Rental Real Estate – Good Idea or Bad Idea?

Recently I had a conversation with a young family man who bought a new home and was thinking about renting out his current property instead of selling it. He said that he had heard that rentals in his area were in demand which was pushing up rents the owners received.

 

In the course of our conversation, it became evident that this young man was not aware of the many advantages of owning rental real estate. There are many advantages, here are just a few.

Advantages

In most situations, rental income exceeds property expenses. That additional income can be applied to other priorities important to you.

Expenses associated with the property are tax deductible and those deductions may reduce the amount of income taxes you pay. For instance, if rental expenses exceed income, you can take up to $25,000 in losses that can offset income from other sources such as wages or interest.

What expenses are deductible?

o       Virtually any expenses associated with the property is deductible including, but not limited to, mortgage interest, property tax, operating expenses, repairs or credit check on your prospective tenant.

o       One of the major expenses, however, that is a “paper expense”  (that is, there is no actual cash outlay) is Depreciation. When depreciation is added to the other expenses a paper loss is usually created. Here is our depreciation works.

On residential real estate, depreciation of the property is over 27.5 years. So take for example a property whose basis is $275,000. Divide the basis by 27.5 equal $10,000.  In this example, each year can depreciate $10k against rental income. Adding depreciation to expenses usually results in “paper loss.”
Appreciation
A symbiosis occurs with real estate – as the mortgage principal decreases with each mortgage payment, the property value increases. The symbiosis occurs on the sale of the property resulting in more cash out.

Take for instance a property that is bought for $300,000 with $100,000 down and $200,000 mortgage. Let's say over time the mortgage principal is down to $150,000 and the value appreciates to $350,000. If you sell that property for $350,000 and pay off the mortgage of $150,000, you now have a cash out of $200,000. Remember, only $100,000 was put down on the property and the sale, the cash return has doubled.

Is Now a Good Time to Invest in Real Estate?There is a wise saying in the investment world: Buy low, sell high.

 

The Reality? People inadvertently buy high and sell low. Why does that happen?

 

It happens because investing is counterintuitive. All investments go thru cycles – up, then down, then up, then down ... By the time the general public hears about a good investment, the market is usually accelerating and the inexperienced investor ends up buying at or near the high of the market.

 

When the investment's values fall, the inexperienced investor becomes concerned, which concern turns into panic, which panic causes the casual investor to sell low to stem further losses.

 

The astute investor looks for the undervalued opportunities, not what has been performing better than average so picks up the investments that others have sold at a loss and the cycle starts over.

 

How does that relate to today’s market?

Beginning about 15 years ago, real estate experienced above average appreciation in values. In the Chicago area, real estate averages appreciation of about 3% annually. During the first decade of the 21st century, many areas saw 10%, 20% and even as much as 30% or 40% in some places.

 

Then the market collapsed - big time!

 

Since then, the market has been rebounding, albeit slowly. This has created some tremendous buying opportunities  as many properties are still selling at below market values. Couple that with historically low mortgage rates creates ideal conditions for buying property.

When buying property, though, more than price needs to be considered.

 

Rental real estate can be a good idea – but  it is not for everyone.

If you are considering investing or converting real estate property, keep the following in mind:

o       You will be dealing with renters and all the headaches associated with renters (such as late rents, damage to property, or calls in the middle of the night). If you have no desire to deal with renters than this option may not be for you unless you hire a property manager.

o       You should have enough savings to cover emergencies or major repairs/replacements. If you do not, you may have to use credit which creates more debt.

o       Buy what you can afford, not what you want.

o       There are tax implications on the sale of a rental property of which you should be aware.

Finally, not everyone is eligible to take advantage of  the tax benefits due to income limitations and other restrictions. However, losses are not lost. Unused losses carry forward into future years and can be used to offset income from that property, such as the capital gains on the sale of the property.

 

If you are considering investment real estate, work with a qualified financial planner who can perform the number crunching and provide guidance so that you make informed - and smart  - decisions.

This topic is elaborated on in my book "Money Matters Made Simple: A Woman's Guide to Financial Health and Wealth." To purchase a copy or for a sneak peek, visit www.MoneyMattersMadeSimple.com

For more information on Anne, visit www.anneschwab.net.