50 years. But just because real estate generates cash flow does not mean that this cash flow is passive. Not only do properties require upkeep over time, but continuing to increase the amount you charge for rent over time is an essential part of managing a rental property. Real estate is often called a local business for these reasons. Maintaining a property is much simpler when you live in close proximity to it, and your understanding of the local market may enable you to feel more confident in charging the appropriate rent for your space.
There are tremendous tax advantages to holding real estate as an investment, because of the way our tax code is structured in the United States. Even though real estate values in the US have historically gone up over time, the IRS allows you to depreciate rental real estate over a 27.5 year life. What does this mean? The IRS assumes that if you buy a residential rental property, after 27.5 years, it will be worthless.
From a practical standpoint, if you bought a property for $275,000 in 2021, every year you would be able to deduct 1 / 27.5 of depreciation expense on your tax return, or $10,000. If you earned $10,000 of income from renting the property, your rental income is essentially tax free. The catch? When you sell your rental property, you will owe ordinary income taxes on ‘depreciation recapture’. So let’s say you bought the property for $275,000 and depreciated it every year; in 2031 when you sell the property, the 10 years of deducting $10,000 of expenses (or $100,000) will be taxed all at once. However, if you are committed to this asset class, the IRS has a second tax provision found in Section 1031. If you sell a property, never take hold of the funds and keep them in escrow (a process known as a 1031 exchange), and reinvest into another property, you do not have to recapture the depreciation. On your next property, you can depreciate it over the same 27.5 years, taking an expense each year. You can do this over and over again, and so long as you never sell, you’ll never have to pay ordinary income on the depreciation expense. At the point that you pass away, your property will be passed to your heirs, marked to market, and at that point, your family will not have to pay ordinary income taxes on the depreciation.
What’s the downside on rental real estate?
As with any investment, there are risks to buying rental real estate. These range from vacancy in your rental expectations, to rent gone unpaid, to higher than expected expenses, to a decline in property values. These risks are always existent, but are unpredictable. The ability for you to weather the storm is an important attribute in investing in this asset class. And because of the inherent leverage in real estate, in a storm these risks are compounded.
When we refer to leverage, we mean that unlike many other commonly held investments (like stocks and bonds), you only have to put a small percentage of cash down in order to fund your investment. This makes real estate attractive when things are going well. Let’s say you purchased a $1 million home with 20% down. If the property increased by 25% in value, your home would grow to $1.25 million. This means that you earned $250k on your $200k initial investment (plus any contributions you made to the property over time). But when the market goes south, the losses can actually extend beyond your initial investment. If the home’s value declined by 25%, which in an investment without leverage would result in a loss of $50k, your property value would be $750k. This means you actually lost $250k on your $200k investment, so if you sold your property, you would actually owe the bank money.
It should be expected that property values fluctuate over time. Climate change, cultural behaviors, and travel preferences can all be drivers into home values and the cash flow that can be delivered. For the most part, these fluctuations are OK if you are able to hold onto the property despite the adverse market environment.
Ultimately, the most significant risk in buying real estate is buying something you can’t afford. If you find yourself in a situation where you cannot afford your house, and you are forced to sell in a time where the price has declined, you can put yourself into a dangerous financial situation where you owe more money than your initial investment to the bank. We saw this exacerbated in the financial crisis in 2008, where individuals were extended loans for homes they could not afford, and ultimately when they tried to sell the homes, the values had declined. Individuals defaulted on loans, bankruptcies skyrocketed, and home prices continued to fall with the rising supply and decreased demand. Any urgency in selling can further complicate matters, because it’s not as easy as logging into your brokerage account and hitting sell on your home. When you sell a home, expect to pay 6% of the home’s value to a broker to assist with this process, and the timeline can take 1-3 months or longer to complete the transaction.
Our biggest tip for anyone in the market for real estate is to have an emergency fund specifically dedicated to your property. For upkeep, expect to pay 1% of the property’s value on an annual basis, but beyond that, we recommend having the cash flow to cover vacancy for 12 months. If you are fortunate, you won’t need to use all of it. But your ability to be the most successful as a long-term real estate investor relies on protecting your personal financial situation against unexpected risks, and even if you decide you want to sell your investment, you need to give yourself the time and financial ability to do so.
