Are Rental Properties Worth Investing in? Pros, Cons, and Expert Tips

Owning a rental property can be financially rewarding. There are tax benefits to consider, such as deducting insurance costs, mortgage interest, and maintenance costs. But there are also drawbacks to be aware of, including market fluctuations, maintenance costs, and tenant challenges. Prospective investors should weigh these factors before committing to ensure positive outcomes.

If you’re exploring this type of real estate as an investment, be aware of the risks and responsibilities. Calculating potential returns against conservative investments is crucial.

Understanding the Fundamentals of Rental Properties

The idea of buying a home or apartment to rent out for profit may sound alluring. However, buying a rental property for income and long-term capital appreciation can have its ups and downs. For example, the housing market can fluctuate depending on location, supply and demand, and the economy.

To make a rental property truly profitable, your returns should surpass those of conservative investments like bonds and dividend-paying blue-chip stocks, due to the involved risks. Additionally, not everyone can manage property and tenants effectively.

Benefits of Investing in Rental Properties

There are several benefits to owning a rental property. They include:

Tax Benefits

The Internal Revenue Service allows you to deduct many expenses connected with rental property in the categories of:

Improvements must generally be capitalized and recovered over time. Owners may deduct insurance, mortgage interest, maintenance/repair costs, and depreciation for rental property, subject to IRS limitations.

Depreciation may create a rental tax loss that may be deductible against other income if the taxpayer qualifies under the applicable loss-limitation rules. This means you could have positive cash flow from rent even with a net tax loss. But be aware that depreciation also reduces the cost basis of a property for calculating capital gains when you sell it.

In addition, the 2017 Tax Cuts and Jobs Act offers a number of tax benefits for landlords. Sole proprietorships, partnerships, S corporations, and LLCs taxed as disregarded entities, partnerships, or S corporations can operate as flow-through businesses. If you own a flow-through entity (also known as a pass-through business) and operate it as a sole proprietorship, limited liability company, partnership, or S corporation, you may deduct an amount equal to 20% of your net rental income, subject to Section 199A limits. Your total taxable annual income from all sources after deductions must be less than $250,000 for singles or $500,000 for married couples who file jointly.

Seasonal Rentals

If you rent your property seasonally, you may use it yourself for 14 days per year—or 10% of the number of days that you rent to others at a fair market price—and still be able to deduct your expenses. If personal use is not more than the greater of 14 days or 10% of fair-rental days, rental-use expenses may still be deductible, subject to allocation and loss-limitation rules.

1031 Exchange

A qualifying Section 1031 exchange can defer recognition of gain when investment/business real property is exchanged for like-kind real property.

Renting Extra Space

If you rent part of your home, you generally allocate and deduct the rental-use share of mortgage interest and other qualifying expenses, subject to IRS and local rules. Be aware of potential pitfalls like local zoning rules.

Drawbacks of Owning Rental Properties

There are also drawbacks to owning a rental property. They include:

Lack of Liquidity

Direct real estate is generally less liquid than publicly traded securities. Even in the hottest market, it can easily take several months to complete a sale. And if your timing is driven by an emergency or other unexpected event, your need to sell fast might not garner the best price.

Rising Taxes and Insurance Premiums

The interest and principal of your mortgage may be fixed, but there is no guarantee that taxes will not rise faster than you can increase rents. Insurance premiums can increase after natural disasters such as hurricanes.

Difficult Tenants

Despite your due diligence in vetting prospective renters, you could wind up with tenants who are not ideal. They might be demanding, pay late, or forget to turn off the water, and more. Or they could be destructive, in which case the depreciation allowance in the tax code may be sorely inadequate.

A lawful lease rider or addendum can be used to spell out additional rules such as occupancy, pet, smoking, and insurance requirements, subject to applicable state/local law. A security deposit can also be helpful here.

Neighborhood Decline

Ideally, your property will thrive among well-maintained homes as local amenities improve, leading to increased cash flow and stable costs. However, neighborhoods can change, and your investment could depreciate over time. You should pay attention to the local politics where you invest, just as you would where you live. With some due diligence, you can minimize this exposure.

Unfavorable Changes to Tax Code

The tax code is not immune to change. It could change in ways that would either reduce or eliminate some or all of the tax benefits for homeownership and flow-through businesses.

