One of the most frequent comments we hear from clients is that they’d like to have rental properties for passive income. What’s better than money that you don’t have to work for? And who wouldn’t want a steady stream of income in retirement?
While we agree that real estate does have a place in a diversified portfolio, we also think it is important to understand what is truly involved in owning rental properties. If you are considering going this route we encourage you to read on.
So many of our clients have mentioned to us their intention to have rental properties. They look at the current real estate market appreciation and assume that having a rental property will be easy income and the property will appreciate in value. But, here is what you can really expect-
1. The property may not generate the income you expect
2. It’s hard to get a return that is truly worth it
3. For many smaller investors this rental real estate becomes a large percentage of your portfolio, and gives you substantial exposure to one asset class-real estate which has high highs and low lows, and
4. Real estate is illiquid. You can’t sell it when you want to, unlike stocks or other investments that trade daily.
Ok, so let’s cover the first issue-Income. The idea of passive income is pretty attractive. The challenge is that it is often years before a rental property is cash flow positive. If you add up your mortgage, property taxes, maintenance, insurance, HOA fees, you will find that your rent needs to be quite a bit greater to turn a profit. You also need to consider that it’s not likely you’ll have the property rented 100% of the time, so that loss of rent needs to be factored in. Depending on your state, you may be subject to rent control even though your costs might increase.
Then there is the issue of being a landlord. Most of our clients work full time in professions unrelated to investment real estate. As a landlord you’ll be responsible for keeping the property rented and maintained, in addition to working your full time job. Don’t underestimate the amount of time and energy this will take. Hiring a management company can be expensive and eat into your profit, so your income would be even less if you choose to delegate the property management. Do you want to be fixing an overflowing toilet at midnight?
Next issue-Return. It’s not as easy to generate a decent, consistent return with rental real estate. In California it seems as though property values are always increasing. But is that really the case? Property values don’t always go up. In fact, as financial planners we use the annual return assumption of inflation when we project appreciation of residential property. At 2.35%, the current rate of inflation, your money is better invested in a diversified portfolio of low cost, liquid investments. If your goal is appreciation on the property, keep in mind that costs like broker commission will eat into any profit, as will lower occupancy.
Then there is the lack of diversification. Why would having a large amount of your wealth tied up in real estate not be a good thing? Because exposure to any one type of asset, in this case real estate, doesn’t provide diversification. Unlike your portfolio, which has different types of investments, having one holding in real estate exposes you to that one market. When the real estate market does poorly, your investment in real estate may perform poorly too. We call this the “putting your eggs in one basket” philosophy to investing. Consider this year, for example. In many states rent has been halted by governor order. If you are a landlord you still have expenses, and yet your renters have been given the right to stop rent payments. Evictions have also been halted in many states, which further complicates your ability to generate income as the landlord. If you diversify your investments over many different investment classes and assets, when one performs poorly, your entire portfolio is not impacted.
Lastly, there is the issue of liquidity. This is what we mean by your ability to buy or sell an investment when you want. Because you cant access real estate when you want it, you should be compensated for that illiquidity. Real estate professionals assume they should earn an extra 3-5% every year just to compensate for illiquidity. That is over and above the returns they hope to get from the income and appreciation of the real estate.
Rather than taking on an industry that for most of our clients is not their area of expertise, we encourage you to think through the pros and cons of active property management. We’d suggest delegating your hard earned money to a diversified portfolio managed by experts so that you can focus your time on living the life you want, and working in the space where you are truly knowledgeable.
Next month we’ll share the real life stories from an experienced financial planner who dabbled in rental properties for years on the East Coast. He most recently sold his last property. He shared with me some important lessons he learned during his tenure as a landlord. Check back on the blog for the valuable lessons he shared.
If you’d like to learn more about how WealthChoice helps female business owners generate the income they need to live the life they want, please reach out.
