Q: What do you think about owning single-family rental properties vs. investing in the stock market?
A: I have seen some families do well with rental properties, but only by owning several properties over many years (if not decades). As rents increase, positive cash flow often occurs while the tenants’ mortgages are being paid. But math is hard, especially in the early years.
A client family inquired about renting a house they had moved out of. The house was worth about $400,000 and they had about $200,000 on the mortgage. Their monthly costs for the mortgage, property taxes and insurance were estimated at $3,000 a month and they felt they could rent the property for $3,500 a month. We also noted that the fact that they had a mortgage technically meant that less of their money was tied up, providing leverage for profit. However, leverage works both ways. A loss of a quarter of the home’s value would drop their equity by half.
I realized that owning this property and the time and work could pay off over many years, but that it wouldn’t really make money for them in the first few years. The only two ways to make money would be the building and equity with each mortgage payment, and the possibility that the house will increase in value.
On the cost side, we discussed that their equity of $200,000 sitting in the house had an opportunity cost-ie, it could be invested elsewhere and presumably make money there. Even if we look at a low expectations 3% return – that means $6,000 a year.
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They should also consider allowing the property to be vacant for a period of time and at least acknowledge the risk and cost of a “bad” tenant. The property will have scheduled/expected maintenance (hot water heater, A/C unit, roof, etc.) and unscheduled maintenance and repairs.
So, we discussed that they are investing in a highly illiquid product that also carries unseen risks (house prices can certainly decrease) for perhaps no net income for several years. Probably and hopefully the rents will increase enough in the coming years to produce net income while the mortgage balance will also decrease. We observed that most of our client families who chose to own one or two properties often remarked to us that it “wasn’t worth it.”
Residential real estate has historically appreciated roughly at the rate of historical inflation (two to three percent per year). The US stock market has historically appreciated at double this rate for the past 70 years, and is a truly “passive” investment.
I would conclude with the belief that rental property can be a good investment – but that it requires patience, time and work. The most successful real estate investors I have seen usually gradually acquire several (or many) properties over a period of years, and do not count on real estate price appreciation to provide most of their profits.
Steven Podnos is a fee-only financial planner in Central Florida. He can be reached at Steven@wealthcarellc.com and at www.WealthCareLLC.com.