Dear New Frugal You,
My husband and I both work and we own our own home. We have been throwing around the idea of buying rental property, either a house or duplex, for an extra source of income. What are your thoughts? Do you think it's a risky decision? What are the pros and cons?
- Isabelle from Cheyenne
Whether you've ever purchased Boardwalk on Monopoly or not, there's a good chance that you've wondered what it would be like to own rental real estate.
That's understandable. Many people, like Donald Trump, have made a fortune in real estate. Of course, many people, like Donald Trump, have gone broke in real estate, too.
In deciding whether to invest in rental property there are three major questions to answer. How much can I earn with rental property? Do I have what it takes to be a good landlord? And how do other options compare?
Tracking appreciation of real estate is difficult. Zillow, a site specializing in home values, expects values to appreciate by about 3% in the year that ends in February 2015.
Their projections varied considerably by region. No city in Wyoming was included in the Zillow report. But you might be able to find something for your area in a different study or report.
Remember that your results will probably be a multiple of whatever return occurs. Unless you'd be paying all cash, your real estate investment would be leveraged.
If you put 20% down you're controlling $5 for every dollar you invested. Leverage multiplies the results, positive or negative, of any investment. Anyone who has been upside down in a home understands the concept.
In addition to appreciation, there are other benefits of investment real estate. The obvious one is that a tenant's rent should pay most or all of your mortgage -- which means that you're gaining equity on someone else's money, and that's always a good thing.
You'll also be able to deduct money spent on your property on your income taxes. Plus, you'll only pay taxes on appreciation once you've sold the property, and when you do it likely will be at the rate for capital gains, not the higher rate charged on ordinary income.
In addition, real estate will never go completely out of style. We all need a place to live. No matter how good or bad the economy is. So, in all but rare exceptions, real estate will always have some value.
On the flip side there are some disadvantages, too.
The real estate market can crash, as it did in 2008. In many markets homes lost 30% of their value or more very quickly. Five years later we're still finding people who have zero equity in their property.
Much of that volatility is reduced if you're investing for the long term. Housing markets tend to level out if your horizon is 10 years or more in the future.
Don't expect a huge income unless you can pay cash or have a large down payment. I can't give you an average income figure for rental property. You'll need to calculate that on each individual property.
The calculation will require some research on the property you're considering. Besides your mortgage payment, find out how much property taxes and insurance will cost. Estimate how much you'll need to set aside each month for repairs.
And, be prepared for an empty rental. It happens to most landlords occasionally. When it does you'll need to pay the mortgage and other expenses out of your own monthly budget. Make sure that you have enough set aside to handle a reasonable period to fill your rental.
You'll want to consider more than finances. There are some personal factors to take into account before you become a landlord.
Someone will need to deal with nonpaying tenants and tenants doing damage to your property. For some people, especially those who don't like confrontations, it's difficult to set limits and to force tenants to live by them.
Rental property requires active management. Either you or someone you pay will need to collect rent and be on call for repairs.
Before making a final decision consider your other financial options.
When you average out annual performance of stocks, as measured by the S&P 500, the stock market has returned 11.2% annually from 1928 through 2013, according to the Federal Reserve Database, as quoted in a New York University report.
Long-term, either investment, stocks or real estate, will likely give you a reasonable positive return. But, with either choice, you'll probably have some good years and some bad ones.
One way to reduce the risk is to have some balance to your investments. For instance, if you do buy investment real estate, make sure you have stocks and bonds in your individual retirement account and 401(k) plans.
Remember that you don't necessarily have to take possession of real estate to befit from ownership. Real estate investment trusts (REITS) or other stocks/mutual funds investing in real property can offer many of the advantages without requiring your hands-on management.
Finally, you might want to ask yourselves why you want extra income, especially since both of you are working. It may be that what you really want is asset appreciation which could affect your decision. Or it could be that you need to adjust some other area of your finances so that extra income isn't necessary.
See related: Owning a duplex