Lately, investors have been scoring with single-family rentals (SFRs), with risk-adjusted annual return on investment averaging 8%, according to a recent report from The Real Deal.
Owning residential rental property can be a good way to generate extra income, diversify an investment portfolio, and build wealth and equity over the long term. However, despite these benefits, real estate investing may not be the best option for everyone.
In this article, we’ll review the pros and cons of investing in real estate, discuss where to find SFR homes, and share some key financial metrics used to analyze investment real estate.
Key takeaways
- Some of the pros of investing in real estate include recurring income, appreciation, tax benefits, and diversification.
- Real estate is historically a hedge against inflation, with home values traditionally increasing much faster than the consumer price index (CPI).
- Real estate is capital- and management-intensive, is illiquid, and requires time and effort to find the right property at the right price.
- Key metrics used to analyze real estate returns include net operating income (NOI), cash-on-cash return, and gross yield.
Pros of investing in real estate
Investing in real estate can take a lot of time and effort. But when everything is said and done, the hard work put into buying a rental property may create oversized rewards.
Here are some of the pros of investing in real estate:
1. Recurring income
Recurring income after the rent has been collected and all of the bills have been paid is one of the biggest benefits of investing in real estate. Rent growth for single-family homes increased by over 12% year over year (as of November 2021) as renters searched for detached rentals, often in lower-density areas.
2. Appreciation
Real estate historically appreciates when held as a buy-and-hold investment. According to the Federal Reserve, the median sales price of houses sold in the U.S. has increased by more than 238% over the past 20 years (Q4 2001 versus Q4 2021).
3. Tax benefits
Investment real estate offers numerous ways to reduce taxable net income. Common deductions on rental property include property management and leasing fees, maintenance and repairs, property taxes and insurance, mortgage interest, and owner expenses, such as travel and continuing education.
4. Depreciation
Depreciation is a noncash deduction that is also used to pretax income. Residential rental property can be depreciated over 27.5 years. For example, if a home is worth $110,000 excluding the lot value, the depreciation expense would be $4,000 per year.
5. 1031 exchange
Owners of investment real estate may use a Section 1031 exchange to defer the payment of capital gains tax when a property is sold for a profit. Each time one investment property is sold and replaced with another within a specific time period, the capital gains tax liability can be deferred over and over again.
6. Leverage with OPM
Using leverage to finance real estate with other people’s money (OPM) is an investment strategy used to control 100% of a rental property with a small down payment. For example, rather than paying $200K in cash for a single home, an investor may use that capital as a down payment for several cash-flowing rental properties.
7. Diversification
Investing in real estate is also a good way to diversify an investment portfolio beyond traditional stocks, bonds, and exchange-traded funds (ETFs). That’s because real estate generally has a low correlation with the overall stock market, which may help to protect an investor from wild price swings. In fact, over the past 25 years, single-family rental returns were nearly identical to stock returns, but with less volatility.
8. Potential inflation hedge
Real estate prices typically increase faster than the rate of inflation, while rental property owners are often able to pass through higher operating costs by increasing rent prices charged to tenants. Between 2001 and 2020, the rate of inflation totaled just over 41% while median home sales prices rose by about 238%.
Cons of investing in real estate
While there are numerous advantages to investing in real estate, there are also potential downsides to consider. Some of the cons of investing in real estate include:
1. Capital-intensive
Investing in real estate requires tying up large amounts of money for an extended period of time. In order to get the best interest rates and terms when financing a rental property, and to keep debt service low, investors typically make down payments of 25% or more.
2. Management-intensive
There are a lot of things to know about owning, operating, and managing rental property.
The many areas an investor needs to be knowledgeable about include determining fair market rent, negotiating a lease agreement, performing routine maintenance and repairs, conducting inspections, and following fair housing and landlord-tenant laws.
Those are just some of the reasons why many investors hire a local professional property manager to help them protect a real estate asset and keep things running smoothly.
