Investing used to be a long and tedious process that involved a hefty fee. Not to mention, the difficulty of obtaining relevant information to make a sound investment. Today, however, investing is at the tip of your fingers. Furthermore, there is a myriad of investment opportunities an aspiring owner can choose from.
One type of investment that has been preached by some of the most successful people in the world for decades is rental property investing. Owning and running a rental property has made 90% of the millionaires around the globe. However, skeptics of the soundness of rental properties insist they aren’t good investments. This begs the question “are rental properties a good investment?”
In this article, we’ll explore the average ROI of rental properties, the cost of owning one, and the amount of time needed to own and manage them. We’ll also look at the advantages and disadvantages of investing in rental properties and look at whether or not it’s the right investment for you.
The cost of owning a rental property
An important factor to consider when it comes to rental property investing is the cost of owning a rental property. Unlike other investment vehicles like stocks, crypto, bonds, and REITs, owning a rental property involves a huge upfront investment and operating expenses.
The median price of home ownership in the US is $440,300 as of the second quarter of 2022. Now, you might not pay the whole of it upfront but lenders typically require a larger down payment for investment properties compared to owner-occupied property.
On average, lenders require a 15-25% downpayment for a rental property compared to 6% for an owner-occupied home creating a steep upfront cost for aspiring investors. Thus, if you are planning to invest in a rental property worth $250,000, you must have at least $50,000 for a downpayment.
Furthermore, there are other costs associated with owning a rental property including
- Repairs and maintenance
- Vacancy costs
- Property insurance
- Property taxes
- Property management
- Miscellaneous expenses
These costs are estimated to be around 50% of the monthly rent. Thus, minor missteps like failing to find a quality renter, paying for an overpriced home, or inaccurately calculating your expenses can easily eat away at your cash reserves.
Average ROI of rental properties
When it comes to measuring the viability of an investment, ROI is one of the first things an investor considers. An aspiring investor typically compares the ROI of several investment types to decide whether one investment is superior to another.
One of the best things about rental property investing is that it has a long history of data that can give you reliable numbers to depend upon. Depending on the type of rental, the ROI may be slightly different across properties. According to Peoples Capital Group, residential properties average a 10.6% ROI annually while commercial properties average 9.5%.
That means, with an average 10.6% ROI, it will take an investor 10 years to recoup the cost of owning a rental property using the rental income alone. From then on, all the rental income received from the property is a gain while still leaving the option to sell, therefore, cashing out with capital appreciation.
Take note that this is just the average. Some rental property investors make a lot more than others while some make considerably less. Like all investment vehicles, skill and market conditions play a huge part in an investor’s ROI.
A property investor who’s able to spot a distressed property in a great location, fix it up to increase its value and rental price, then find a high-quality renter will make considerably more than a property investor who bought an overpriced home in a less sought-after neighborhood and is unable to find renters.
That said if a rental property owner manages to get an annual ROI of 20% (which many of them do), recouping the cost of their investment will only take 5 years and all the rental income received from then on is a gain.
The work involved in owning a rental property
Unlike other investment vehicles, owning a rental property is not a hands-off investment. Excluding the time you spend looking for the property, an average property owner spends about 4 hours a month or 48 hours a year per property on maintenance and administrative task.
Also, you’re going to spend roughly the same time on leasing your property, screening applicants, and turning over your property. So, if you’re managing multiple properties yourself, becoming a rental property investor can quickly turn from a passive investment to a full-time job.
Advantages of rental property investing
Unlike other investments, rental income is quite predictable provided that you accurately account for your expenses. The rent that your renters pay month after month is expected based on your lease agreement. Furthermore, your average yearly expenses can easily be taken into account.
Compare that to stocks, for example, it isn’t a guarantee that the company will pay dividends every year. It’s also not a guarantee that the company will be as profitable as the year before, hence, the volatility.
Steady cash flow
Owning a rental property gives you a steady cash flow every month provided that you keep it occupied with a high-quality renter.
Rental properties are scalable. If you increase the number of your properties, you’ll most likely increase your rental income which will further boost your cash flow.
Hedge against inflation
In general, when inflation goes up, rent and tangible assets go up as well. This makes rental properties a great hedge against inflation.
Using recent years as an example, the rate of inflation rose 8.3% over the past year. However, rent prices and the median price of single-family homes also increased at a rate of 13.4% and 15.7%, respectively.
Calculating the combined average increased rates of single-family homes and rent prices subtracted by the increase in inflation, rental property owners hedged 6.25% against inflation in 2022 alone.
