From a financial standpoint, rental property is at the top of the list of assets to own. Why rental property? Let's explore the main benefits of this asset class. But first of all, you have to be smart about investing in a rental property. Otherwise it can become a huge headache if you don't screen properly. You need to select reliable tenants and buy in a location that attracts quality tenants. Good thing you screen like the CIA and only buy in prime locations.
Rental property is the ultimate hedge against inflation. In addition, it is the ultimate asset to make money during inflation. This is both from a cash flow and real asset appreciation perspective.
With the US Dollar going into the crapper, your goal should be to borrow as much USD as your personal balance sheet allows. Then buy a real asset in an appreciating foreign currency! Alas, if you can't do that you just have to do the next best thing and buy American.
Why Rental Property Makes Money Every Which Way And Sideways
Declining Inflationary Environment
Let's say you have one million dollars sitting in the bank earning 2% interest from a long dated CD. Every year, you earn a respectable $20,000. You used to be able to earn $42,000 a year. But thanks to the downturn, inflation is nowhere to be found.
During a low inflationary environment, your rental property INCREASES in value. Why rental property? Rents are sticky for the most part, and trend up and to the right.
Let me explain with some realistic numbers. Over two years, one of my rentals' saw rent go from $3,000 to $3,100 a month. That's not too impressive. However you have to compare the rental yield with what risk free rates have done in the same period.
5-year CD rates plummeted from 4.25% to around 2% during the same time frame. If you capitalize the rental value, you simply take $3,100 X 12 months = $37,200 divided by 0.02% = $1,860,000.
In other words, if I had no mortgage and no expenses, at a 2% cap rate, my rental property is suddenly worth $1,860,000 from under $1,000,000 when rates were at 4%.
When 5-year CD rates were yielding 4.25%, the $37,200 annual stream of rental income was worth only $885,714. Another way to look at it is this. In a low interest rate environment, you'd need to have $1,865,000 in a 5-year CD yielding 2% to generate $37,200 in income. The importance here is cash flow and opportunity cost.
Increasing Inflationary Environment
When inflation, and therefore interest rates, start ticking up there's a commensurate uptick in rent and property valuation as well. Inflation is only bad if you don't have real assets.
If you have zero real assets and just cash, the stuff you buy is inflating higher in prices while your dollar loses its buying power, thereby hurting you. In an inflationary environment, your rental property increases in value by definition, often times by a rate much quicker than the Consumer Price Index as we saw in the bubble!
As a landlord who has a mortgage, the large part of your costs are fixed due to a fixed rate mortgage. Your insurance, property tax, and maintenance costs will creep higher. However, these costs generally account for no more than 25% of total costs.
Inflation Puts Upward Pressure On Rents
Why rental property? During an inflationary environment, there is upward pricing pressure on rents. As a result, you simply follow the market higher. Raise the rent to a level the market can bear.
Back to our example of capitalization rates. You might be asking, “Isn't it bad if cap rates go up, since your underlying value goes down in the example of 2% to 4%?”
Yes, it's bad from a balance sheet perspective, but from a cash flow perspective, you are loving it. With rental property, your #1 concern is cash flow generation. Only when it's time to sell your asset, do you care about the underlying value.
Since we are in an inflationary environment, your responsibility as a landlord is to raise your rent accordingly. You must be vigilant every year in following the market, or else you will lose out on a relative basis.
In a 3%-4% inflationary environment, I will raise my rent by 3-4% per annum. For example, five years from now, my $3,100/month in rent will jump to $3,682/month if I increase the rent by 3.5% every year.
In order to calculate the capitalized value of my rent I simply take $3,682 X 12 = $44,184 divided by 4% = $1,104,600 as one means of valuing what the rental property is worth.
Zero Inflationary Environment
In the unlikely scenario of zero inflation, nothing really changes except that every month you are paying down your debt so that one day, you will own the rental property free and clear. You are using other people's money (OPM) to own an asset and other people's money to service the debt.
