Should You Buy an Investment Property?
There can be something particularly gratifying about buying and owning real estate plowing your hard-earned money into your very own corner of the Earth. That may partly explain why direct real estate investing has been a renaissance. Becoming a landlord is often touted as a critical strategy for building wealth and financial independence among financial influencers and the so-called "FIRE" community (which stands for financial investment, retire early). In addition, 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 a good place for someone to live while building equity in a property over time," says Meredith Stoddard, a Fidelity life events experience lead who's been purchasing, selling, and renting out properties since her college years. "It may also provide a way to diversify your cash flow."
Potential Risks of Real Estate Investment: Costs of Ongoing Time & Effort
Buying investment 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 of the factors to keep in mind.
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 must manage an ongoing relationships with those tenants, maintain and periodically upgrade your property, and make sure you abide by any applicable laws or regulations. If your portfolio expands to multiple parcels, these management duties can become full-time jobs.
Options for Property Management
You essentially have two options for handling management: You can commit time to do it yourself or pay a property management firm like E & G Real Estate to do it for you. And even if you hire a firm to handle the day-to-day, you'll still have to make critical decisions.
Short-term vacation rentals can add another layer of management complexity. Vacationers expect sheets, towels, soap, and other hotel-like items for their stay. And if you take bookings online, you may have to worry about cultivating a steady stream of 5-star reviews.
Potential Reward of Real Estate Investment: Unique Tax Advantages
While the rental income landlords collect is generally taxable as ordinary income, there are deductions for various items, which Stoddard notes can help reduce the tax bill.
Deductions for income from rental properties can include: 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, but they can still provide tax benefits. "Money you put into improvements of the property can be added to your cost basis," Stoddard says. "A higher cost basis can reduce the taxes you owe if and when you sell."
Real Estate Investing & Taxes
It's important to note that if you eventually sell an investment property at a profit, you'll have to pay capital gains tax on the total amount of any appreciation over the adjusted cost basis. As a result, you won't be eligible for the capital gains exclusion (which applies to the sale of a primary residence) for properties you've exclusively used as rentals.
If you're getting serious about real estate investing, consider consulting with a tax professional to understand the potential tax implications better.
Some Other Potential Risks of Investment Properties: Lack Of Diversification & Liquidity
As we mentioned earlier, buying even just one investment property takes a significant commitment of cash. Moreover, because properties are of such a high value, 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 your individual properties, and a few strokes of bad luck—tenants who stop paying or a 100-year flood—could put a real dent in your financial well-being.
In addition to becoming overconcentrated in a few specific properties, your total portfolio may also become heavily concentrated in real estate rather than broadly diversified among stocks, bonds, and other asset classes. Make sure to evaluate your exposure to real estate in the context of your entire portfolio, and consider working with a financial professional to understand the risks that can come with a lack of diversification.
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 reasonable price may also heavily depend on the dynamics of your local area at a given point in time.
Another Potential Reward of Real Estate Investing: Inflation Protection
Inflation is a word we are all too familiar with these days. Investment properties have the potential to hedge inflation in 2 ways: rising rents and rising property values. Rental income can provide a perfect inflation hedge if you have a fixed-rate mortgage on the property, says Stoddard. "Rents generally go up over time, but the payment on a fixed-rate mortgage stays the same," she notes.
And 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. (Of course, the significant ongoing expenses for owners—from taxes to repairs and improvements—also tend to rise with inflation over time.)
Mistakes To Avoid for Beginner Real Estate Investors
If you're serious about getting into direct real estate investing, beware of these common beginner mistakes:
- Not keeping enough cash on hand
- Not researching the local area
- Alienating Tenants
For investors who are comfortable with and financially equipped to handle the risks, investing in property has the potential to provide cash flow and growing equity over time.
It may work best if there's a fit with your financial goals and situation and your personality. For example, dealing with tenants, contractors, and neighbors may feel like an unwelcome headache for some investors. It may feel like part of your investment in your asset and your community for others.
Remember that buying properties outright isn't the only way to gain exposure to real estate or an inflation hedge. Real estate investment trusts (REITs) can offer direction, plus the added possible benefits of diversification and professional management, with similar convenience and simplicity as traditional stock investments. Treasury Inflation-Protected Securities (TIPS) and exposure to commodities can also potentially help provide an inflation hedge.
Key Take-Aways for Real Estate Investing
Buying investment properties can come with a unique set of potential risks and rewards. Risks can include the cost of ongoing time and effort to manage properties and maintain relationships with tenants, plus the possibility of a lack of diversification. On the other hand, it can offer income and property values that may keep pace with inflation in some cases. In addition to considering whether it fits your financial situation, think about whether you have the personality to be a landlord.
Let us help you determine if owning real estate is for you. Reach out to Danny today.