Is residential property a good idea?

June 23, 2022June 30, 2023 monfinance accounts, bank, business, commercial, downpayment, fees, finance, income, investment, money, mortgage, property, residential, tax benefit

Cost and benefit analysis of owning a residential property

It is always great to have many streams of income, some active and some passive. After all, accumulating assets and avoiding liabilities is the secret to getting rich.

Rental Property investment has been high on the list of passive income investments since automation will eventually result in robots taking your job.

I currently have a house and also a rental. With my cash out refinancing, my original plan was to buy another rental property as investment. Based on all the work from home trends, I evaluated whether San Francisco Real Estate is still a Good investment?

Advantages Of Rental Property Investment

There are many benefits to buying rental property as an investment. When you consider the three types of income – earned, capital gains and passive; we find that real estate passive income ranks higher than earned income.

Familiarity With The Investment

If one has already purchased their home; then it is a quick learning curve with rental investment properties.

Diversification

Rental property is not co-related to the stock market. One can achieve a fair level of diversification with stock like returns. Of course, Bonds allow you to diversify; with much lower returns.

Purchase With Leverage

Rental property investments are great because you can borrow money and leverage it to buy property. The down payment is a fraction of the purchase price providing you leverage. When you have a 30 year fixed rate mortgage and make the monthly payments; the bank doesn’t care about the value of the property. This enables you to ride out the downturn in the property market. In fact, you can use several strategies to buy real estate with little or no money down.

You cannot use leverage to buy stocks in a similar manner. The brokerage firm evaluates your stock portfolio daily. If you use leverage and the value drops; a margin call is triggered. The brokerage will either ask you to add more funds to the account or sell your stocks immediately.

Cash Flow

Rental properties provide a steady cash flow. Rental income generates a passive income stream.

Investment Control

When you buy a rental property as an investment; YOU are directly responsible for the investment returns. Rental property investment returns depends on your skills to find a great deal, negotiate a deal. Or fix up the property increasing the value. Or your photography and copy writing skills to attract a great tenant. Or your management skills in keeping a great tenant. Or all of the above.

Contrast this with stocks where you have no control on the returns. I could do all the research and pick Tesla as part of my Moonshot Investing portfolio. But Elon could send a tweet causing the price to drop. Nothing is in my control with stocks.

Appreciation

House prices typically increase at the rate of inflation. As a result of applying leverage; you come out ahead. Of course, if you pick a neighborhood undergoing re-development; your gains could be higher.

You could also get lucky. Since the best place for Technology Jobs is still San Francisco; an investment here would have led to enormous gains.

Loan Pay Down

Typically you would buy the rental investment property with a loan. The tenants with their monthly rent payments are paying down the loan for you. If you hold the property as a long-term investment, your loan would be paid down. And you now hold the property free and clear. This again increases your cash flow.

Tax Benefits

Rental property investment offers many unique tax advantages. IRS provides a mechanism for recovering your cost in an income-producing property. This depreciation must be taken over the expected life of the property. You can also use accelerated depreciation if you follow cost segregation.

When buying a rental property as an investment; inexperienced landlords only focus on rent vs mortgage payment.

Consider a Single Family House with 3 bedroom and 2 bath in the Bernal Heights neighborhood of San Francisco (Zip Code 94110). Assume we buy the house which our flipper was considering in Flipping Houses: How To Flip A House Profitably at 3% interest rate. The sale price of a median home in San Francisco is $1.3M.

This landlord has been very diligent in anticipating all the costs involved in owning a rental property. Also the property is not over leveraged as the landlord has invested a large 20% down payment of $260,000. They evaluated the rental property using standard metrics and bought it

Unfortunately the landlord barely makes a monthly positive cash flow of $56.

The Cash on Cash return of the down payment is a terrible 0.26%.

In fact, if the landlord had adopted my strategy of investing Emergency Funds at 8% return they would at least have a better ROI.

One of the biggest mistakes landlords make; is not running their rental properties as a business. I use Stessa for tracking my time and expenses. Very useful during tax filing to ensure you do not miss any tax benefits.

Exit Options For Rental Property Investment

Rental property investment is not very liquid like stocks. Also you cannot dollar cost average to reduce price volatility when buying a rental property investment. Thus, you need to have many exit strategies planned in advance.

One of the biggest risks with rental property investment is that the tenant is unable to pay the agreed upon rent. Landlords should always build contingencies in their estimates for a few months of vacancies. And also for lost money and time due to evictions.

Switch To Airbnb

Most long term tenants move to a new property depending on the school year. If you need to evict during a time which is not attractive for long term renters; Airbnb could be one of the options. Before buying rental property as an investment; check to see if your local jurisdiction permits Airbnb.

Lower Rent

Always run the numbers assuming you can still pay the mortgage, property tax, insurance etc with 70% lower rent. In case of job losses and high unemployment; the best strategy is to always have an open line of communication with your tenant. Offer them reduced rent if possible.

Rent To A Paying Tenant

If you end up with a non-paying tenant; the other option is to file eviction. And then rent to another tenant who has the ability to pay.

Sell

Many mom and pop landlords are accidental landlords. They are unaware of the intellectual and emotional work needed to be a landlord. Selling the property provides them a way to recoup most of their investment.

As you can see, rental property investment offers many benefits. As long as you run the number and have a few exit options available. But, when facts change, it is time to change my opinion. Why do I now consider residential rental property to be the worst investment?