8-Minute Read
There is an appeal to directly owning real estate as an investment. Aside from the aesthetics of owning a tangible asset, some practical advantages include:
- Rental income can provide stability and potential protection against rising future costs.
- If a property grows in value, the gains can be deferred for tax purposes into the future until sold, and perhaps even further deferred through what they call like-kind exchanges.
- Tax laws allow favorable treatment on rental income as it can be offset with depreciation
- If chosen properly, real estate can improve the diversification of your portfolio, in some cases reducing your volatility for a given target return.
Even with all these advantages, you should exercise caution if you’re looking to jump into this space as an investor. This piece briefly explores the reasons why.
Considerations and Risks of Rental Real Estate
Labor
Real estate investors learn quickly that labor comes with the turf, pardon the pun. The cost of labor can come in the form of time or money. Time is needed to handle administrative duties, find tenants, collect rent, and handle maintenance issues. Even if you’re willing to do this work yourself, this time spent should still factor into your analysis.
Alternatively, you could hire a property manager and pay anywhere between 7 percent and 12 percent of your rental income. This is often a necessity for those owning properties out of state. The key point here is: Labor costs, in the form of time or money, may detract from your true expected return on a property. This is helpful to remember when comparing real estate to other investment opportunities that may be less time consuming.
Leverage
Most real estate investors use debt, a form of leverage, to acquire their properties. As real estate tends to be relatively expensive, this is often a necessity. But leverage produces a broader spectrum of investment outcomes than you might realize.
An example might help: Let’s say you acquired a property five years ago worth $500,000 with a 20 percent down payment ($100,000) while financing the remaining 80 percent ($400,000). Let’s also assume the property was cash flow neutral for the first year; that is the total rental income received exactly offset the operating expenses and debt costs. Next, we fast forward five years to the present day and assume you’re now looking to sell the property.
If the property appreciated at 5 percent per year, it would now be worth roughly $638,000. But you only committed $100,000 of your own capital. The use of leverage helped you gain an annualized return of around 23 percent! Notably this return is assumed to be before taxes and selling costs.
However, leverage can cut both ways. If instead the property declined in value at 5 percent per year, it would now be worth around $387,000. But the use of leverage magnified your losses in this case. You’d be left looking at annualized return of around minus 21 percent!
These figures above are based on an internal cash flow model, assuming (among other things) a 30-year mortgage note with a 4% interest rate that is paid off upon sale. The numerical results estimated above are meant only to show the power of leverage.
Negative Cash Flow (Potentially)
When analyzing a property, an investor needs to make an estimate of net operating income, or NOI. This is basically a measure of profitability that considers all expenses of operating a property. But it’s possible to have a positive NOI but still be left with negative cash flow. Why? One reason is the cost of debt servicing as noted in the previous section.
There’s another reason. Negative cash flow can arise from underestimating the true costs of owning real estate. Considerations for vacancies and reserves for replacements and repairs are a couple of areas that fit in this category. Underestimate these and you may have cash flow surprises later.
Why could negative cash flow be a problem? The investment could simply become a burden because you must use other resources to keep the property afloat. More money you are forced to contribute is money that could have been invested somewhere else, perhaps more productively. Some call that an opportunity cost.
On the other hand, negative cash flow on a rental property may not last forever. If you can at least keep a property occupied and demand rental income in line with the growth of your expenses, it’s possible for negative cash flow to eventually turn positive. This is aided by the fact that debt servicing costs tend to remain fixed with most mortgages.
Concentration Risk
A definition might help here because I’m not advocating against the power of focus! Concentration risk, in an investment context, is the risk of amplified losses that may occur if you have a large portion of your portfolio in a single investment.
Because real estate tends to be more costly, it’s difficult in practice to altogether avoid this risk. But you might mitigate the risk by building your real estate portfolio slowly with modest capital commitments in the beginning years and growing those commitments over time.
Any single rental property will have its own unique source of risk and return, as it is often tied to the economic activity of a specific geographic area. So, it could take a successful real estate investor years before a rental portfolio is diversified enough to meaningfully mitigate concentration risk.
