Investing in real estate by purchasing rental properties can be a smart way to balance your portfolio, hedge against inflation and build long-term wealth.
Investing in real estate by purchasing rental properties can be a smart way to balance your portfolio, hedge against inflation and build long-term wealth. Not everyone is cut out to be a landlord, though — but even if you feel you’re not landlord material, you can get the same portfolio benefits by investing in real estate indirectly through a private loan fund or a real estate investment trust. Here are five questions to help determine if investing directly in real estate is right for you.
1. Do you have 20% down payment and 5% to cover repairs and unexpected expenses?
Buying a rental property takes a much bigger down payment than buying a personal residence. Most lenders want at least 20% down, even if the property will generate enough income to pay the mortgage plus expenses like property taxes and hazard insurance. Having another 5% set aside to cover repairs and big-ticket expenses, such as replacing a roof or an HVAC system, may keep you from having to dip into personal funds to pay for unexpected problems.
2. How will you handle renters who don’t pay and the possibility of evicting tenants?
At some point, almost every landlord has to deal with tenants who stop paying rent. Eviction is a financial decision with emotional underpinnings. When tenants don’t pay rent, you still have to pay the mortgage, the property taxes, the water bill and all the other holding costs. But sometimes, nonpaying tenants are families with children or have unexpected circumstances like a serious illness or accident occur, leaving them unable to pay rent. If it’s too emotionally taxing to handle the eviction yourself, you can hire an attorney to represent you in court and movers to remove the tenants’ possessions from the property. Before becoming a landlord, you should know that the possibility of evicting a tenant might become a reality.
3. How do you feel about other people using your stuff?
Landlords hold security deposits because damage happens. Carpets get stained, hardwood floors get scratched and there is a fair amount of general wear and tear that should be expected in and on your property. As long as the cost to repair damages doesn’t exceed the security deposit, there shouldn’t be an issue. The real question becomes, what happens when the cost of repairs required exceed the security deposit? How will you confront your tenant to address these issues? If contemplating this (somewhat common) scenario is stressful, becoming a landlord may not be an optimal option for you.
4. Can you wait at least 15 years for your investment to pay off?
Real estate is a long-term investment for a couple of reasons. First, the transaction costs are high. Real estate sales commissions, state and local transfer taxes, appraisals and settlement costs all reduce your resale profit. Second, the length of your mortgage dictates the monthly payment. The longer your keep your mortgage, the lower the monthly payment.
When buying a property, landlords typically choose a mortgage payment that can be covered by the monthly rent, plus expenses. When rents are relatively high compared to home prices, you might squeak by with a 15-year mortgage. In a market where rents and home prices are balanced, the monthly payment that best matches the rent price is typically tied to a 30-year mortgage. Both factors make investing in rental properties a long-term play.
5. What’s your risk tolerance?
All investments carry some level of risk, meaning how likely you are to lose your entire investment or even owe more than you invested. Real estate falls in the midpoint of the risk range. It’s less risky than commodities futures but more risky than investing in Treasury bills.
There are property owners whose home values still haven’t recovered from the real estate crisis a decade ago. And when property values fall, rents can fall, too. When rents fall, you can find yourself having to pay out of pocket to cover the monthly mortgage and expenses on your rental property. If the thought of declining property values will cause you to lose sleep, owning real estate as an investment may not be for you.
Purchasing a rental property with a mortgage timed to pay off before you retire can create a steady retirement income stream that rises with inflation. However, direct investment in real estate investment is unlike the other investments in your portfolio because it’s not a buy-it-and-forget-it proposition. It requires hands-on management of tenants, repairs and ongoing expenses. If becoming a landlord doesn’t seem like the best fit for you but you still wish to incorporate real estate in your investment portfolio, private loan funds and real estate investment trusts may be alternatives to investigate. With either option, investing in real estate can balance your portfolio and help you build wealth.