What You Need to Know Before You Invest in Rental Property
Contrary to popular belief, just having the funds available to invest does not an investor make.
The economic and cultural landscapes are shockingly different than they were even a few months ago, and just about every change requires your attention if you are going to make an informed decision. There are no silver bullets and not every strategy will work for everyone, but there are several questions you can ask yourself to gauge your interest, ability, and potential return.
There are plenty more than six, but below is a closer look at six of the most important questions you should ask yourself before you invest in rental property.
I would love to say “yes” or “no”, but the most accurate answer is almost always “maybe.” Or at least until you take stock of the contributing factors that you can control, such as your long-term goals, short-term goals, and available capital. From there you embark on a journey through the mysterious, chaotic world known commonly as “the market.” If you can figure it out on your own, you’ve got a good portion of the world’s investors beat…
Economic Uncertainty Due to COVID-19
As if investing wasn’t hard enough already, there is a global pandemic to deal with on top of everything. As far as the stock market is concerned, you can make yourself dizzy following the ups and downs. This, however, presents an opportunity for the shrewd investor. History has shown that panic selling leads to discounted buying. Warren Buffet had this to say on the matter…
“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”
Economic uncertainty can become an investment opportunity for those with the capital, the fortitude, and the patience to weather the storm.
Unemployment May Drive the Demand for Multifamily Housing
It’s not many markets that see an increase in activity as unemployment grows. Rental property, however, is one of them.
Mortgage payments are simply harder to make. Business is falling off, which means people are getting laid off. Marketing professionals may find themselves cleaning swimming pools just to keep something coming in until the world returns to some semblance of normal. In turn, multifamily rental property becomes a good option for those who can’t hold onto their house.
Resist the Urge to Time the Market
Home prices rose 75% from 1997 to 2005. Champagne corks popped, yachts were purchased, and investors found themselves in a Real Estate Neverland, where all assets increased in value, and owning property was akin to printing your own money. Surely the good times would never end.
Seven years and a decrease of 36% later, many of those yachts were repossessed and investors came crashing to earth. Better tighten the belts, because we’ll never see those days again.
Cut to 2020, where home prices are back up 45% since 2012, regardless of a global pandemic.
The moral of the story is simple. If everyone could time the market, everyone would be rich. On average, a steady, long-term plan without regard for economic cycles yields a better return than trying to shoot the moon.
When you boil it down, there are really two ways to invest. On your own or with others. You could keep all the profit for yourself, but that means you are keeping all the work for yourself as well.
How do you decide which is right for you? Let’s examine the options.
Going it Alone
Certainly the most profitable option. It’s also the most likely to give you a medical condition brought on by lack of sleep. But some people like complete and total autonomy. If that sounds like you, there are a few things you should know.
Due Diligence – It doesn’t matter how low risk you believe your property might be. The fact is there are still hundreds of thousands of dollars on the line. If you do not take the time to do your homework on every single detail of your financial responsibility, and every square inch of the property, you are setting yourself up for a big hurt later on.
“Shallow men believe in luck or in circumstance. Strong men believe in cause and effect.” – Ralph Waldo Emerson
ROI – No one ever got rich by throwing money against a “for sale” sign and crossing their fingers. Once you have done your due diligence, you have everything you need to figure out your return on investment, or ROI. Those who struggled in high school math may get queasy here because before you get to ROI, you need to figure out your cap rate and net operating income (NOI). The answers are slippery because they can fluctuate wildly depending on the type of property and location. Buckle down and study. It’s worth it.
Investing with Others
Not just any others. Many a friendship has been demolished when two people thought they could go into business together.
REIT – A Real Estate Investment Trust behaves kind of like a mutual fund. Several investors inject their resources in order to fund the projects.
Crowdfunding – The social media age has given Average Joe the chance to connect with people across the country, and the world, who are interested in pooling funds to invest. The amounts could be infinitely smaller than REIT investing and could include thousands of people if the campaign is successful enough.
Real Estate Companies – You sure would sleep better knowing your hard-earned dollars are in the hands of seasoned professionals who have seen and done it all.
Simply put, become an expert on every aspect of the deal.
Financing, contracts, zoning, population density, industry, demographics, and so on. Getting a great deal on a 30-unit complex in excellent condition means nothing if there are no jobs to be had within a reasonable distance. Buying a house on the beach and posting for rent on Airbnb sounds like a great plan, but you’ll be stuck with those monstrous mortgage payments on your own if the community has new laws restricting short-term vacation rentals.
And then comes the math. Math, math, and more math…
You’ll recognize NOI from the previous section, and you should probably get used to it because you’re going to see it a lot more.
Net Operating Income = Real Estate Revenue (RR) – Operating Expenses (OE)
Money that goes into your pocket from your property minus money that goes out of your pocket to make fixes, hire a property manager, buy marketing supplies, etc.
A percentage that indicates the rate of return you can expect on your property.
Capitalization Rate = NOI / Current Market Value
If all the other aspects of your deal look pretty good, but your cap rate comes out to just 5%, consider that mutual funds averaged a return of 13% in 2019. You might just be better off investing elsewhere.
Debt-Service Coverage Ratio (DSCR)
It doesn’t matter how slick the pitch is. If someone wants you to invest, ask about the DSCR.
DSCR = NOI / Total Debt Service
If the number comes out less than 100% on the other side, that means the investments are not making enough to cover the organization’s debt. That’s not a situation you want to find yourself in.