For the bank and the renter's troubles, you provide them a payment and shelter respectively in an exchange deemed fair by both parties.
Develop Multiple Asset Classes
There's no such thing as completely passive income with rental properties. You've got to work for everything for the most part. However, if you invest in real estate crowdfunding, you can really relax. Not only does the Sponsor handle maintenance and everything else, you can typically invest with as little as $1,000.
Rental property is a wonderful asset class to own during both the good economic times and the bad economic times. Here in San Francisco, rental prices were out of control with people queuing out the door during the Internet Bubble.
Companies where hiring like mad. Property prices were also screaming higher, thereby pushing more people to rent at the margin. Then the Internet Bubble burst. The people who could no longer afford to own had to rent, thereby stabilizing rental prices from decreasing.
Cash is nothing more than a medium of exchange. And stocks are pieces of nothing that lay claim to a company's stream of profits. Why rental property? Because it's a powerful real asset class. Buy real assets. Ten years later, you'll be happy you did.
Recommendations
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Real estate is a key component of a diversified portfolio. Further, real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible.
For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you're looking for strictly investing income returns. Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It's free to look.
Updated for 2020 and beyond.
[…] those willing to take on the task of managing a property, real estate can be a powerful semi-passive income stream due to the combination of rental and […]
Why no consideration of the opportunity cost of your time spent managing the property? Otherwise you could spend it working for someone else and getting paid for it.
When you incorporate that opportunity cost, do you still do better than you would with, say, a 2X leveraged stock portfolio? I doubt it, at least for urban areas.
Getting a few rentals paid off is about the hrdest thing a persn can ever do.. but when you do it you will be in a different place fin’ly for the rest of your life.
My wife and I have 4 places we rent out. No loans on any of them. It took 20 years. For half the time we were having to cntribute a few hundred a month in addition tot he rentthat was coming in. When we first started we almost sold one of them, would have been te biggest mistake we ever made. $00 dollar rents have turned into 1,100 dollar rents ver time. And these properties are all in costly areas. But each is about the smallest in each eighborhood. We manage them ourselves. Never have any outside work done by anyone else. except the rare roto-rotor job and even then it os only when we are out of town and can’t do it ourselves. Anyone wo thinks fora second that they can “do” rentals without doing all repairs and “rentin out” themselves IMHO is deluding themselves. Yes… it’s a job. It’s a business not unlike owning a small farm or small business. It certainly isn’t a hands-free source of magic income. And not once have I ever run a credit check. My rule of thumb is: “…where do you work and how long have yu been there?”… I have had almost zero problems with this approach. Also… narried coupls are best. The originator of this site is 100% right in everything he(she?) says. I have no mortgages… …and I never will ever take loans on any of these houses)… …therefore I love the analysis that so many people never seem to “get”… of the idea that the worth of the rental property means nothing… (this is hard to believe or accept)… but it is 100% true. It is only gross rents minus yearly overhead that is important. Let the stock market nitwits all back on their ROI arguments. ie: I havea 525k house that generates only 1850/mo. I have a 24k house that generates 1,100. The 24k house was purchased 25 years ago. It is worth 250-300 now but it’s worth makes no absolutely no difference to us. Only it’s ability to generte rent is of any importance. This lesson is probably the most important and hardest to learn. Plus… the ability to pick renters. without the personality to do this step… and to be able to do plumbing-electrical-carpentry repairs by yourself…or with your kids and/or friends and the entire effort simply will not work. The very idea of property managers doing it for you is a huge mistake. Anyone who has tried know the pitfall; property managers run up repair costs and it turns out to be a huge mistake to think rentals can be operated this way. MY point: the recomendatons laid out here are right. Buying in good areas is very hard to do. But if you can… you will have a great hedge against inflation… and against poverty. Forever.
Steven, thanks for your thoughts. I agree with you. Once you have the rental property paid off, you will likely never be poor at the very least. I look back at the rental property I bought 10 years ago and am amazed at the cash flow.
