Is Buying a Rental Property a Good Investment?

I get asked this question all the time. And even more often, I give my unsolicited opinion to anyone who mentions it. The short answer is that it can be, but most often it wouldn’t be for the people who are asking. Let’s dig into why.

Passive Income

First off, I want to shatter the fantasy of “passive income”. I detest this phrase because people misuse it so often. I consider income like savings account interest to be “passive income”. You put your money in a savings account, it sits there while you wait, and at some point the bank deposits interest into your account. That’s passive.

Let’s pretend that instead you purchased a rental property with your cash instead of sticking it in a savings account. In order for it to generate income, you have to find a tenant to pay you. How are you going to do that? Do you market the property? Post on Craigslist? Now you have people who are interested - how do you make sure they are going to pay you? Have them fill out an application? Run a credit check?

Your tenant moves in. You are waiting to get paid. And the water heater breaks. Now you can’t just sit there and wait to be paid. You have to find a plumber to install a new water heater and pay for it.

You get paid for a while, but then your tenant loses their job and stops paying you. Now you need to hire a lawyer to get them out. If you’re in CA like I am, this takes time and money. Maybe while you’re trying to evict them, they trash your property. Then not only do you have to start all over again with finding a new tenant, you have to pay to fix your property up. And in the meantime, the property taxes and insurance payments are due. Ugh.

You get my point? You see how this is not the definition of “passive”? Can you hire a management company and an attorney to make it more passive for you as the owner? Definitely. Will that take some of your income? Definitely.

Ok, so we agree the income is not passive, but is it worth it? This is where we have to start talking about other aspects of investing you need to consider.

Market Risk

Despite what many people think, real estate doesn’t just increase in value over time. I’m still traumatized by the condo I bought in 2008 right before the market crashed. I lived in it for 3 years, then I rented it at a loss for 5 years, and then I sold it in 2016, and STILL didn’t get what I paid for it in 2008.

Am I an especially poor real estate investor? Maybe. But this is my point about buying a rental property. You aren’t an expert. You don’t have the capital and research of expert investors. You don’t know what you’re doing any more than I did.

My point is that the market is uncertain. Is this true with a lot of investments? Yes. This means that the investment should be compensating you for the risk you’re taking. So the rental property should be paying you more return than the savings account.

Leverage

So as if comparing returns isn’t complicated enough when you have cash to buy a property, and you feel good about the market, let’s discuss what happens if you don’t have the cash. You decide to borrow money to purchase the rental property.

There are two ways leverage can impact the return of your investment.

First, leverage costs money. If you’re getting a mortgage to buy the property, you’re paying interest. There goes part of your income generated from the rental property. In today’s higher interest rate environments compared to the last 10 years, this is especially true.

Second, leverage amplifies risk. Let me explain how this works. If you purchase a $500,000 rental property with cash, and the value goes down by 5% to $475,000, your investment is down 5%. Instead, if you purchased ten properties with a 10% downpayment and $450,000 mortgages, your investment is still $500,000. When the value goes down to $475,000 on your properties, however, your investment is down 50% instead of 5%!!!! The same drop of 5% in the value of your properties led to a loss on paper of $250,000!

Concentration/Diversification

Was it better to have invested in one property for $500,000 cash, or 10 properties for 10% down with mortgages? Depends. Maybe instead of all of the properties decreasing in value, one is now worth $725,000. All of a sudden, your 50% loss due to leverage is breakeven because of diversification.

One topic I stress with clients looking to invest is to make sure that they aren’t concentrated too much in one investment. I preach about diversification because investing in many assets with different profiles can mitigate risk. Putting all of your proverbial eggs into one rental property basket opens you up to the possibility that one bad tenant, in one bad property, in one bad neighborhood, in one bad location can really turn your investment into a bad one.

Liquidity

Let’s go back to the savings account example. If all of a sudden you need the money in your savings account, you can take it out. What happens if you need money and all your funds are tied up in real estate?

Real estate is illiquid. It takes time and money to turn it into cash again to get your investment back. If you’re in or nearing retirement, you often need to spend part of your investment assets in addition to the income they generate. You can’t just sell part of your rental property if you need more cash. This is another risk people don’t often consider.

In the end, will you earn more investment return from this property than you would by sticking it in your savings account (or investing in something else)? You can see how it’s hard to know going into it. You have to consider your market risk, any leverage you plan on using, how concentrated or diversified your investments are, and what kind of liquidity you need.

That’s why it’s hard to know if it’s a good investment just because it produces income. I always ask “compared to what?”.