A final consideration here is that the price of a property, even if it fluctuates, may not impact your ability to derive cash flow from the property. Building in conservative cash flow projections and sufficient cash reserves for each property can help tilt the odds in favor of having a long-term profitable experience that’s less dependent on the market value.
Legal Risk
Some people become real estate investors almost accidentally. They might have impulsively jumped on an opportunity, inherited a property, or converted a previous residence into a rental. Often in those situations, the property is titled directly in the owner’s name. That can present another risk.
If someone were to get injured on your property and file a lawsuit against you, it’s possible you could be exposing some of your other personal assets to a legal or liability risk.
The usual solutions here are to increase liability insurance or own a property within a separate legal entity structure. The latter is usually a limited liability company, or LLC. As an investor, you would just need to factor in the additional time, costs, and complexity of liability protection into your investment decision making process.
Additional Considerations in a COVID-19 World
Any investment can be subject to scrutiny when dealing with this current Coronavirus pandemic. But real estate investing has other considerations that go beyond financial. You should consider how you intend to deal with real people (tenants) who may face difficulty meeting their rental obligations.
My friend and colleague, Cynthia Meyer, devotes her own practice to helping people make good real estate decisions. I highly recommend her piece COVID-19 Impact: What’s Next for Landlords? In it she describes 20 changes rental property owners might expect during this time.
Cynthia also shared several tips to help you understand if you’re ready to handle direct real estate investments. At a minimum, they include:
- Having strong cash reserves to cover the down payment, potential rehabilitation and enough to cover a full year of the property’s expenses in the case of vacancy or non-payment of rent.
- Having the ability to simultaneously make enough contributions to your retirement accounts to stay on track for your broader financial goals.
- Having low (or no) credit card debt.
Comparing Rental Real Estate to Your Alternatives
The goal of listing all these considerations and risk factors for real estate is to help you set the right expectations.
Real estate tends to have one psychological advantage over most other investments in that you have something you can see and touch. It is often something that is also quite pretty (if maintained well). We might not stop personal preference and emotions from playing their parts in your investment decisions. But if you closely look at your alternatives before moving forward, it may help avoid regret down the road.
Let’s say in your personal investment accounts (e.g. 401k, IRAs, Brokerage), you were considering a portfolio of well diversified stocks, mutual funds and/or exchange traded funds (ETFs). Through your own analysis, or with the help of an advisor, let’s assume you determine that such a portfolio had a future expected annual return in the range of 7 to 9 percent.
Notably such a portfolio might have some type of real estate exposure itself, typically in the form for Real Estate Investment Trusts, or REITs. In some cases, investors gain real estate exposure through limited partnerships, or LPs. These can be good alternatives if you’re not ready to make an undiversified, illiquid investment in a single property.
If you were looking to complement the portfolio above with directly owned real estate, you may want to target a higher expected return in the range of 10 to 13 percent. This is only an example. It’s not so much about the absolute return number here but rather it’s the difference that really matters. That difference is also known as a risk premium. It comes down to asking this question: How can you, as a real estate investor, be compensated adequately for the additional risks that may not be present in a passively invested equity portfolio?
Answering that question in the right way for you is where the real work comes in, pardon the second pun. Hopefully, this piece may help you towards building a framework to find the answers that make sense for your own investment plan. If you’re still not sure if real estate is right for your portfolio, you may schedule a complimentary discovery call here.
If you have other comments or questions, feel free to drop me a line at: [email protected]
References
- https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
- https://www.investopedia.com/articles/investing/060815/how-rental-property-depreciation-works.asp
- https://www.investopedia.com/terms/n/noi.asp#:~:text=Net%20operating%20income%20(NOI)%20is,all%20reasonably%20necessary%20operating%20expenses.
- https://www.legalzoom.com/articles/forming-an-llc-for-real-estate-investments-pros-cons
- https://reallifeplanning.com/blog/covid-19-impact-whats-next-for-landlords
- https://www.investor.gov/introduction-investing/investing-basics/investment-products/real-estate-investment-trusts-reits
- https://www.investopedia.com/terms/r/realestatelimitedpartnership.asp#:~:text=A%20real%20estate%20limited%20partnership%20(RELP)%20is%20a%20group%20of,to%20the%20amount%20they%20contribute.
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