One of the questions I’m often asked is if a client should buy rental real estate as an investment. As with most investments, the answer is “it depends”.
There’s no question that buying and holding real estate can be a great way to accumulate and build wealth over time. Many fortunes have been built using this very method. People like real estate because unlike stocks, it’s tangible. They can go walk it, visit it, and they understand it.
Real estate also allows the wise use of leverage or debt. While leverage cuts both ways, you can control an asset worth perhaps hundreds of thousands of dollars while investing a fraction of that cash as a down payment.
So is owning a rental property right for me?
First, do you like the idea? That sounds funny, but for some the thought of dealing with tenants or property managers bothers them. And it’s understandable. You may be able to successfully delegate your duties as an owner to a manager, but there will come a day when you have to take matters into your own hands – if even on a temporary basis.
Are you prepared for this? It doesn’t mean you need to be a handy or know how to fix things but you may need to manage people and have a real understanding of what things cost.
What type of real estate should I own?
In general, there are two types of real estate investments. Commercial and residential. Each has its benefits and drawbacks.
If you buy a small office, medical, or commercial building, you will generally be dealing with business people who work during the day. I’ve found them easier to deal with. They’re professionals who understand business; they pay on time and don’t complain much.
They can sign long term leases, which may bring a sense of security and steady cash flow for many years. This low turnover is attractive and can make owning commercial real estate a breeze in the good times. And you generally don’t have toilets, showers, appliances and noise to deal with.
The drawback is that commercial vacancies can be difficult to fill. When a tenant leaves, your property may sit vacant for months before you find another tenant.
In the case of large spaces, the market for tenants who have a business that requires 8,000 square feet of commercial space and can afford $10,000 a month in rent is limited.
Likewise, with the advent of the home office, your small office space may stay vacant for a long time because small businesses can set up home offices, store data online, and may not need a real office.
This vacant space can create cash flow problems when you’re on the hook for loan payments on the building and rely heavily on the income
Lastly, the loans available on commercial property are often more challenging. They tend to renew more often and require that you produce tax returns on an annual basis. Commercial loans may also float with interest rates making it more difficult to lock in permanent long term financing.
In fact, permanent long term financing for commercial real estate sometimes isn’t available at all. In this situation, your rate will adjust frequently and will likely be more costly. It’s not like locking in a 30 year mortgage where it’s set and you forget it.
Bottom line. It’s often best to consider investing in commercial real estate for the first time only if you’re an owner tenant (51% or more) and need the space for your own business while leasing extra space to others. Owner occupied commercial financing is easier to obtain and typically has more favorable terms.
Residential property, like owning one or more rental houses or a multifamily property, can work out well. There always seems to be a need for good rental housing and it’s unlikely your property will sit vacant for long. You can always reduce the rent and have it occupied in a month or two at most.
The drawback is you have more issues because you have showers, plumbing, appliances, people, and noise to deal with. And, you may have more problems collecting rents.
Know your Market
Yes, you may say you will run credit checks and choose only the best tenants. But remember, people often rent because they can’t buy houses. Either due to credit problems, lack of income, down payments or other resources.
So by only shooting for the very cream of the crop tenants, you’re eliminating a large part of your market. Many won’t qualify and your property may sit empty. This doesn’t mean you shouldn’t do your homework, but you’ll find that a lot of the people submitting applications to rent your property have dings on their credit and you may need to loosen your standards.
One check that landlords often overlook is a criminal background check. I’ve found this to be equally or more important than financial checks.
I once had an applicant who was very anxious to rent and wanted to pay his first month and deposit in cash. His income was adequate and he seemed like a good guy. The only problem was a criminal background check revealed he had been arrested multiple times for battery and gun violence in other states.
The other problem you will have is likely higher turnover, meaning carpets will need cleaning, painting will need to be done, and flooring may need to be cleaned or replaced. It’s all part of the cost of doing business.
Can you delegate all of this to a manager?
Yes, but. Trust but verify. Why? Managers who collect other people’s money (yours) have an easier time spending it than you would.
The idea of delegating all of your problems and responsibilities to a property manager for a fee sounds like a great idea. And in some cases it is. The typical manager charges 10% of each rent collected. That may seem reasonable, but keep in mind that managers also make money on repairs.
Consider putting a limit on what managers can spend on repairs and maintenance without approval. For example, you might give them the OK to spend up to $200 for any repair and insist that they contact you first before going ahead with any work.
Price, Location, Income
When purchased at the right price, rental real estate can be a great investment. But pencil out your income and expenses to see how the income matches up with your expenses.
After you collect your income, will you have negative cash flow? In many parts of the country where housing is expensive, that’s a given.
Can you maintain this negative for a long time? Has the housing market in your area recently corrected or is it on an upswing? Do you have the financial resources to cover maintenance and a negative if your property sits empty for a few months? Is the property in a growing area where you can expect demand to increase? Or have jobs left the area and do things seem to be in decline?
Real estate has proven to be a great investment for many investors. But realize that you can’t rely on delegating all responsibilities to a manager and there will need to be some involvement on your part. It will take some work, but you can learn and get up to speed quickly.
The opinions voiced in this article are for general information purposes only. They are not intended to provide specific advice or recommendations for any individual, and do not constitute an endorsement by Sagepoint. Please remember that investment decisions should be based on an individual’s goals, time horizon and tolerance for risk.