The Pros & Cons Of Owning Rental Property
The economics of buying rental property for current income and long-term capital appreciation have not been more favorable for a generation or more than they are right now, unless you were smart enough or contrary enough to buy at the bottom of the Great Recession of 2008. And the tax code is stacked in favor of real estate ownership even beyond home ownership.
Consider the Pros
• With mortgage interest rates in the range of 3.75% – 4.25%, you can lock in the biggest wedge of the cost pie at those low rates for 30 years.
• Even modest inflation means that you will be paying off current debt with future, cheaper dollars. Low fixed rate debt secured by real property is the best possible hedge against inflation, since the market value of your property and the rent you can charge can increase in concert with other prices at lease renewal time, while your major expenses can remain flat.
• Mortgage interest, insurance and all of the other expenses of maintaining a rental property are deductible against its income. (For more info, see Tax Deductions For Rental Property Owners.)
• If it’s a seasonal rental, you can use it yourself for two weeks without jeopardizing the deductibility of the expenses.
• Depreciation, the allowed deduction for wear and tear (3.64% of the building’s purchase price per year for 27.5 years) may even produce a nominal loss, which you can deduct against other income. In other words, you may achieve a net positive cash flow from the rental income less expenses and still have a net loss for tax purposes. But be aware that depreciation reduces the cost basis for purposes of calculating capital gains when you finally sell it. You can model all of this by preparing a pro-forma tax return with a tax preparation software package like TurboTax, as if you already owned. If you filed that way, start with your last tax return and enter the details of your prospective investment and your income and expense estimates.
• You can even treat a unit in your own home or on your own property – a garage apartment or mother-in-law apartment, for example – as a rental and lay off a share of the mortgage interest and other expenses against its income, thus reducing your overall cost of living.
• In a so-called 1031 Exchange, you can sell a rental property and invest in another of “like kind” without paying capital gains taxes.
So why wouldn’t you? Well, consider the cons
• The biggest caveat is that real estate is not liquid. Even in a hot seller’s market like New York City or San Francisco, it can easily take several months to complete a sale, and if your timing is driven by unexpected need or other exigencies, you may not get the best price, as in the housing market unpleasantness of 2006–2008 when median new house prices sank by about 30%.
• The interest and principal parts of your mortgage may be fixed, but there is no guarantee that taxes will not rise faster than you can increase rents, or that insurance premiums won’t spike, as they have in the wake of the 2012 Hurricane Sandy floods that inundated desirable shoreline property in New York and New Jersey, or that insurance claims in such cases will be fairly adjusted.
• Despite your due diligence in vetting prospective renters, if you wind up with a tenant from hell, one who is needy and demanding, pays late, won’t turn off the water, can’t change a light bulb, and whose friends, followers, children and pets leave a trail of destruction behind them, then the 3.64% per year depreciation allowance in the tax code seems sorely inadequate. (You can add a lease rider to the standard lease form spelling out rules about occupancy, pets, smoking, tenant insurance requirements, etc., but still….)
• Neighborhoods can change over three decades. With good research and some luck, your investment property will flourish amidst other well-maintained houses and apartments, and local amenities will actually improve so that your cash flow will steadily increase while your costs remain stable. But things happen. For example, municipalities can be capricious or corrupt and you might find some undesirable development impinging on your neighborhood. You should pay attention to local politics where you invest, just as you would where you live.
• The tax code may change by reducing or eliminating some or all of the tax benefits for home ownership.
• Landlordhood is not for everyone. You may feel squeamish about increasing rents. Your lefty friends may disapprove of it on principle, even if you are a good and reasonable kind of landlord. (It’s OK to be friends with your tenants, but friendship can easily be a drag on the rate at which you can raise rents. One Manhattan brownstone owner rented an apartment to old friends from the West Coast and wound up, 20 years later, with a rent that was half the fair market rent – after a period of especially high inflation in the 1970s. Her friends were better negotiators than she was.) (For tips on running a rental property, you may want to read Investopedia’s tutorial: The Complete Guide To Becoming A Landlord.)
• Minor repairs are most economical if you can do them yourself, but you may not have the time, tools or skills. Whether or not you are handy, find a local handyman (or woman) and be very good to them so they will be inclined to respond on an emergency basis.
The Bottom Line
The economics of rental property ownership may be compelling, but the return you can achieve must be much higher than you could earn in conservative investments such as bonds and dividend-paying blue chip investments because there are real risks, not the least of which is your own capacity to manage property and tenants. (To learn more, read Buying A Second Home To Rent: Dos and Don'ts.)