The main reasons people purchase rental property – as well as any other asset – is to make money and build wealth over the long term. As with any other market, housing prices and demand for rental property can fluctuate up and down, depending on the real estate market cycle.
Residential rental properties come in all shapes and sizes. From single-family rental homes to condos and coops, townhouses and mobile homes, small multifamily properties with 2 to 4 units, fractional ownership shares of a home, crowdfunds and REITs.
That’s one of the best things about real estate. There’s literally something for everyone who wants to invest in rental property.
However, just because owning a rental property may sound like an attractive investment, investing in real estate may not be the right decision for everyone. Let’s take a look at some of the biggest pros and cons of owning a rental property today.
Key takeaways
- People invest in rental property for a number of reasons, such as to diversify an investment portfolio, generate rental income, and have more direct control over their investments.
- Potential drawbacks to owning a rental property include lack of liquidity, dealing with tenants, and deteriorating neighborhoods.
- Investors who understand the pros and cons of owning a rental property can better decide if investing in real estate is the right move.
10 pros of owning rental property
1. Diversification
One of the risks that investors can face is having all of their eggs in one basket, so to speak. Because it’s easy to purchase stocks and bonds online, people may end up over-weighted in traditional investments. Many investors use rental property as a strategy for diversifying their portfolios.
2. Less volatility
Volatility measures the amount of change in an asset price over a specific period of time. Most investors view low volatility as a good thing, because prices and financial performance is more predictable over the long term.
As a blog post from Roofstock earlier this year observed, single-family rentals (SFRs) have historically offered more attractive risk-adjusted returns than the S&P 500 and bonds, providing nearly identical returns to the stock market with far less volatility.
3. Direct control
People who own rental property directly have complete control over their investment. For example, landlords are free to choose the best tenants (provided all applicants are treated fairly), use the property as a short-term or long-term rental, and decide when and if the time is right to sell.
4. Rental income
The potential for recurring, monthly net income is another advantage to owning a rental property. Unlike the S&P 500 which has offered a dividend yield of 1.34% (September 2021), rental housing may offer significantly higher returns. Some of the rental properties listed for sale on the Roofstock Investment Property Marketplace offer annual returns of 5% or more.
5. Property appreciation
Home prices in the U.S. have historically increased over the long term. As the Federal Reserve reports, the median sale price of houses sold has increased by more than 52% over the past 15 years. However, during that time frame, home prices did go up and down. During the Global Financial Crisis of 2007 – 2009 housing prices dropped by about 20%, and declined by nearly 5% between Q4 2017 and Q2 2020.
6. Tax benefits
Many beginning real estate investors are pleasantly surprised to learn just how friendly the tax code in the U.S. is to real estate investors. Some of the biggest rental property tax benefits include:
- Operating expense deductions from gross rental income
- Capital improvements added to property cost basis and recovered through depreciation
- Depreciation expense used to reduce pre-tax net income
- Owner deductions such as traveling to the rental property and tuition for continuing education
- 20% pass-through tax deduction for qualified real estate investors
7. Financing options
Residential rental property is generally easy to finance. Loan programs for investment real estate include conventional mortgages from banks and savings and loans, conforming loans backed by Fannie Mae and Freddie Mac, private lenders who invest in real estate debt instead of equity, and money raised from real estate partnerships.
8. House hacking
House hacking is a popular rental property investing strategy for people who may not have enough money for a down payment to purchase a rental property.
Many investors begin their careers by renting out part of their primary residence and save all of the extra cash to raise capital or pay down the mortgage faster. Eventually, there’s enough money to put into a rental property or sufficient equity in a primary residence to do a cash-out refinance to raise money to directly purchase a rental home.
9. Exit strategies
Rental property owners have choices when the time comes to sell. People who own commercial property or even small apartment buildings end up selling to other investors. If the demand for the asset class is low (such as some office buildings or retail properties) buyers may be few and far between.
