Thinking of an Investment Property?
After a market decline like we saw in March, we will get asked the following question by at least one client:
What are your thoughts on rental real estate?
The amygdala in our human brain tells us to run away from fear, so as we see our account value go down, the biological response is to look for something safe. A lot of people have the misconception that a rental property is a “safe” investment. While it can help diversify the portfolio, there are several things you should consider.
- Landlord: You remember Mr. Stanley Roper from Three’s Company? Well it doesn’t always work out so well! Do you have the mechanical skills to fix the plumbing problem? Do you want to be responsible for the broken heater at 2 am? If the answers are no, then you are going to need a management company to take care of the property and this will drastically eat into your profits.
- Stable Investment: We regularly hear that rental real estate “doesn’t fluctuate in value.” While you may not be able to look the price up every second (like you can your stocks), the truth is the value is what a willing buyer and seller will agree on. So, in reality your price is moving up and down just as much as a stock without you seeing it daily.
- Tax Impacts: Most people who own rental real estate know of the good current tax benefits that rentals provide. However, many are surprised to learn about a concept called depreciation recapture. When a rental property is sold, the IRS will not only tax the gain on your investment, but they will also charge you a 25% tax on any amount of depreciation you have claimed. Nearly everyone claims depreciation to decrease the taxes they must pay on their monthly income. So ensure you keep good tax records and be prepared to pay a big tax bill upon sale.
- Quick Cash: If you find that you require quick cash, a rental property could be difficult, costly, or nearly impossible to convert to cash. You have your money tied up in one invest, in one location, with one use. We are much bigger fans of diversification!
Still like real estate? Let’s look at it a different way…
Most experts agree that you will typically make an 8-10% long-term return on your rentals, so we like real estate too. In fact, it is in nearly all of our clients’ portfolios, but we like to use real estate mutual funds (sometimes called Real Estate Investment Trusts or REITs for short).
A mutual fund like Vanguard Real Estate Index (VGSLX) or DFA Real Estate (DFREX) allows you to own multiple types (houses, hospitals, strip malls, apartment complexes, industrial parks, etc.) of real estate in many locations (cities, states, and even country’s) and sell your investment in a couple of days with low transaction costs. Did we mention that both mutual funds are up over 10% for each of the past 10 years?
Unless your dream is to be Mr. Roper, 70s suit and all, keep it simple and be a good long-term investor!