Photo credit: Philip Taylor
We’ve all heard the mantra: “Location, location, location!” When buying investment property, a great location is often considered the #1 rule for success. But as we’ve all seen in that late night, drag-out game of Monopoly, location certainly isn’t the only factor at play.
A decade ago, we all learned more than we wanted to know about subprime mortgages. People were investing money they didn’t have using loans they should never have been given. The stage was set for the perfect storm. Home prices started falling, refinancing became difficult (especially with historically high debt-income ratios), and those previously attractive adjustable-rate mortgages began to reset at higher interest rates. Monthly payments rose dramatically and mortgage delinquencies soared. It’s the scenario that led to a shocking 3 Million foreclosures in 2009 followed by a complete overhaul of mortgage banking regulations. It took years for housing prices to climb back out of a deep, black hole—and even longer for people to recover financially and psychologically.
Prior to the housing crash, real estate had almost always been viewed as a solid investment, averaging over 6% for decades. Now that housing prices are on the rise, investors are once again turning their eyes toward rental properties. Many risk-averse investors gravitate to real estate as an attractive proposition. You can feel it. You can see it. You can drive by your property and know your investment is real. But is investing in property the right choice for you? The answer depends on one thing: the margins.
Many investors look at a basic equation, “money in and money out,” when calculating returns. It seems so simple. Purchase a $200k property that generates $1,300/month rent and earn $15,600 a year—it’s a risk free 8% return using borrowed money! But is it? There’s much more to the equation, and if you dive in and look at the details that deliver the actual margins and return, you may find your investment isn’t what it seems. Be sure you’re considering these key factors when calculating your actual profit margin:
- Maintenance & turnover costs. Of course, installing that new water heater costs more than just your time, and your renters may not be very forgiving of an overgrown lawn. Maintaining any property can be expensive, and costs can escalate even further when you experience turnover. Cleaning, marketing, and preparing your property for a new tenant adds up, and every day your property is vacant becomes another drain on your margin.
- Insurance & mortgage expenses. Insurance premiums for rental properties can run over 20% more than a typical homeowners policy, and additional liability insurance may be required. Also consider that mortgage rates are higher for second (and third and fourth) homes, and require a 20%+ down payment. Creative techniques to use personal lines of credit can be used to mortgage the property, but that means tying up your available credit that may be needed as an emergency fund during leaner times.
- Liquidity. Speaking of liquidity, you pay a steep price for being able to ‘touch’ your property. While it may not be a tangible expense, real estate’s lack of liquidity creates costs when you need cash and timing is an issue. In most cases, completing a sale and seeing any cash in your pocket can take several months, which can force you to borrow money to cover expenses. And borrowing may be difficult if you’ve tied up your credit line with property.
- Weighting. Many clients ask me, “How much should I invest in property?” Unless you’re building a career in real estate, an age-old rule of thumb is that your net worth should be spread evenly across three areas, with 33% of your equity in each: 1) real estate, 2) partnering with the great companies (i.e., owning equity), and 3) lending to great companies (i.e., owning bonds). And yes, your home must be included in this equation!
- Estate & legal complexity. Have you seen what lawyers charge these days? As a landlord, you’ll need legal help to understand your rights, draft rental and operating agreements, choose which type of entity should own your properties, etc. If a tenant needs to be evicted or if you have a dispute, legal fees can skyrocket. Plus, estate planning for real estate can get complicated (and expensive) quickly with an LLC or partnership.
- Capital gains & depreciation. It’s not uncommon for CPAs to recommend investment property to minimize taxes, but in reality, when the time comes to cash in your chips and sell that property for college or that summer home you’ve dreamed about for years, all depreciation is essentially recaptured by your diminished basis—and subtracted from your “earnings” and any return on investment. Capital gains tax ranges from 15% to 20%, so they’re an important part of your real margin. Postponing capital gains is simply robbing Peter to pay Paul…and it all comes around in the end. (Think you’re exempt? If you haven’t lived at a property for at least two of the previous five years, you’ll lose the capital gains tax exemption, which allows individual filers to keep $250,000 of profit from the sale tax-free.)
- Tax complexity. It sounds great: write off expenses through the property to avoid Self Employment tax on your income. If you carry a loss, now you have stepped into Passive Loss Land. Income exclusions limits, at risk rules, passive activity limits, etc. Don’t forget property tax! All of this complexity eats up your valuable time, increases your expenses, and reduces your margins.
- Compensation for your own hours worked. Here are a couple of questions for you: How much do you make an hour? Is your money working for you, or did you “buy” another job? For example, if you’re earning $150K annually working 40 hours a week (with a few weeks vacation thrown in), you’re making about $78/hour before benefits. It’s not uncommon for property owners to spend several hours a week managing everything from rent collection to fixing water heaters to dealing with vacancies and rental applications. Of course, if you’re paying someone else to manage your property, be sure to subtract management fees from your margin, and include your true hours worked in the equation as well.
So is buying investment property a wise idea? Is it the best way to build wealth? Is rental property really ‘risk averse’? Only if you can be certain that “sure bet” doesn’t turn into a financial drain that steals your precious time, overweights your net worth with investments that lack liquidity, and adds too much complexity to your finances. If you’re not willing to do your homework and consider these important factors, don’t expect location to save a poorly planned use of your life savings. Even Park Place won’t win the game if your margins aren’t in line with your costs.