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Looking for a safe place to put your investment money? Real estate is renowned as a smart choice—but when you decide to sock away cash in the housing sector, you still need to hedge those bets and do your due diligence.
Just as with every type of investment, real estate has its ups, downs, and unique challenges, and it’s vital that you understand both sides of the fence before committing your hard-earned dollar in that direction.
“There can (also) be a lot of cons—if you don’t invest the right way you can have a very large outflow with no return.”
Let’s dig into the pros and cons of investing in real estate so that you better understand the:
- Level of patience real estate investing requires in order to reap returns
- Various tax benefits of investing in real estate
- Challenges of property management and tenant screening
- How real estate provides the opportunity for passive income
Then, we’ll walk you through the best practices for making your real estate investment successful.
Pro: Real estate increases in value over time.
On average single-family rental homes, which are collectively an estimated $2.3 billion, generate yearly returns of around 9%, according to 2018 research by Andrea Eisfeldt of UCLA’s Anderson School of Management and Andrew Demers of Stamford, Conn.-based Structured Portfolio Management.
That makes single-family rental investments “almost as potentially lucrative as stocks and considerably more so than bonds, deposit accounts and other conservative instruments,” according to a USA Today report.
Real estate is an asset that appreciates, gaining value over the long term. As you can see from the St. Louis Federal Reserve graph below, sales prices for U.S. homes has been on a continual rise for decades.
“It’s a secondary stream of income for lots of agents,” Friesen said, “so it’s a thing that’s easily accessible for us to try to supplement what we do sales-wise in real estate.”
Con: Real estate investing isn’t a “get rich quick” endeavor and requires a lot of maintenance.
That profit doesn’t come without a cost: in this case, the time commitment it takes to be a responsible landlord if you choose to go that route.
“The last (property) we renovated took us six months,” Friesen said. “We spent 40 to 50 hours at that house painting and making repairs on our own.”
Moreover, that time commitment also means being available around the clock—if a tenant’s water heater blows, it can’t wait until you as the landlord return from vacation.
If you’re thinking of flipping homes, consider this: it’s not cheap. In fact, flipping is a high-cost business—a kitchen upgrade alone can run you anywhere from $35,000 to $60,000. In addition, 2018 saw a crash in the flipping industry, with returns dropping to an almost-four-year low.
Pro: Uncle Sam likes to give real estate investors tax benefits on their profits.
Generally speaking the government wants a piece of any “capital gains” (aka profit) you make from selling off assets like stocks, bonds or property. Although the capital gains tax exclusion that applies to personal residences does not carry over to investment properties, Uncle Sam does have a few special tax vehicles just for investors, such as the 1031 exchange.
A 1031 exchange allows investors to sell productive-use properties (meaning property you make money from, like apartments, rental homes, land, or office space) and buy another like-kind property (another investment property) while deferring payment of capital gains taxes.
“This can obviously be a benefit to investors—deferring your tax payments,” said Friesen, adding that real estate investment can also drive retirement savings.
There are multiple tax benefits to owning investment properties, including breaks on interest, repairs, depreciation, and personal property. The Tax Cuts and Jobs Act of 2017 has brought fresh opportunity for investors and property purchasers with a 100% first-year bonus depreciation deduction that will be in force until 2022.
Con: The tax advantages don’t necessarily apply to all real estate investors.
Failing to know one’s tax laws can be a major detriment when it comes to the real estate investment game. “This is why we always have an accountant on hand,” Friesen said. “Some of these tax benefits—at certain income levels, they don’t even work for you any more, if you make over a (certain) amount of dollars per year… It’s not anything you can claim on your taxes. You just have to eat that loss. There’s different levels of what’s good for investing.”
Before you assume you qualify for any breaks, consult with a tax professional.
Pro: Owning property allows for the laziest type of income: passive.
Monthly rent payments are a major plus of owning investment properties: “If you buy properties the right way and rent them out for an appropriate amount, you can have supplemental monthly cash flow,” Friesen said.
In August, the National Council of Real Estate Investment Fiduciaries found that returns for institutional real estate had hit their highest peak in more than two years, with the average quarterly return over the past five years at 9.85% annualized.
Con: Property management is not without its challenges.
Cash flow can be substantially reduced by a tenant that leaves the property in poor condition. “I own several rentals,” Friesen said. “If you have a poor tenant in there who doesn’t take care of the property, it really can become more of a money pit than a benefit. We have one who just moved out after two years; I think the total cash flow was $300 per month. Nothing to speak of. There was $15,000 worth of damage when he moved out.”
