Is Owning A Rental Property Worth It? Pros, Cons and Tips

Owning a rental property can be financially rewarding. There are tax benefits to consider such as deducting insurance costs, mortgage interest, and maintenance costs. But there are also drawbacks to be aware of. If you're exploring this type of real estate as an investment, be aware of the risks and responsibilities.

Rental Properties: The Basics You Need To Know

The idea of buying a home or apartment to rent out for profit may sound alluring. However, buying a rental property for income and long-term capital appreciation can have its ups and downs. For example, the housing market can fluctuate depending on location, supply and demand, and the economy.

Financially speaking, for the rental property to be really profitable, the return you reap should be greater than what you could earn in conservative investments, such as bonds and dividend-paying blue-chip stocks, because of the real risks involved. And on the human side, not everyone has the ability to manage property and tenants.

Pros of Rental Properties

There are several benefits to owning a rental property. They include:

Tax Benefits

The Internal Revenue Service allows you to deduct many expenses connected with rental property in the categories of:

• Ordinary and necessary expenses
• Improvements
• Depreciation

This means that you can deduct your insurance, interest on your mortgage, maintenance costs, and physical wear-and-tear on your property. 

Depreciation may produce a nominal loss, which you may deduct against other income. In other words, you may achieve net positive cash flow from the rental income minus expenses and still have a net loss for tax purposes. But be aware that depreciation also reduces the cost basis of a property for calculating capital gains when you it.

In addition, the 2017 Tax Cuts and Jobs Act offers a number of tax benefits for landlords. If you own a flow-through entity (also known as a pass-through business) and operate it as a sole proprietorship, limited liability company, partnership, or S corporation, you may deduct an amount equal to 20% of your net rental income—as long as your total taxable annual income from all sources after deductions is less than $250,000 for singles or $500,000 for married couples who file jointly.

Seasonal Rentals

If you rent your property seasonally, you may use it yourself for 14 days per year—or 10% of the number of days that you rent to others at a fair market price—and still be able to deduct your expenses.

1031 Exchange

In a 1031 exchange, you can sell a rental property and invest in another of “like kind” without paying capital gains taxes.

Renting Extra Space

You can also treat a room or area of your home—such as a garage, basement, or accessory dwelling unit—like a rental, writing off a percentage of the mortgage interest and other expenses against its income, although you should be aware of the potential pitfalls of renting out extra space, including local zoning rules.

Cons of Rental Properties

There are also drawbacks to owning a rental property. They include:

Lack of Liquidity

Real estate is not a liquid asset. Even in the hottest market, it can easily take several months to complete a sale. And if your timing is driven by an emergency or other unexpected event, your need to sell fast might not garner the best price.

Rising Taxes and Insurance Premiums

The interest and principal of your mortgage may be fixed, but there is no guarantee that taxes will not rise faster than you can increase rents. Insurance premiums may also spike after natural disasters like hurricanes.

Difficult Tenants

Despite your due diligence in vetting prospective renters, you could wind up with tenants who are not ideal. For example, they could be needy or demanding, pay late, forget to turn off the water, and so on. Or they could be destructive, in which case the depreciation allowance in the tax code may be sorely inadequate. You can, however, always add a rider to the standard lease form that spells out rules about occupancy, pets, smoking, tenant insurance, and the like. A security deposit can also be helpful here.

Neighborhood Decline

In an ideal scenario, your investment property will flourish amid other well-maintained dwellings, and local amenities will improve. As a result, your cash flow will increase steadily, and your costs will remain stable. However, neighborhoods can change, and your investment could depreciate over time. You should pay attention to the local politics where you invest, just as you would where you live. With some due diligence, you can minimize this exposure.

Unfavorable Changes to Tax Code

The tax code is not immune to change. It could change in ways that would either reduce or eliminate some or all of the tax benefits for homeownership and flow-through businesses.

