Rental Real Estate Ownership
by Kristina K. Bolhouse, CPA/PFS, CFP®
We often get the question, “What do you think of rental real estate?”. It may come up in a client meeting if someone is thinking about diversifying their assets or they hear of someone who seems to be making a lot of money owning rental properties. More often than not, we learn about it after the fact—after a rental property has been purchased and it is added as an asset to the Net Worth statement.
The reason we often balk at the idea is because for the amount of risk assumed, we generally see very little return over a long period of time. Now I know there are exceptions to this rule. I know there are some sweet deals where someone may have a long-term, low maintenance tenant, with an easy to manage property that has outstanding cash flow. However, true return on a rental property, as with any investment, must be measured from date of purchase to date of disposal, with all related costs taken into account.
It is easy to fall for the deceptive attraction of rental real estate. Here is a simple example: Assume a $200,000 initial purchase, with a $50,000 down payment, and monthly cash flow of $2,000. Assume also there is a payment of $1200/month for mortgage and other expenses. With just those two facts, it appears on the surface there is an $800/month return on investment. That works out to about 19.2% annual return (cash flow divided by down payment) in this simplistic example, plus future appreciation on the property.
Where are the hidden costs?
Unfortunately, I have yet to meet anyone who can clearly tell me whether they are making money on their real estate investment. After the initial purchase, there tends to be on-going hidden costs. So here are some quick questions to ask before you or someone you love wants to jump in:
- Is an attorney needed? Should a legal entity own the real estate? How will it be titled? Who will draft/modify the lease agreements? How will I handle any legal disputes that may arise with a tenant?
- Is an accountant needed? How will I know how much I am making? Who will track income and expenses? What are the IRS record keeping requirements? How much more will my tax preparation cost?
- Is a property manager needed? Will they put my interests first? Or could I do it myself? Am I willing to screen tenants and deal with issues that arise if there are leaks, breaks, cracks, or safety issues that arise? If I pay a property manager, how much does that impact my return on investment?
- Who will handle repairs, lawn maintenance and plumbing issues? Will these costs be affordable with the number of properties I have? Or will I be paying a premium for services based on the number of properties I own?
- What happens when a tenant moves out? Will the cleaning fee cover major issues—such as carpeting that needs to be replaced, painting, and wear and tear? How do I determine normal wear vs. damage or theft to my property? What if I have trouble finding good tenants, or have issues with the property being vacant too long?
- Do I want to keep my property in top condition to attract the best tenants? Or do I want to spend the bare minimum so that I can keep my return on investment high? If I do the minimum, what is the impact on the property value long term?
- Should I have landlord insurance coverage? What is the cost?
- Should I require my tenants to have renters insurance?
- Could I be a target for a frivolous lawsuit based on my profession or some other reason?
This list is not all inclusive, but is intended to help in the decision on whether or not to dive into the rental real estate market. In speaking with those who have made a full time business of rental real estate, the key to success is VOLUME. That way, costs referenced above can be spread among many properties, and tracked carefully so that adjustments can be made to truly manage properties for the optimal return. As a general rule, casual ownership of rental real estate is a low return/high risk proposition.
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