Landlord Role

Being a landlord is not for everyone. You might hesitate to raise rents or be too protective of your property, leading to conflicts. You may even become friends with your tenants, or they may already be family or friends. If you cannot be firm about rent increases or property care, for example, you could wind up collecting rent that is well below market price or with an undervalued property.

Upkeep

When maintaining a property, minor and major repairs arise. Some owners can save money doing repairs themselves, but many lack the time, tools, or skills for it. Expect to shell out periodic contractor fees.

Is a Rental Property Worth It?

Rental properties are worth the investment if they are planned for and handled correctly. There are several considerations for would-be rental property investors that might help them decide if it is worth the time, effort, and money:

• Rental properties are not assets you can purchase and leave to grow with the market; they must be nurtured with maintenance and concern for those living there.
• You should have enough capital held in reserve to maintain the property.
• You’ll need to be able to ask and collect enough rent to cover and recoup your operating (recurring) and capital (maintenance) expenses.
• Your time frame is important. Broad U.S. home-price and stock indexes have historically fluctuated, but they trend upward over long periods. The rise in market value creates upgradeability or lower-cost loans for more property.

Potential Income From Rental Properties

There are many factors that go into generating income on a rental property. A single rental can net you a few thousand per year, which can increase with the more units you own and rent. Your income depends on mortgage, down payment, monthly payments, insurance, maintenance, operating expenses, cash flow, rental growth, and property appreciation.

For example, imagine the following scenario—you acquire a two-family, four-bedroom, two-bathroom duplex for $250,000. You put about 20.6% down ($51,500) and have a 7.5% interest rate on a loan with a term of 30 years and closing costs of about 3% of the loan amount. Other costs can include, but are not limited to:

• Property taxes: 1.5%, $3,750 annually
• Insurance: $1,000 annually (would realistically be higher)
• Vacancy reserve: 5%, $2,400 annually (would realistically be higher)
• Capital expenditures: $4,560 annually (est.)
• Loan payment: About $1,400 monthly ($16,800 annually)
• Management fees: $380 monthly ($4,560 annually), depending on rates in your area

If tenants pay their utilities, your operating costs will be about $2,756 per month, or $33,070 yearly.

You decide to try to earn about $500 monthly, so you set the rent at $1,650 per unit. This results in $39,600 annually and an annual cash flow of about $6,530 ($39,600 – $33,070).

Assuming no extra expenses arose and not counting appreciation or other factors, it would take 7.9 years (7.9 years x $6,530 = $51,550) to recoup your down payment and begin profiting from your venture. You could experiment with the rent so you could have more cash flow, build your reserves, or try to generate some income, but the higher the rent, the less attractive the units are to prospective tenants.

Expert Tips for Successful Rental Property Investments

Several tips circulate in investing circles regarding real estate that can give you a place to start. Here are some of the more popular ones:

• Assess your finances first and determine whether you can afford the expenses
• The 2% rule states that monthly rent should be at least 2% of the property’s purchase price.
• Network with other real estate investors to open opportunities for buying and selling
• It might cost you more to evict a bad tenant than to keep them—vacancies are costly
• Screen your tenants carefully
• Overestimate expenses and underestimate income
• It might be years before you can become profitable or make a living from multiple properties

Key Considerations for Rental Property Investors

Whether you are buying a primary home or a rental property, it is important to consider what’s happening with mortgage interest rates. Low fixed-rate mortgage debt is generally a good hedge against inflation. Landlords may be able to use periodic rent increases to help offset inflationary upkeep costs.

Mortgage rates vary depending on many circumstances, especially on the state of the economy and the inflation rate. While a low-rate environment might present an opportunity, it is also important to remember that mortgage rates are typically higher for investment properties than for traditional homes.

The Bottom Line

Rental properties can be financially rewarding and offer tax benefits, but they’re investments that require involvement and commitment. Proper planning and management can make rental properties a worthwhile investment, but you’ll deal with challenges like a lack of liquidity and dealing with tenants. Staying current with market conditions and interest rates is crucial.

Rental properties come with several risks that should be considered before making any investment, so you might want to consider speaking with a financial advisor or tax professional familiar with real estate investing before making any investment. Achieving profitability may take time and requires a well-thought-out strategy and commitment.