Landlord Role

Being a landlord is not for everyone. You may feel shy about increasing rents or be over-protective of how others treat your property, which can lead to conflicts. You may even become friends with your tenants, or they may already be family or friends. If you cannot be firm about rent increases or property care, for example, you could wind up collecting rent that is well below market price or with an undervalued property.

Upkeep

When maintaining a property, minor and major repairs arise. Some property owners can save money by doing the work themselves. However, most lack the time, tools, or skills for home repair. Expect to shell out periodic contractor fees.

Is a Rental Property Worth It?

Rental properties are worth the investment if they are planned for and handled correctly. There are several considerations for would-be rental property investors that might help them decide if it is worth the time, effort, and money:

• Rental properties are not assets you can purchase and leave to grow with the market, they must be nurtured with maintenance and concern for those living there.
• You should have enough capital held in reserve to maintain the property.
• You'll need to be able to ask and collect enough rent to cover and recoup your operating (recurring) and capital (maintenance) expenses.
• Your time frame is important. Property, like stocks, goes up and down in value but generally trends upward in time. The rise in market value creates upgradeability or lower-cost loans for more property.

How Much Can You Make on a Rental Property?

There are many factors that go into generating income on a rental property. A single rental can net you a few thousand per year, which can increase with the more units you own and rent. Your mortgage, down payment and monthly payments, landlord and property insurance, maintenance costs, operating expenses, cash flow, rental growth, and appreciation all factor in how much you make.

For example, imagine the following scenario—you acquire a two-family, four-bedroom, two-bathroom duplex for $250,000. You put 20% down ($51,500) and have a 7.5% interest rate on a loan with a term of 30 years and closing costs of 3% ($5,953.50). Other costs can include, but are not limited to:

• Property taxes: 1.5%, $3,750 annually
• Insurance: $1,000 annually (would realistically be higher)
• Vacancy: 5%, $2,400 annually (would realistically be higher)
• Capital expenditures: $4,560 annually (est.)
• Loan payment: About $1,400 monthly ($16,800 annually)
• Management fees: $380 monthly ($4,560 annually), depending on rates in your area
  

If you decide that your tenants should pay their utilities, your annual operating expenditures will be $2,795 per month or $33,070 annually.

You decide to try to earn about $500 monthly, so you set the rent at $1,650 per unit. This results in $39,600 annually and an annual cash flow of about $6,530 ($39,600 - $33,070).

Assuming no extra expenses arose and not counting appreciation or other factors, it would take 9.75 years (7.9 years x $6,530 = $51,550) to recoup your down payment and begin profiting from your venture. You could experiment with the rent so you could have more cash flow, build your reserves, or try to generate some income, but the higher the rent, the less attractive the units are to prospective tenants.

Rental Property Tips

Several tips circulate in investing circles regarding real estate that can give you a place to start. Here are some of the more popular ones:

• Assess your finances first and determine whether you can afford the expenses
• The 2% rule states you should charge at least 2% of a property's purchase price in rent.
  
• Network with other real estate investors to open opportunities for buying and selling
• It might cost you more to evict a bad tenant than to keep them—vacancies are costly
• Screen your tenants carefully
• Overestimate expenses and underestimate income
• It might be years before you can become profitable or make a living from multiple properties

Special Considerations

Whether you are buying a primary home or a rental property, it is important to consider what's happening with mortgage interest rates. Low fixed-rate mortgage debt is generally a good hedge against inflation. If you are a landlord, periodic rent increases are one way of offsetting inflationary rises in property upkeep expenses.

Mortgage rates vary depending on many circumstances, especially on the state of the economy and inflation rate. While a low-rate environment might present an opportunity, it is also important to remember that mortgage rates are typically higher for investment properties than for traditional homes.

The Bottom Line

Rental properties can be financially rewarding but are investments that require involvement and commitment. They also come with several risks that should be considered before making any investment, so you might want to consider speaking with a financial advisor familiar with real estate investing before making any investment.