Pro: Technology has made the tenant-selection process more streamlined and accurate.
“The last one we rented took us a whole 24 hours,” Friesen said. “Not a big deal, whereas before we would have had to run it through our own (personnel). As technology advances, some of that stuff is getting easier.”
28% of rental-property applicants studied had a criminal hit on their record, according to TransUnion data and The Harvard Joint Center for Housing Studies and Pew Research. Online screening makes finding such information simpler and more accurate.
Such resources include:
- My Smart Move, a partnership with credit agency TransUnion that allows potential renters to apply online and then lets landlords check backgrounds and credit
- Tenant Background Search, which lets landlords check prospective renters’ backgrounds and credit
- My Rental, which also includes eviction histories of potential tenants
Con: There’s still no perfect system for screening your tenants.
Unfortunately, technology is still not where it needs to be in order to prevent potential renter fraud.
According to a November TransUnion and Forrester Consulting report, nearly all property managers struggle with tenant screening fraud due to multiple factors:
- Today’s technology is somewhat manual, not fully automated
- Established solutions still lack advanced capabilities for detecting fraud.
The report indicates that fraud detection requires a more sophisticated technological approach: “Today’s market dynamics and sophisticated fraudsters mandate a fraud technology solution,” the report reads. “And property management decision makers from this study agree.”
The report: “Misunderstanding and Inconsistency: The State of Fraud in the Rental Housing Industry,” indicates that technology must continue to advance in order to nip such activities in the bud.
Pro: Property management companies are available to help allay the burden of managing rentals.
Research from the inaugural Rental Property Owners Survey conducted by property management solution All Property Management indicates that the majority of landlords use property management firms to outsource attendant managerial burdens such as maintenance as well as finding and retaining quality tenants.
51% of surveyed owners said they had already retained a management firm, with another 24% indicating that they planned to do so. Good communication was the main reason cited by landlords for retaining property-management firms.
Con: The most trustworthy property manager is still you.
Friesen believes that landlords themselves can—and will—take better care of their own properties than management firms.
“There are very few that will take care of a property as I would take care of it myself,” she said. “I want my properties to be in a condition where it would take no more than 60 days to get ready (for lease). They just don’t care about them the way you do. There are a few that do a great job. But they’re collecting that 10% of the rent every month.”
How can I make my real estate investment successful?
Now that you’ve had the opportunity to consider some of the advantages and challenges of investing in property, it’s time to think about how to make the most out of that commitment. Here are a few suggestions for doing just that:
1. Monitor real estate market conditions
You have to understand the playing field before you can expect to win. Forbes Real Estate Council members offer six indications of a changing market:
- Days on market and new construction: How long does it take to sell a property? How much competition is out there?
- Pricing history and absorption: Are prices dropping, rising, or remaining steady? Are units selling?
- Inventory levels: Are there low levels, indicating a price increase, or high levels indicating the opposite?
- Supply and demand: How are these market fundamentals looking? Are they in balance or out of whack?
- Sales and price changes: Are downward sales trends dampening prices?
- Limited inventory and higher prices: Are prices on the rise and inventory limited? Or is it the inverse?
- Choose smart financing options.
With home values continuing to climb as of November—and interest rates remaining historically low—you as an investor are in an interesting place. Bankrate, an objective and independent resource for financial content, has a few tips for nailing down the right financing for your needs:
2. Make a large down payment
Traditional financing typically requires 20%. Mashvisor, a data source providing analysis to real estate investors since 2014, lists three reasons this is necessary: lower monthly payments, avoiding mortgage insurance, and lower interest rates.
3. Check your credit score before applying
Strong borrowers usually have a score of 740 or better.
4. Give the major banks a wide berth
Neighborhood institutions have local knowledge and often better rates as well.
5. Think outside the box
If you’ve got a good prospect, consider getting a home equity line of credit or a personal loan to lock down the deal.
6. Make sure you’ve got the cash to proceed
According to Investopedia, a trusted source for money-management issues since 1999, startup costs include:
- At least 20% of the property purchase price as a down payment
- Closing costs of approximately $5,000
- Any additional funds to get the property in rentable condition
7. Keep your expectations reasonable
For example, Friesen warns that while property flipping was big a few years back, it’s not nearly so profitable as it once was. “If you go over budget and can’t even sell it for what the agent thought you could, you have a problem,” she said. “You just lost money to make a house pretty. It can be scary. That’s why you don’t have a whole lot of investors who do that.”
Ultimately, the decision to make a real estate investment comes down to your individual situation. Before you make a move, check in with yourself—and your financial advisor—to make sure this is a freight you can carry.