I love our rental property and we are trying to buy another within the next year and half. It does take work but it can bring great profits and increase over time. When our tenant moves out in Sept, we plan to raise the rent since we have over the last year been fixing up the place. This should increase our income by 1.5%, not a lot but every bit helps.
Every little bit helps indeed, and you’ll wake up 10 years from now and be so happy you own your properties.
Hi Sam,
What you’ve written is a fantastic post which articulates my thoughts on rental properties perfectly. The millionaires around us all have an extensive property portfolio (residential, commercial, interstate, overseas). I have a cf+ property and can’t wait to buy another one hopefully next year.
I’d like to get into real estate investments potentially in the next year. My goal is to purchase my first home and get a roommate that will help pay the mortgage then trade up after 2 years.
I loved having rental real estate as a grad student. I got excited every year with the “loss” on the tax return, yet having my mortgage covered.
Sam, with interest rates low, and property values lowish, now is a great time to get into rental property. The one thing to underscore, which you stated very nicely, “there is no such thing as passive income.” If you get some bad tenants, have to make big time renovations, go vacant for a while, it is a a pain in the neck. Don’t get me started on “evictions.”
If you manage the property yourself, it can definitely be a headache to deal with that stuff. My advice is to hire a property manager. Let them deal with the daily headaches and just figure the added expense into your numbers when you’re making offers.
I would like to invest in some rental property now, but I feel like I don’t know enough about the true costs of owning rental property, and I don’t have enough cash flow to cover contigencies, like large repairs or vacancies. Maybe in a couple of years.
Don’t rush it for sure. Like having a kid!
That only applies on a very liquid and developed market. Look at most of European countries, like Portugal, where I live. The housing sector is highly leveraged, therefore dependent on the euribor rate. With rates going up and record unemployment rates, npl’s will go up as well. On the other hand, rentals are nowhere near acceptable levels. With the IMF Mou, rents will decline, inflation will go up, housing values will go down. So, investing in a buy-to-let only based on yield, thinking that with inflation comes a house appreciation… think twice! That’s not entirely true, times are different now!
I am not a real estate owner yet, and still not sure whether it is the right thing for me to do.
I definitely see the benefits in owning real estate, but in my area, and in my life, there are still too many variables. Firstly, real estate in my city is overpriced compared to other areas. It continues with not having the time to look after my real estate, and perhaps my greatest barrier is a sense of wanting to be free… who knows where I want to be in 2 or 3 years from now.
Perhaps investing in real estate focused funds/securities is a good alternative.
Forest, with the way you like to travel and enjoy your life, I would think twice about getting into more debt too. Your London flat must be up a handsome sum. Just be happy with that!
You’re so right. I’m itchin’ to do the rental property thing and just haven’t gotten my act together. Around here, the residential market is still priced to high to make sense (I’m not willing to buy a property that’s not cash-flow positive from day 1) and at some college campuses, I almost did a larger deal with a partner that fell through. Rents are spiking – because people aren’t buying homes! So, it’s naturally a great investment right now. Thanks for the motivation!
Ironic isn’t it that rentals win either way, unless there’s a massive and permanent economic collapse! Always buy in the best place possible. If I can be cash flow positive in 2 full years, I’ll consider it if I see future appreciation.
I don’t own real estate yet, but some day I would like to!
I think I would try to get a triplex or larger. I don’t think I would own more than a few units though, but who knows with money comes opportunity…
So I have to settle for purchasing REITs like NLY (Annaly), at least until I have enough money to buy some actual real estate…
Just curious, do you manage your properties or do you just use a management company to take care of your rental properties?
Don, frankly I wouldn’t do it if I were you. I’d rather just enjoy your liquidity, debt-freeness for the rest of your life!
I should write a follow up about investing in rentals before age 35 or something… b/c it requires work, and not something people in their 40s-70s want to deal with frankly!
Actually, I was thinking of going in with my kids. Now granted, my son is only 10… I think he would do a good job in that role since he does well with people. Maybe when he’s 16 or 18.