There is also Risk-Adjusted Return, which figures ROI as it relates to the risk of your investment and Internal Rate of Return (IRR), which estimates the profitability of an asset.
Or you could wing it…but I wouldn’t recommend it.
As long as we’ve adequately answered all the previous questions, apartments sure look like an enticing option. As we’ve discussed above, the rough state of the economy is driving many single-family homeowners into the rental market. Investing in an apartment building near plentiful employment could be a big win for you and your tenants.
Here are just a few of the benefits of investing in apartments.
How do you make your money work for you? There’s no shortage of advice out there, but if you want to be out enjoying life while your money multiplies itself, apartments are a pretty sure way to go about it. Filling a building with tenants means filling your bank account with rent…every month…until you sell. Property managers can take even more of the work off your plate if you’re willing to pay them.
Depreciation – The IRS has decided, in their infinite wisdom, that a building is “useful” for about 27.5 years after it is purchased. That means you get to write off 1/27 the value of your property on your taxes.
Repairs – I hate to be the one to tell you, but something is going to break. Some tenants will shove something down some pipe that will cost quite a bit to repair, but the good news is you can write it off.
Advertising Costs – Don’t be afraid to spring for a photographer to take those fancy pictures. And any listing services you use to advertise your vacancies, all deductible.
Accounting and Legal – Need someone to help you draw up your paperwork and do all that math we talked about earlier? Deductible. Here’s hoping you never get into legal trouble, but those massive hourly fees charged by an attorney? Also deductible.
Property Management – Pay someone else to take phone calls about plumbing problems in the middle of the night, because it’s deductible.
We’ve already discussed the roller coaster that is the stock market. Even if you do wheel-and-deal your way to a 5% return on your investment, the standard inflation rate (projected at 2.24% for 2021) could eat up half of it before you get a chance to spend it. An apartment building, however, is not a slave to inflation since its value is not tied to the market, and you can adjust your rent right along with it.
More units mean more money. A 30-unit complex full of tenants paying $2,000 a month puts $60,000, minus expenses, in your pocket every month. Buying one house and renting for twice the monthly rate at $4,000 still only gets you $4,000.
Easy one. Yes! How? That gets a little tougher. Luckily you have options and each of them is a great way to offset the volatility in the market. Real estate and stocks, for example, are uncorrelated assets. That is a fancy way of saying the performance of one does not really affect the performance of the other.
Take the current situation. Stocks have seen some rebound as of late, but they sure took a dive as the pandemic began to spread across the world. Real estate, by comparison, is still flying off the shelves and holding, if not increasing, in value.
Through the 2017 Tax Cut and Jobs Act, thousands of disadvantaged areas throughout the country were identified as Opportunity Zones in order to attract development. If you were to take funds from the sale of one investment and pour them into an Opportunity Zone (through a Qualified Opportunity Fund), capital gains are deferred on those funds until you sell the new property, or December 31, 2026. Whichever comes first.
The initiative was also designed to incentivize investors to hang onto their property. After 5 years, you can trim 10% off of your deferred capital gains. After 7 years, 15%, and if you hold onto the property for 10 years, you are free from Federal taxes on appreciation at the date of the sale.
The IRS allows investors to plug the funds from the sale of one property into another of “like-kind” free from taxes on the funds from the sale, as long as the new property is of equal or greater value compared to the old.
It’s hard to believe, but pretty rosy if current conditions are any indication.
We’ve already discussed prior to this how real estate can thrive even when other assets are in the tank. That doesn’t mean any old property will stand the test of time. Understanding what people need, or in some cases want, and when they will need it can go a long way in priming your investments for success.
In the age of COVID-19, for example, a high-rise apartment building with units crammed in tight is not nearly as attractive as it may have been pre-pandemic. Young and old alike are fleeing the congested city life in search of more wide-open spaces in the suburbs–not only for recreational purposes, but their lives may very well depend on it in some cases.
Because of this, garden-style, or vintage, apartments have become an attractive option. A garden-style apartment puts the emphasis on the outside as opposed to the in by surrounding much smaller buildings (usually no more than 4 stories) with lush, green landscaping. Breezeways and courtyards continue to allow more space between tenants and there are typically no elevators, which means no sharing air. Many landlords have also mitigated infection risk by hiring more cleaning staff to disinfect what little common area there is.
And if you think being in the suburbs may conjure images of a nasty commute, think again. Business, large and small alike, have taken the cue as well. The financial district is no longer the center of industry, and cities like Austin, Texas are a perfect example. Apple, Google, Amazon, Tesla, and more are setting up shop in more suburban areas, which means living in the ‘burbs doesn’t mean sharing a bus with dozens of other people. And now that much of the country is working from home, a home office with the soundtrack of lawn sprinklers and children on bikes sounds far more appealing than the sirens and street vendors in a big city.
If people can lower their monthly expenses, feel safer where they live, and still be close to plenty of top industry, you better believe they will.
I wish I could tell you that’s all there is to it. Alas, there is plenty more. But hopefully, this can provide a starting point that will lead you to an informed decision of your own.
Knowing what you can control and what you cannot is key, but time has shown that rental property has the potential to become a sound investment choice in any market, including one that is weathering a global pandemic.
And your bottom line is not the only benefit. Families all over the country have had their lives upended. The American Dream has been knocked sideways and no one knows when, or if, it will ever return to normal. Investing in rental properties like vintage apartments offers those same families a chance to get back on their feet without feeling like they have “stepped down” in their ability to provide.