Good capital appreciation
Aside from the consistent rental income that you get from owning a rental property, the capital appreciation of rental properties is also quite reliable. A 10-year market data report reveals an 88% increase in the average prices of properties over the last decade. That means, if you bought a piece of property worth $250,000 in 2012, it might have grown to $470,000 in 2022.
Although that’s less than half of the 181.2% growth of the S&P 500 over the last 10 years, investing in a rental property gives you the advantage of control over its value. When you renovate or remodel a property, you are actively increasing its value, thereby increasing the return on your investment.
Although real estate prices have taken large drops in the past like the real estate crash of 2008, it generally isn’t as volatile as other investments like stocks and cryptocurrencies.
This makes putting your money into properties a more stable way of investing than the two investments mentioned above. Plus, since people will always be looking for a home, rental properties are less affected by the swings of the economy.
Another huge advantage of being a rental property investor is that you get lots of tax benefits including:
- Operating expenses deduction
- Mortgage interest deduction
- Depreciation deduction
- Owner expenses deduction
- Exclusion from FICA taxes
Additionally, you can even use a cost segregation study to accelerate the depreciation and offset your income tax giving you a substantial amount of cash that you can use to expand your portfolio.
Can be leveraged to grow your wealth
Leveraging has been a strategy used by investors to grow their wealth. Using leverage, you can own an asset 3 to 4 times the cash you have and earn a steady income from it. You can use your assets as well to leverage acquiring other properties.
Disadvantages of rental property investing
High upfront cost
As we’ve already discussed, owning rental property requires a large upfront cost and continuous operational costs. This makes it a steep barrier for those who want to invest but don’t have enough capital.
If you decide to leverage your property and fail to rent it for the right price or simply can’t find a quality renter, you may have to pay the mortgage with your own money, or worse, risk foreclosure.
It requires a lot of research
In general, investing in any asset requires knowledge. However, running a rental property requires not only knowledge of the housing market but also landlord-tenant laws, state laws, mortgages, and property management.
Plenty of work involved
There is also plenty of work involved in owning a rental property. Unlike investing in stocks, investing in rental properties requires time and effort.
From learning about taxes, laws, and property management to screening tenants, collecting rent, and dealing with renters calling you midday for maintenance requests, all this work piles up and can eat away your precious time.
You do have an option, however, to hire a property management company that can take care of the day-to-day operations of your properties.
For a fee equal to 6-12% of your monthly rent, property management companies will handle all the maintenance and administrative tasks of owning a rental property including:
- Rent collection
- Handling maintenance requests
- Financial Accounting
Some property management companies can market your property, screen applicants, and onboard them for an additional fee. If you’re wondering how much ROI you can get from hiring a professional property management service, you can use Poplar Homes’ ROI calculator.
Liquidity is another aspect that you have to consider in deciding whether or not you want to invest in a rental property.
Real estate, in general, is considered the least liquid of all assets. That means, if you invested a large amount of money in a rental property and you needed cash the following year, you cannot easily sell your rental property to gain access to that cash.
So if you’re investing with money that you might need within the next 5 years, rental property investing might not be the best type of investment for you.
It takes time to grow
You might’ve heard of college dropouts who suddenly became millionaires by investing in cryptocurrencies and tech stocks, but I doubt you’ve heard of instant millionaires who invested in rental properties.
Despite rental property investors being among the wealthiest, you’ll never hear of anyone who instantly became a millionaire by buying a rental property. Why? Because getting rich in real estate is a long process.
Putting it all together: Are rental properties a good investment?
When deciding whether or not a certain type of investment is a good investment, it should come back to your goal as an investor.
Rental properties give you a stable income, decent capital appreciation, and fewer exposures to the wild swings of the market, however, they require a lot of money, knowledge, and effort to own and maintain. Plus, they’re not liquid and take a long time to offer returns.
Investments like stocks and cryptocurrencies, on the other hand, can give you large returns on your investment quicker at the expense of exposing yourself to a greater risk of losing your money. However, they don’t give you a stable income like monthly rent does.
The real question you should ask is if rental properties are a good investment for you. Are you looking for a stable income or a quick profit? Do you mind spending time to make sure your investment goes well or do you want an ultra-passive investment? These are questions that you could ask yourself to determine if you should invest in rental properties or not.
The average yearly return of rental properties is 10.6% which is almost the same as the returns of the S&P500 but with the added benefit of stability and steady cash flow. However, rental properties require a steep upfront cost and time in order to own and run.
Like all types of investments, rental properties have their advantages and disadvantages. As an investor, your job is to weigh them and decide whether or not these pros and cons fit with your investment goals.