I’m not sure about my daughter though, I don’t think she would do well in that role, she’s brilliant but get emotional easy, but then again she’s only 7.
Good point though, at that point in time that I’m considering I would definitely be in that age range that you mention. I probably wouldn’t like to be approaching 50 and deal with the hassle.
Rental property is a great way to build significant wealth over the long term, but you can’t just jump into it without knowing what you’re doing. There are a lot of pitfalls and it’s not easy to get rid of a bad property once you have it.
One good rule of thumb I use to determine if a property will cash flow is the 1% rule. If the monthly gross rent is equal to 1% of the purchase price, you’re breaking even. If the monthly gross rent is equal to more than 1% of the purchase price, you’re starting to head into cash flowing territory.
This rule is by no means a substitute for full analysis when you’re making offers, but it will quickly help you determine if a listing you’re looking at on the MLS will potentially cash flow for you.
Why not just buy REITS in your porfolio. That would eliminate the risks and headaches of actually owning the property. Or am I missing something
Leverage, control, returns, not directly owning a physical asset. I can write about this more later.
Great post! Now is the time to buy a place to rent – the market favors buyers and more and more people are choosing to rent. I had a friend back in college who decided to buy a condo. His reasoning was that the mortgage was less than rent payments, and thus he would save money. Of course, being young and inexperienced with real estate, he ended up losing money – at first. After graduating, he started renting the property to other students and is now starting to see a really great profit. I think owning a rental is not only a great financial investment, it’s also an excellent learning experience for investors of all ages.
It definitely is a good learning experience, about an important asset class, the responsibilities of a landlord, running a business, and understanding taxes. Let’s just hope it’s not too expensive for too many folks!
Sam,
I loved the post! As for me I own 7 rentals. I don’t actually have a primary residence (still too expensive to buy in LA). I just got into RE investing over the past 2 years and since prices (in the right markets) are so great, I’m seeing and ROI Cash on cash 25-30%. Each of the propertys have a positive cash flow of about $450-500 after debt service/taxes, etc.
Too many people look at real estate from the entire value of the asset vs the cash invested in the asset. I can definately see how one could get burned though. I would say if anyone is truly interested in RE investing (buy and hold), cash reserves are the key. That being said, if you buy right, you can also generate a nice passive income. I currently recieve 2800-3100 in side income from the rentals. I use a Property manager in the market i buy in. So far it has worked out great, but who knows. I think once I can bring in 7K, I may quit my primary job and take over the mgmt part of the business.
Its funny, all my friends are hung up on buying a primary home. Some of them have saved for as long as 5 years to put a 60-80K down payment (crazy i know) only to take on a 3K mortgage. On the other hand, I live essentially rent free (tenants cash flow pays it for me).
Anyway, I think the media and wall street has done a great job of scaring people from RE. However, if you get educated, RE investments can far outpreform stocks, bonds, CDs, etc.
just my two cents!
Arthur
Wow, that’s a lot! Glad real estate will allow you to quit your day job and provide that steady income stream you need!
Where did you buy your property? I live in huntington beach, ca, and need some help.
youngandthrifty sounds a lot like me, but I haven’t even gotten around to buying a house for myself. We’ve been moving so much that it just hasn’t seemed prudent to buy, rental or otherwise. Hopefully when I graduate and settle down in a new job I won’t have student loans, there will still be bargains out there, and will have the flexibility to take advantage of them!
Pls don’t buy until you’ve got 30% of the house’s value in reserves saved up AND you know you will be there for at least 5 years, or hope to be! No rush!
I agree, its a part of real estate investment. Income from house rental is a good supplemental income that can help a lot to survive an economic crisis. However, you are right, finding the right tenant is important to be able to be successful with this kind of venture.
Math is a beautiful thing. Can’t refute. Always do your conservative calculations and just start. Investing in yourself is great too. Consider doing what is most imoortant to you first. I’ve been renting out for about 8 years now.
