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Owning Rental Properties Might Not Be As Great An Idea As It Seems

It seems like a way to make easy money:  Own a property, rent it out, collect the cash. What could be better?

Turns out, owning a rental property might not be your best choice if you’re looking to add to your income. Rental properties often sound good, but moving ahead with purchasing one might not be sound advice. Here are four reasons why you might not come out ahead if you buy a rental property as an investment.


Diversifying Your Investments Is A Better Choice

Putting all of your eggs in one basket – in this case, one specific property – can be as risky as investing in one individual stock. Most likely, you won’t outperform the market unless you’re a real estate professional with an informational advantage, or you’re committed to devoting lots of time, energy, and money into finding the ideal property.

Minimizing the risk of real estate investments requires diversification to generate a higher long-term return. Why? Because it’s difficult to know when a specific type of property or a real estate strategy will lose its appeal – and its value. In contrast, a real estate index fund, which is comprised of many Real Estate Investment Trusts (REITs), offers diversification among multiple properties. But even diversifying your real estate may not be the best solution. To maximize your long-term, risk-adjusted return, you need to diversity across types of investments or asset classes. Real estate alone is not enough when it comes to increasing your chances of realizing substantial returns.

Photo: Waxman

Don’t Expect A Compelling Return

Buying an investment property isn’t the same as buying a home. It’s a fact that not all homes values appreciate, which is acceptable as long as you enjoy where you live and you’re not looking to make money off of your home. But if you have an investment property that doesn’t appreciate, you could be looking at money going down the drain.

Oftentimes it’s difficult to charge enough rent to offset the cost of carrying the property, not to mention the real estate broker commission, which means that generating a compelling return on an investment property requires significant appreciation of that property. As an example, assume you charge a rent of $2,000 on a $500,000 property, and you increase that rent by 2% per year to adjust for inflation. If the property appreciates at 3% per year, it would be worth $580,000 if you sold it after five years. After deducting a 6% real estate commission, the compounded return on your equity investment would be just 4.1%, assuming that your rental property was occupied for all five years, if you’re lucky. The lower the occupancy rate, the lower your return. 


Rental Income Isn’t Always Guaranteed

You can close the door on this myth:  Real estate is an investment that always guarantees additional income.


In reality, most real estate investments (especially residential properties) don’t generate steady, positive cash flow for a significant period of time. And that means you’ll need to fund losses for those years when you’re not making extra money from renting out your property.

Say you bought a house or condo for $500,000 and financed it with a $400,000, 30-year mortgage at a rate of 3.8% with no points. Your monthly payment would be $1,864, and your monthly real estate taxes would be at least $400. After factoring in monthly upkeep and insurance, you would need to charge $3,000 in rent to just break even. Additionally, if your rental property is a condo, you’d need to add in homeowner association (HOA) fees, which would take another bite out of your rental income.


Liquidity Is Unpredictable

Most likely won’t be able to sell your property immediately, if and when you finally decide you want to unload it. It’s often difficult to predict how long – or even if – a residential property will sell. As a general rule, institutional investors believe they should earn 3% to 5% annually on their investment to justify having their money tied up; attaining that level of return is extremely difficult to do in the real estate market.

Rental property investing is best taken on when it’s limited to 10% of your liquid net worth, and when you can consider it more or less “play money” that allows you to dabble in the real estate market. But if you own a property that doesn’t bring in more rent than the costs you’re carrying, you might want to consider putting it on the market and looking into a portfolio of low-cost index funds.