Ready to take the leap? Here’s how you start your journey.
If you’ve decided you’re ready for launch into rental real estate, there are lots of decisions to make on what type of rental property is right for you.
The first and most obvious is where?
As we mentioned, real estate is commonly thought of as a local business, and from a time and investment perspective, operating locally can be accretive. We think this local mentality should be balanced with an informed understanding of the rules and regulations for landlords and renters. For example, in California, legislation is heavily weighted in protection of renters. Here, when your renter cannot pay rent, you may not have much recourse to recoup payments or evict.
You also need to consider your physical proximity to the rental property, and your connections to the local community. If something breaks, you are responsible for fixing it. Living nearby means that you can personally assess the damage and repair, and possibly do it yourself for cheap. Living far from your property means that you could be relying on strangers or repair companies that may not have your best interests in mind. Additionally, living far from your rental often means that you will be less in touch with the local culture, economy, and housing trends, which could put you at a disadvantage in competitive markets.
The next decision is a cost-benefit analysis on turnkey homes vs. fixer-uppers...
The question to ask yourself here is, how do you want to spend your money and time on your rental property? Turnkey homes are usually newer, and by definition, do not require major imminent repairs or renovation. This will save you some time and labor, but will certainly cost you more up front and in your mortgage payments. Fixer-uppers can seem like a good way to save on mortgages or down payments, but they will require both time and financial resources to make them reliably livable. Fixer-uppers will take longer to rent, and can require ongoing active maintenance. This can be stressful if you want a more hands-off experience, but can be fulfilling if you enjoy hobby projects and don’t have a hard timeline for cash flow generation from your property.
Once your rental property is ready to go, you’ll need to decide who to rent to...
Certain locations will be the determining factor for if you decide to rent long-term versus short term. For example, if you are purchasing a home in a small suburb in a great school district, you are probably more likely to receive consistent income by having a consistent renter. However, if you are buying a home in a vacation locale, Airbnb or short term rentals might be your best option. Both can be fruitful in terms of making money over the long term. For long term rentals, less money needs to be spent on marketing, and provided whoever rents your property has stable income, your income stream can truly be more “passive”. You do, however, run the risk of reliance upon a single family’s income. Once again, this can cause difficulties if they encounter hardships and cannot pay rent on time (or at all). This is a bigger concern for owners in places where renters have high legal protections, or the pace of rental cost increases does not match inflation or your own cost of living (and this risk should be calculated into your emergency savings). For Airbnb or short term rentals, you can typically charge a higher price per night, which can lead to higher profits, but you’ll want to take marketing costs and higher management fees into consideration as a result. The other added benefit of short term rentals is you spread your assumed risk out over an unlimited quantity of new renters, versus relying on a single family.
If you decide you want to purchase in a vacation home that serves partially as a rental property, know that you’ll want to hire a CPA who can help you track the amount of time spent in the home versus renting it. All of the aforementioned tax benefits are most relevant when you use the property less than 14 days in the year.
And lastly, how much can you spend?
Sizing depends on your financial situation and we always recommend working with a CFP® who has a comprehensive understanding of your full financial picture. Two metrics we like to consider when advising clients on the amount to invest in rental real estate are 1) net worth and 2) monthly cash flow. From a net worth perspective, it’s important that any single investment does not represent such a large portion of your net worth that your future success relies on the outcome of this single investment. Similarly, from a monthly cash flow perspective, it’s important that even if you were unable to rent the property, you are able to reasonably afford the monthly payments. Once again, we will never recommend rental real estate as a reliable source of “passive income”, and we will never recommend purchasing it because the market appears “hot” over a short time horizon.
Rental real estate is an asset class worth considering once you’ve built up your net worth, have cash that you are prepared to allocate for the initial investment and ongoing savings, and the time and income capacity to successfully manage a property. The tax advantages and cash flow benefits are often first achieved after a number of years, but if property management is something that interests you, it can serve as a great financial asset over the long run. In summary, there are some great long-term advantages (namely in the tax space) that come from rental real estate, but it should never be viewed as a fad or a get rich quick scheme. The risks are significant, and it’s important to consider the full spectrum of cost-benefit before you commit. It’s really no different than most other assets, where those who can make slow and consistent investments, do proactive maintenance, and carry a healthy dose of patience will have the greatest success!
Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.