By Micah Porter, CFA, CFP®
When most people discuss ideas for producing investment income, investing in rental property is - after bonds - among the first to come up. The idea of generating a steady stream of income from a tangible asset is attractive, particularly when the stock market is going through one of its periodic downturns. Additionally, time is on your side with real estate since mortgage payments are usually fixed while rents rise with inflation.
That said, there are potential pitfalls and it's important to understand the pluses and minuses of investing in rental property. If you have a specific property in mind, there are ways of determining the return you can expect on the home. However, there are a few issues to be aware of before even considering the investment. (For related reading, see: Top 10 Features of a Profitable Rental Property.)
Have a Good Estimate of Expenses
Aside from the mortgage, property tax and property management fee (if applicable), maintenance is likely to be your biggest expense. Make sure you have a good idea of what shape the property is in before you buy it and work up a list of likely expenses. A thorough inspection before you buy the property can be very helpful in identifying potential maintenance issues. Ideally, over time you’ll fund a reserve to cover maintenance expenses.
Set Realistic Expectations
Set realistic expectations with regards to rental rate and vacancies. Determine rental rates for similar properties in the area of the property you are considering purchasing. Additionally, build in time for vacancies as nearly every rental is vacant at some point. Understand the tax implications of real estate investing. The IRS is a stickler when it comes to taxing rental income. For most, it will be taxed as ordinary income so if you are in a high tax bracket, the after tax return on your property may be paltry. Worse, if the property is generating a loss, high-income earners may not actually be able to deduct that loss until the property is sold.
Finally, depreciation will reduce net income and taxes. But that depreciation is recaptured when you sell the property, driving up taxable gains when you sell. Tax rules on rental real estate can be complex. At the end of the day, after-tax return is what matters to investors. Make sure you understand how tax will impact rental income.
Do You Really Want to Be a Landlord?
Decide whether or not you want to be a landlord. Shares in IBM don’t call about a clogged toilet and a CD will never skip out on the rent. Rental real estate requires more work than traditional financial investments. A property manager can handle the day-to-day issues, but that comes with a cost. If you decide to use a property manager make sure you still get a sufficient return on your investment.
Direct investing in rental property can have a place in a diversified portfolio. However, it has some unique issues as an investment and understanding those issues is key to determining whether it should be part of your investment plan. (For more, see: The Complete Guide to Becoming a Landlord.)
This article was originally published on Investopedia.