The demand for single-family rental property is soaring, with occupancy rates the highest they’ve been in more than 25 years and rent growth reaching record highs. If you’re like a lot of people today, you may be wondering if you should buy a rental property.
While there are numerous potential benefits to owning a rental property, the truth is that what’s right for one investor may be wrong for another. If you’re considering investing in real estate, keep reading to learn 5 reasons why you should and 5 reasons you should not buy a rental property.
Key takeaways
- Reasons for buying a rental property include income potential, tax benefits, and appreciation in property value over the long term.
- On the other hand, people who expect to get rich quick, think income and expenses will never change, or can’t afford to tie money up probably shouldn’t buy a rental property.
- One thing investors should do before deciding whether to buy or not to buy is to put in the time and effort to research the market and make the right choice for them.
Is rental property a good investment?
Rental property may be a good investment, depending on an investor’s objectives and time horizon. Because real estate markets typically move through cycles, investors who buy and hold rental property as a long term investment may be able to generate high returns on investment.
Some of the main reasons why rental property can be a good investment include:
- The potential to earn income after tenant rent has been collected and operating expenses have been paid.
- The potential for long-term appreciation, with the median sales price of homes in the U.S. having historically increased over time.
- The opportunity for tax benefits, such as deductions for operating expenses, mortgage interest, property taxes, and depreciation reducing pre-tax net income.
- An asset with the potential to hedge inflation.
- Use of leverage to potentially increase returns.
5 reasons you should buy a rental property
Investing in a rental property, or any other asset for that matter, is an individual choice that every investor makes. Let’s begin by looking at some of the main reasons why you may wish to consider buying a rental property:
1. Rental income
Ongoing income from renters is arguably the number one reason why many investors choose to invest in real estate. Although having a positive cash flow every month isn’t guaranteed, rental property can generate significant annual yields.
2. Property value appreciation
Home prices in the U.S. have historically increased in value, although there are also periods of declines. For example, as the Federal Reserve reports, the median sales price of houses sold in the U.S. has increased by more than 64% over the past decade. In other words, an investor may be able to make a profit by purchasing and maintaining a rental property over the long term.
3. Tax benefits
The tax benefits available to owners of real estate provide another reason for buying rental property. The Internal Revenue Code is friendly to investment property owners, with tax-deductible expenses such as:
- Property management and leasing fees
- Maintenance and repairs
- Property taxes and mortgage interest
- Depreciation to reduce taxable net income
- Owner deductions such as travel expenses and continuing education
- 1031 exchanges to defer paying capital gains tax
4. Inflation hedge
Rental property also acts as a hedge against inflation, when rent prices and home values increase faster than the annual rate of inflation. Here’s how the math works.
According to the U.S. Bureau of Labor Statistics, the 12-month percentage change in the Consumer Price Index (CPI) is 5.3%. However, even though prices are going up, home prices and rents are rising even faster.
Zillow notes that the value of a typical middle price tier home in the U.S. increased by 17.7% over the past year (through August 31, 2021). Rents have risen nearly as much. As the Q2 2021 Single-Family Rental Investment Trends Report from Arbor Realty Trust, Inc. reveals, vacant-to-occupied rent growth has accelerated to 12.7%, setting a record high.
The difference between the reported CPI and the double-digit increase in home values and rent prices is the inflation hedge that rental property owners receive.
5. Use of leverage
Financing the purchase of a rental property using other people’s money (OPM) is another reason for buying rental properties. The cash-on-cash return formula illustrates how real estate investors can use leverage to boost returns on a rental property.
Assume that a rental property worth $100,000 generates an annual rental income of $12,000 and operating expenses are $5,000, for a net operating income (NOI) or pre-tax cash flow of $7,000.
If an investor finances the rental property using a 25% down payment ($25,000 down), the mortgage principal and interest expense would run about $4,200 per year for a net cash flow of $2,800 ($7,000 NOI - $4,200 debt service).
At first glance, paying all cash appears to be the best choice, because the NOI is higher. However, by calculating cash-on-cash return, an investor using leverage may receive a higher return:
- Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
The cash-on-cash return without the use of leverage is:
- $7,000 annual pre-tax cash flow / $100,000 purchase price total cash invested = 7%
The cash-on-cash return using a down payment and financing the remaining purchase price is:
- $2,800 annual pre-tax cash flow / $25,000 down payment = 11.2%
By using other people’s money, the investor receives a return that’s 60% higher than paying for a rental property using all cash.
5 reasons why you shouldn’t buy a rental property
Of course, there are some potential drawbacks to owning a rental property as well. To be fair and balanced, here are several reasons why some people shouldn’t buy a rental property:
1. Requires large amount of capital
A big down payment is one of the main reasons people think that they shouldn't buy a rental property. Most lenders require 25% down on an investment property, so if a property costs $100,0000 the down payment would be $25,000 (excluding closing costs, impound accounts, and cash reserves).
However, they say that where there’s a will there’s a way. Potential sources to get money for a down payment on a rental property include getting a loan from friends and family, asking the seller for assistance, and tapping into a retirement account.
2. Get rich quick
Do an internet search using the phrase “How to get rich quick in real estate” and 87.5 million results pop up in 0.71 seconds. Unfortunately, in the real world, getting rich with real estate requires a lot of education, effort, and time, and doesn’t happen overnight. As Robert Kiyosaki says, “Financial freedom is available to those who learn about it and work for it.”
3. Lack of liquidity
Another reason some people shouldn’t buy a rental property is because real estate lacks liquidity. Unlike stocks and bonds that can be bought and sold using sites like Robinhood and Charles Schwab in real-time, it can take a month or more to sell a rental property.
So, if you’re not sure you can leave money tied up in real estate for several years, it may not be a good idea to buy a rental property.
4. Dealing with tenants
Tenants can be a pain in the you-know-what, even if you hire a good local property manager. Neighbors can complain to the local zoning department, a greasy stove can catch on fire, and some tenants simply can’t (or won’t) pay the rent, even with the best process to screen tenants.
As a rental property owner, the buck stops with you. Fortunately, the profile of a single-family housing renter is much different than those in the apartment market, and in a good way.
According to a recent feature from GlobeSt.com, single-family renters (SFRs) have a higher education than apartment renters, and often rent rather than own by choice instead of necessity. SFRs want a home-feel without the burden of owning a home, and are more likely to renew their lease instead of moving every year.
5. Taxes can increase
Buying a good rental property and hiring a great local property manager can help to keep rental income high and operating expenses reasonable. However, one of the biggest variables that is difficult to control is property taxes on a rental property.
Investors who think that income and expenses will always stay the same should think twice about buying a rental property, because nothing moves in a straight line.
The good news is that there are some things investors do to help reduce the risk of rising taxes, such as buying a rental property in a state with property and income taxes in mind. Some sunbelt states, such as Arizona, Alabama, and Florida have low property tax rates and low or no state income tax rates.
Closing thoughts
There are other reasons you should – or should not – buy a rental property as well.
Owning a rental property can be a good way to diversify an investment portfolio away from traditional stocks and bonds, and building a portfolio of cash flowing rental properties can be a good way to generate extra income.
On the other hand, the demand for rental property in an area can go down if the neighborhood starts to decline or hundreds of brand new homes hit the market. Before deciding whether you should or shouldn’t buy a rental property, be sure to put in the time and effort to research the real estate market and understand which choice is right for you.