On the other hand, investors with single-family rental homes have the option of selling to another investor or to someone looking for a home to call their own. As the saying goes, people always need a place to live.
10. Tax deferred exchange
Taxes on rental property work a little bit differently than a primary residence. For example, people selling a primary residence can qualify to exclude up to $250,000 of the gain from taxable income, and up to $500,000 if married filing a joint return.
Investors who sell a rental property don’t receive a capital gain exclusion, and also have to pay tax on depreciation recapture. However, investors who choose to conduct a 1031 exchange by selling one rental property and buying another may indefinitely defer paying tax on capital gains and depreciation recapture.
10 cons of owning rental property
1. Capital and credit required
Most lenders offering loans for a rental property require a down payment of at least 25% of the purchase price.
In addition to a large down payment amount, borrowers can expect to pay a higher interest rate than with a primary residence, generally between 0.5% and 0.75% more. Investors are also expected to have a minimum credit score of 620 out of 850, and keep enough cash in reserve to cover up to 6 months of loan payments.
2. Tenants
Even with the best tenant screening process in place, it’s possible for a landlord to end up with a problem tenant. Some tenants can’t or won’t pay the rent on time, or break the lease by damaging the property or doing something illegal.
While collecting a tenant security deposit can help to reduce the risk, most states have laws that limit how large of a deposit a landlord can require from a tenant.
3. Landlord responsibilities
Some investors decide to self-manage a rental property. Others choose to hire a good local property manager to take care of day-to-day details like tenant communication, rent collection, coordinating repairs with vendors, and complying with landlord-tenant laws and fair housing laws.
Regardless of the option an investor might select, the fact is that the buck stops with the investor. Decisions still have to be made about issues such as when to make a costly capital repair (such as replacing the roof or the HVAC), or when and how to evict a tenant.
4. Property taxes
While there are plenty of things an investor can control with a rental property, two of the expenses that can be a challenge to predict are annual property taxes and the cost of insurance.
For example, taxes on property vary widely from state to state, and may significantly increase year over year due to the operating budget of the local government. In some states property taxes readjust each time a home is sold, a fact that some investors overlook when putting together a profit and loss pro forma before purchasing the property.
5. Constant maintenance
Rental property requires constant maintenance and repairs to keep the home habitable and maintain the property value. Although some investors use the 50% Rule to ball park the operating expenses of a rental property, maintenance costs will vary from month to month. In fact, it’s possible to have negative cash flow in a month where repair costs are unexpectedly high.
6. Neighborhood changes
The neighborhood a rental property is located in can change over time, which in turn affects the value of the property. As the CDC explains, when gentrification occurs, the transformation of neighborhoods goes from low value to high value.
Unfortunately, the opposite can occur as well. Signs that a neighborhood is beginning to decline may include rising property taxes, falling ratings for public facilities like schools and hospitals, and “For Rent” signs suddenly appearing everywhere.
7. Tax code changes
For the time being, the tax code is real estate investor friendly, and has been for quite some time. But that doesn’t mean that tax laws won’t change. For example, the current administration has proposed raising the top capital gains tax rate from 20% to 39.6% for people making more than $1 million a year.
8. Lack of liquidity
Even in today’s hottest real estate markets, homes can take 30 days or longer to sell. Investors who need to sell fast may end up selling a home for less than what the property is really worth. Depending on the property condition, a seller may also need to make a significant amount of repairs to find a buyer willing to pay a fair price.
9. Real estate market cycles
While home prices historically increase, the real estate market also moves through fairly predictable 18-year cycles, even if it doesn’t seem that way today. Since the late 1800s, real estate has cycled through phases of hypersupply, recession, recovery, and expansion. Investors buying for the short-term at the top of the market may find property values declining for several years before they begin to rise again.
10. Profit isn’t guaranteed
Owning a rental property isn’t a guaranteed way of making money. Home prices can go down, operating expenses can be much higher than expected, and it can take much longer than expected to find a qualified tenant willing to pay a fair rent.
