Rental properties: The dangerous promises of easy money & passive income

Rental properties: The dangerous promises of easy money & passive income

06.12.2023

More than ever, online discourse feels saturated with content about rental properties as a fast track to wealth through passive income. Whether it's someone selling courses on investment properties or social media influencers showing off an expensive watch paid for by their short-term rental empire, it seems like everyone is saying real estate investing is easy.

But real estate investing is definitely not easy, and there’s nothing passive about it. An investment property is a business you’re in charge of running, with costs and risks involved just like any other business. If an investment property doesn’t go as planned, you could find yourself stuck with a money-losing asset that you’re unable to sell without taking a big loss.

There’s no such thing as passive income unless you happen to write a hit song or strike oil on your land. If you want returns higher than the yield on a bank account, you need to take risk and you need to pay money to make money. As the old investing adage goes, “There’s no such thing as a free lunch.” You can’t get something for nothing.

5 reasons (and responses) for investing in rentals

So what makes investment properties an attractive idea in the first place? Some reasons are financial, and some are psychological. Remember to consider the bigger picture around these points.

Why you may want to invest in rental properties

What to keep in mind as the bigger picture

Real property is tangible. Most investments (and our money) are just numbers on a screen. Owning an investment you’re able to see and touch can feel comforting.

The ability to see your property in real life has no bearing on its investment potential. And a property is by definition not diversified since it exists in a single geographic location.

Investment properties pay an income stream and have the potential to gain value. Just as it feels comforting to own a tangible investment, it can feel even better if that investment pays you money every month until someday, you’re able to hopefully sell it for more than you paid.

Many investment properties offer mediocre returns after accounting for all future estimated costs; it’s just difficult to charge rents high enough to maintain strong positive cash flows without increasing vacancy rates.

Real estate can be leveraged. Mortgages are the easiest and largest leverage accessible to most investors. Leverage can increase returns if things go your way, because you’re able to capture all the profits on an investment you haven’t fully paid for.

 

Leverage goes both ways and can increase losses if you sell after the property loses value.

 

Physical real estate typically isn’t as volatile as the stock market. While home values do move up or down, this often happens with less speed than stocks.

While home values usually move more slowly than stocks, the flip side is that you can’t sell a property at the push of a button – it takes time. If prices have already fallen you may find that “low-ball” offers coming in are actually close to the current fair market value.

Rental properties may offer tax benefits.

The tax benefits of rentals are complex and often overstated. For example, depreciation recapture alone can turn into a very significant extra cost when it comes time to sell. And while tax benefits sound nice in theory, we don't believe they should be the main reason to invest in a rental (especially without exceptional projected returns).

Costs to keep in mind

Effectively operating investment properties can be both challenging and time-consuming, with numerous external factors potentially impacting both your overall returns and your peace of mind.

Rental property investors should carefully consider the total costs involved, including the impact of any surprise increases in those costs over time. For example, if a property is cash flow positive right now, what would happen if taxes and insurance costs went up by 20% in one year while rents didn’t keep pace?  Many parts of the country are seeing this happen firsthand, and in some cases, costs have gone up by a lot more than 20%.1

Even if the property were still cash flow positive each month, would the income be enough to pay for large repairs that become necessary all of a sudden? Rising property values usually lead to higher taxes over time, while inflation in building material prices can increase insurance premiums considerably.  Some other variables and risks to consider include:

  • Interest rate moves affecting home values and rents
  • Tenant-friendly laws that in some cases can prevent evictions, even if the tenant hasn’t paid rent in years
  • Destructive or litigious tenants
  • Elevated vacancy rates
  • High unexpected maintenance/repair costs

The bottom line

Ultimately, finding an outperforming rental property is similar to identifying any other investment that can potentially achieve above-average returns – it's difficult.   While gems do exist, finding them may take some work and it’s important to be realistic about estimating rents and costs long into the future before making a commitment.  If the projected income on a property is low enough that rising costs could mean you’re actually paying money every month just for the privilege of owning it, that may not be a good investment.

If you’d like to learn more about evaluating real property investments or managing risk through a diversified portfolio, consider talking with one of Empower’s financial professionals. Qualified individuals are eligible for a free review of their financial life.

1 CBS, “The next shock for homeowners: Surging property tax assessments,” May 2022.

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JJ Lester, CFP®

Contributor

JJ Lester is a CERTIFIED FINANCIAL PLANNER™ professional at Empower. Prior to his work at Empower, JJ served both as an estate specialist at Oppenheimer Funds and financial advisor through LPL Financial. JJ holds an M.S. in Management from The American College of Financial Services and a B.A. in Psychology from the University of Colorado, Boulder.

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