I’m a fan of real estate but haven’t gotten in on it (except for my principal residence, in which we will rent the basement out). My dad on the other hand, is a mini-real estate mogul and I see him enjoying his passive income for an apartment building, a few houses, and a few commercial properties- he acts as the property manager too so he gets to keep even more of it to himself. I wish I bought 30 years ago LOL.
Your dad is a smart man! Yes, I too wish I bought 30 years ago… but, that would mean I have 30 years left to live, so I’m fine with it!
I’ve done some work in property management. It definitely helps to have a cool head because when something breaks it generally needs to be addressed and fixed very quickly (ex. plumbing problems, broken furnace, garage door problems, etc). Finding honest, responsible tenants makes such a difference too.
I am with MC on this one…sounds cliche but it is about location. RE investment is not as good of an “investment” if the value of the underlying land does not appreciate. Structures deteriorate and will cost more to rebuild tomorrow than today and yesterday. Moreover, carrying costs which only creep up over time, and not necessarily under the creep up in rents either. RE is still a good “investment” for several reasons – cash flow, equity build up using OPM, tax benefits, leverage (I just took a LOC out at 2.5% and invested in a 9.5% instrument) and a prettier balance sheet. Whether one has to sacrifice the first few years into the deal is also location dependent. In jurisdictions where I invest, I generate positive cash flow from the time I buy the property. I can see however how/why one would be in a negative cash flow situation in places like California
Real estate is great as long as you can deal with systemic risk. It’s hard to minimize risk, and in many cases real estate investors incur higher risk, but with less risk-adjusted returns.
Much of the risk is, unfortunately, geographic. Look at Detroit. In it’s heyday it was a real estate dream. Property sold for reasonable prices due to its relative lack of “city sexiness” and midwest feel. Additionally, earnings for people without a specialization were strong, buoyed by manufacturing.
Then the manufacturing said, “see ya!” and the city went to garbage.
Obviously this is a rare case, but it does go to show how real estate is more than just basic finance in arbitraging the difference between cap rates and capital costs. Unfortunately, real estate doesn’t work so well with fixed-income models, either. Rents are rising tremendously, but home prices haven’t. Rates are falling, but home values aren’t rising.
At any rate, if you know the risks and feel comfortable, I think real estate is a great long-term vehicle for wealth generation. I wish there were a broad-based residential REIT, but unfortunately no one has made one yet. OPM doesn’t easily come into play with a REIT, but wealthy investors could potentially double up with margin at 2:1 with rates equal to Libor rates plus a point. Call money rates (currently 2 %) plus 50bp might be reasonable for $1M+ accounts.
Do you plan to start investing in physical real estate after you graduate JT?
Considering I’d invest in pretty much anything, absolutely. That said, real estate is generally an investment that works its way into your personal balance sheet.
Examine two investments: Direct investment in real estate, or purchase of public securities.
In purchasing real estate with leverage (I don’t know why you wouldn’t, that is the allure, after all) you increase your personal debt-to-equity ratio, as well as debt-to-income.
In purchasing securities, you purchase part of a company, which may be just as leveraged to any business (real estate even) without putting it on your balance sheet. Just as an example, you could buy a company for..say $200 a share that has $1000 in assets and $900 in liabilities for every share.
Both direct real estate investments and public securities have the same leverage…effectively 5:1 with 20% down on a home, or 5:1 in assets-to-stock price with the public securities.
The difference, though, is one of opportunity. There isn’t a possibility that an individual could acquire the capital they need if their personal balance sheet is weighted heavily toward debt. However, another person (all things being equal) who owns securities could still access capital for future investment as their DTI and DTE are still reasonable on a personal level, even while maintaining similar leverage.
This is why direct investment in real estate doesn’t really excite me all that much. Wall street is a numbers game; I can make sense of it, with better accuracy and leverage. I can’t do the same with real estate–there are far more variables to secularize from a single individual property, or even 10 properties.
Detroit is one city out of how many cities in the US? 55? That’s just using one extreme example. What if you used San Francisco like how the Samurai did? It would have been a different conclusion. Most property investors know that they need to diversify in terms of suburb location, cities and if you’re that successful, ultimately countries.
