Buzz
Making money from a rental property might seem simple initially—if you can afford to buy a property and rent it out, the expectation is to earn back your initial investment and more. While investment properties can be profitable, they come with notable risks and require significant financial and managerial knowledge that many people may not possess. Let’s explore both the benefits and drawbacks of real estate investments, along with the typical pitfalls to watch out for if you choose to go down this path.
Benefits
A reliable stream of income
Over the past two decades, the S&P index has yielded an average annual return of 9.8%, and by most measures, the real estate sector has performed just as well. Unlike stocks, real estate is a physical asset, one that can generate passive income through rental payments. However, the property also depreciates over time, so maintenance costs can erode your profits. It's a fine balance, but with effective management, a property can provide a consistent income stream that isn't directly impacted by the volatility of the stock market. Real estate can also serve as a useful way to diversify your investment portfolio, with the added benefit of being an insurable asset, offering some protection in the event of a disaster.
Protection against inflation
According to Forbes, one of the most effective strategies to combat inflation is to invest in buy-and-hold real estate properties. As inflation rises, so too does the value of your property, as well as the rent your tenants pay. Since inflation generally remains steady or increases over time, real estate can often outperform fixed-income investments in the long term.
Tax advantages
Many Americans view property ownership as a fundamental right, and the tax code certainly acknowledges this, offering a range of deductions for property owners. These include deductions for ordinary costs, improvements, and depreciation, which allow you to subtract mortgage interest, insurance, and repair expenses, enhancing the overall return on your investment.
Simple financing options
You can purchase a property with as little as a 20% down payment, allowing you to use other people's money to get started. This can be advantageous for scaling up quickly, though it can also pose risks if the investment isn’t managed well. Still, it provides a way to increase your holdings without needing a large upfront investment.
Drawbacks
Depreciation
You will constantly face the challenge of dealing with repairs, both big and small. While doing the work yourself can save money, it’s a significant and ongoing time commitment (hiring professionals is a better choice, though it adds additional costs). Furthermore, it’s difficult to anticipate—the property might appear in good condition after an inspection, yet unforeseen costs often arise, even in newly built homes. For instance, SoFi provides a long, frightening list of potential surprise repairs that could come your way.
Low liquidity
Unlike stocks, real estate is not a liquid asset, meaning that if you find yourself in urgent need of cash, you might need to wait months—or even years—to sell your property, even if the market conditions are favorable.
Problematic tenants
Being a landlord means depending on the income of others for your cash flow, and people can be unpredictable. Managing tenants is a stressful and demanding responsibility, whether it involves chasing after late or missing rent payments, resolving conflicts between tenants, or handling unexpected vacancies. Protecting your investment requires perseverance, and you must be prepared for confrontation if you want to succeed in this role. Alternatively, you can hire a property manager, though this will come with added expenses.
Understand what you’re committing to
Before purchasing an investment property, it's crucial to develop a clear plan for how it will generate income. This includes creating a detailed budget that covers both fixed and variable expenses, setting aside an emergency fund, accounting for taxes, and factoring in legal fees (to get an idea of the many items you’ll need to monitor, refer to this list). You must also stay informed about real estate market trends and select a property with promising long-term potential, though predicting this can be challenging. Despite being labeled as ‘passive income,’ investment properties demand significant effort, and it may take years before you begin seeing a return, so ensure you fully understand the commitment before proceeding.
