Should You Diversify Your Investments with Rental Real Estate?

February 22, 2022

Many people invest in marketable securities, including stocks, bonds, money market funds and real estate investment trusts (REITs). But a less conventional investment option that’s historically paid off for many investors is purchasing a home or condo to rent out to third parties. This alternative may help diversify your existing portfolio and hedge against public market trends.

With any investment, there are no guarantees of success, especially if you have a short time horizon. But rental properties may be a wise investment alternative for people who do their homework.

Location, Location, Location

One key to successfully investing in residential real estate is picking the right location. In order to buy low and eventually sell high, you’ll need to monitor demographic trends to determine which neighborhoods are becoming trendy and the attributes — such as proximity to retail and favorable school ratings — that renters value. From an investment perspective, buying in a city or county that has a progressive economic development philosophy may be advantageous over one that’s resistant to outside investment and change.

It’s important to note that market trends may have shifted during the COVID-19 pandemic. For example, the increasing prevalence in remote working arrangements during the pandemic has prompted many renters to move from expensive, high-density urban markets to larger properties in the suburbs or rural areas. Some investors are already positioned to profit from this trend.

Before you buy a rental property, it’s important to immerse yourself in the local market. That’s why many real estate investors choose properties in their hometowns or vacation spots that they’ve visited for years and would consider moving to after retirement. It’s important to learn about different neighborhoods, demographics, zoning laws, economic development plans and local contractors.

Defining Success

What do you hope to achieve from investing in a rental property? If you want to flip a fixer-upper for a fast profit, you might be setting yourself up for disappointment. That’s a competitive market that’s generally best suited for real estate and construction professionals.

But, if you want a reliable long-term investment that will provide a return that’s comparable to a securities portfolio, rental real estate can be a viable option. The tricky part with real estate is to avoid getting emotionally attached to a particular property. Instead, you should focus on the numbers, not gut instinct.

Annual Yield

Pre-tax yield is a basic measure of how attractively priced a rental property is. It’s a simple calculation. First, estimate your annual operating income — that is, rental income net of expenses. Then, divide that amount by the purchase price. For example, a house that costs $250,000 and will provide annual operating income of $10,000 generates a pre-tax yield of 4% ($10,000 divided by $250,000).

Examples of operating expenses to factor into your calculation include:

  • Property taxes,
  • Insurance,
  • Repairs and maintenance,
  • Property management fees,
  • Rental licenses and inspection fees, and
  • Mortgage interest if you finance the purchase.

You also must factor closing costs and improvements into your calculation. For example, if a property costs $250,000, plus $5,000 in closing costs and $45,000 in renovations to make it sufficiently appealing to renters, your total investment is $300,000. If that property generates annual operating income of $10,000, your pre-tax yield drops to 3.3% ($10,000 divided by $300,000).

Is the property’s expected yield good or bad? The answer depends on whether you could earn a higher yield by investing that $300,000 another way that exposes you to the same (or lower) risk. If you could earn a higher return by investing in, say, a low-risk bond portfolio, it might not make sense to purchase the rental property.

Important: There’s more to consider than just the operating income that a property will generate each year. Another component of your return on investment is appreciation in the value of the property, which you’ll recoup when it’s eventually sold.

Federal Tax Benefits

Don’t forget to consider the federal tax consequences of investing in real estate. Any benefits can effectively boost your after-tax yield.

For example, the operating costs for an investment property are tax deductible. You can also deduct depreciation on the home — a noncash expenditure — although those deductions are ultimately recaptured when you sell. In addition, when you sell the property — assuming you’ve held it for at least a year — any profit will be taxed at favorable long-term capital gains tax rates, which are lower than ordinary income tax rates that apply to capital gains on assets held for less than a year.

There is also the possibility of converting a rental into your principal residence if you move into it that can provide tax savings in the future. Your tax advisor can explain if you are interested in this strategy.

For More Information

Investing in rental real estate can be an exciting (and potentially lucrative) alternative to stocks and bonds. But this option comes with its own risks and opportunities. Your financial and tax advisors can provide more detailed information to help you consider all the financial angles.

© 2022