There will always be risks, it’s a matter of minimising the risks. It’s a shame that direct real estate doesn’t excite you because if done correctly, it really is one of the BEST investment asset that you can have in a diversified portfolio.
There’s nothing better than owning a positive cash flow property with rents that increases in line with inflation. You may understand Wall Street, but you will never beable to control Wall Street the way you can control a property that you own.
Detroit is an outlier, an extreme and not a great representation of the general US property market. Detroit’s population has supposedly been declining since the 1950s from 2 million to around 713,000. Why would an investor acquire a property portfolio in a city that has a declining population and less and less jobs? The driver of the demand for property is the population growth and the development that is in the area. In 30 to 40 years time, will properties in New York/San Francisco/Toronto/London and any other major cities fall or be up? As population increases, the demand will increase and you will be lucky if you can buy that same house in New York at today’s prices in 30 years time.
Our economy is very different from the US. Mining and primary agriculture is unfortunately the dominant driver of our economy and because of that, yes we are reliant on China and the world’s appetite for buying the manufactured stuff that’s exported from China (US and Europe particularly and that’s why China has been buying all your US bonds and are now contemplating buying European bonds). And Australia isn’t loving foreign hot money in that way. Foreign money has been loving our Australian dollar because our risk free interest rates are the highest in the world and while it’s hot, investors get double bang for their bucks (currency gains + higher interest returns). The personal debt level of Australians do bother me and that is a great point you make because households here are very (and over)leveraged.
Au contraire, I am invested into both, real estate and stocks. They are equally the riskiest asset classes to own. Quality stocks such as Johnson and Johnson, Coca Cola, Apple etc are great when bought directly. Not mananged funds, mutual funds or hedge funds where they charge a high MER only to not provide any alpha returns. The problem with Wall Street isn’t the stock market per se but the financial machinations, derivatives and all the creative crap that comes out of Wall Street. All the ‘experts’ who invested billions into Madoff’s ponzi funds. All the ‘expert’ ratings that were crap coming from the ratings agencies who were paid to shut their mouth and give AAA ratings, all the AAA mortgage securities that were sold off to pension funds around the world which were infact, highly risky sub prime loans, all the companies who were trying to outperform for shareholders so they borrowed millions and couldn’t refinance during the credit crunch and thus collapsed. When you invest in public companies, you are highly reliant on the ratings, the ‘experts’ and the analysts who write ‘buy’ or ‘sell’ recommendations, the accounting firms which audit those companies and qualify their reports or move ‘short term liabilities’ to the ‘long term liabilities’ section to hide their upcoming refinancing… these are uncontrollable factors that are out of our control.
Thus, a mix of property, shares and risk free investments will always triumph over a portfolio that is just one or the other. Anyhoo, just my 2c
I’ll have to agree with you on that one. That’s why all of us need to assess the level of risk that we’re comfortable with. After the financial crises and all the bad apples surfacing, I’ll always prefer to have a heavier weighting in direct property (plus the ability to leverage a lot more than in shares using OPM because our banks will accept a higher LVR for property than for shares).
Our markets are significantly different and if I were a US investor, I probably would stick to property in the major cities for fear of buying into a potential slum or not be enticed to buy one like youself. Right now, there have been heaps of property spruikers and new property funds(REITs) created so that Aussie investors can buy into the US property market- I can’t tell whether those funds will succeed or end in tears.
JT, whatever works for you – keep doing it. You’re right that we’re not going to agree because my mix of property + stocks works very well for me and I can’t imagine being able to sleep with having over a few hundred k’s in only one asset class. But you and I probably have different risk tolerance.
You might change your mind one day when you find yourself renting short term leases and constantly having to move your furniture around a few times (a/lease ended, b/rent spiked up, c/landlord won’t fix the problems, d/property got sold and owner wants to move in etc) … that’s what caused several friends and colleagues to contemplate buying :)
Anyway, I agree with you, it has been an interesting conversation and it’s been fun to discuss our different views.