3. Not liquid
Real estate is a long-term investment that cannot be quickly and easily sold. Even in a strong seller’s market, it can take 30 days or more to list a home, negotiate a deal, and close escrow. That’s why, before investing in real estate, it’s important to pay off high-interest debt and set up an emergency fund for personal expenses.
4. Takes time and effort
Investing in real estate requires a lot of time, effort, and knowledge. While many investors build a real estate team of trusted professionals, including property managers, real estate agents, contractors and maintenance workers, and mortgage brokers and attorneys, at the end of the day the buck still stops with the investor.
5. Liability risks
Rental property investors run the risk of being sued by a tenant, guest, or contractor who gets injured on the property. To mitigate potential liability, a real estate investor can purchase a landlord insurance policy and require tenants to buy a renters insurance policy, if allowed by local landlord-tenant laws.
Important real estate investing metrics to know
One of the biggest challenges of investing in real estate is knowing when to buy a property and when to take a pass.
The key real estate investing metrics to be aware of:
- Cash flow - the amount received after collecting all of the rent and paying all of the bills, including any mortgage payments.
- Cash-on-cash return - the amount of net cash received each year compared to the amount of money invested.
- Net operating income (NOI) - calculated by subtracting operating expenses (excluding any mortgage payments) from rental income collected.
- Cap rate - a percentage rate of return determined by dividing NOI by the property value or purchase price.
- Gross yield - the annual gross income (without any expense deductions) divided by the property purchase price or value.
- Total return - the dollar amount of total cash profit when a property is sold, including net operating cash flows, minus any outstanding mortgage balance.
Where to look for investment real estate
The options for investing in real estate are sometimes described as a box of chocolates. There are so many choices that it can be hard to know which one is going to taste the best or, in the case of investment real estate, be the most financially rewarding.
Options to consider include indirectly owning real estate through a real estate investment trust (REIT) or real estate crowdfund and directly owning real estate.
REIT
A REIT is a company that owns and operates real estate, which may include SFRs, apartment buildings, commercial properties, special-use investments like cold storage facilities, or a combination of property types.
REITs can be private or publicly-traded. Private REITs like Roofstock One are unregistered securities, meaning they are not traded on an exchange and have limited liquidity. Sales of private REITs are limited to accredited investors who meet certain salary or net worth requirements. Shares of publicly-traded REITs can be bought and sold on major exchanges, just like stock. By law, a REIT has to pass through the majority of its net income to shareholders, so there’s the potential for dividends if the REIT turns a profit.
REITs provide investors a fully passive opportunity to benefit from the economic performance of real estate. However, REIT shares don’t offer all of the benefits of directly owned real estate, such as tax deductions and the ability to defer paying capital gains tax with a 1031 exchange.
Real estate crowdfund
Crowdfunding companies raise money from a large pool of investors to develop, own, and operate different types of real estate. A crowdfund can offer the opportunity to take part in deals normally out of reach for the everyday investor, such as investing in a new home development or large apartment building.
However, unlike REITs and directly owning rental property, investors in a crowdfund may be required to lock up their capital for several years before selling, making a real estate crowdfund a very illiquid investment. Also, like private REITs, some crowdfunding deals are reserved for accredited investors.
Rental property
Directly owning rental property may be a good option for investors seeking recurring rental income, appreciation in asset value over the long term, and all of the tax benefits that real estate investors enjoy.
While it’s possible to find rental homes for sale from traditional listing services like the MLS and Zillow, investors looking for SFR property with a tenant already in place may find the Roofstock Marketplace to be the perfect choice.
Since 2016, buyers and sellers of SFR properties and small multifamily buildings have completed over $4 billion in transactions with Roofstock.
Final thoughts
There are a number of advantages to investing in real estate, including recurring income, appreciation in property value over the long term, and a wide variety of tax benefits. However, real estate is also capital- and management-intensive and can’t quickly be sold. Before investing in real estate, take the time to research the best real estate markets across the country for both long-term and short-term rental property investments.
