At some point in your money journey, you've probably heard someone excitedly share all the benefits that come from real estate. And you've probably found yourself wondering what's the truth about owning rental property. That's why we tapped a team of real estate experts to learn more about rental property pros and cons.
Plus, we'll share our personal favorite way to invest in real estate so you don't have to worry about the majority of the common real estate drawbacks.
What Are Rental Properties?
Before you can weigh the pros and cons of rental properties, it’s important to be clear on the definition of what a rental property is.
A property is a rental property if:
- An investor purchased the home,
- Tenants other than the investor live in the home, and
- A lease or other rental agreement outlines this arrangement.
If a city or town zones a property as residential, it can be lived in. That means that they are supposed to be occupied by individuals or families, not commercial businesses.
Types of Rental Properties
Now you’re clear on what rental properties are. But did you know there are actually different types of rental properties?
Rental properties can include:
- Single-family homes
- Duplex and other multi-family homes
- Apartment complexes
- Condos and townhouses
There are also commercial rental properties in addition to these residential types of rental properties. However, we’ll keep our focus on residential rental properties for this article.
You can also get more details on residential rental properties from the IRS to know exactly what qualifies as a rental and what counts as rental income.
Rental Property Pros and Cons
If you’ve spent any amount of time working on your money goals, you’ve probably heard someone talk about real estate. Adding rental properties to your portfolio can help you on your financial journey. However, it’s key to be aware of rental property pros and cons before diving in.
Rental Property Benefits
Some of the most important rental property benefits relate to how much income they can generate and how quickly you can potentially see that income. However, there are lesser-known rental property benefits that you also want to explore!
Outperform Index Funds
It’s hard to find an investment that is loved more than index funds. In fact, they’re probably the simplest hands-off way to become a millionaire.
However, real estate investors like Scott Trench from Bigger Pockets point out that real estate can outperform index funds. Scott says, “I believe long term, a leveraged real estate portfolio that has operated well can and statistically should outperform a comparable index fund or other average stock investment. I believe that that effect can be very dramatic over a long hold period of let's say 10 or more years.”
Of course, this isn’t a guarantee. And that’s why people often diversify their investment portfolio to include real estate, as well as index funds, and other investments.
Grow Your Money More Quickly
Another benefit to rental properties is how quickly you can grow your income stream. Paula Pant from Afford Anything owns eight rental properties.
Paula says, “When you're investing in a rental property, the returns bias towards that dividend, they bias towards the income stream. What that means is that rental property investing is a more appropriate choice for somebody who has the goal of building passive income to reach financial independence because of the fact that the returns bias towards the income stream.”
Paula also says, “Now, assume the property just keeps pace with inflation and no more, that means the total return would be 9%, and so comparably you might put that same $300,000 into the stock market. Let's say you put it into an S&P 500 index fund and that over a long-term aggregate average also has a 9% return, but in the case of the rental property, you have 6% out of that 9% coming in the form of an income stream, which means that if you were to achieve an early retirement or you wanted to live on passive income, you could then keep that 6%.”
One way that people hit FIRE or Coast FIRE faster is through house hacking. They rent a room or an area of their homes, and that covers much of their housing costs. By minimizing your own housing costs, you can find financial freedom a lot faster.
In addition to potentially covering all or part of your mortgage, rental properties often come with tax benefits. Even if you only rent extra space in your primary home, you can often write off a portion of your mortgage interest.
Set It and Forget It Options Exist
If you talk to rental property experts, it can often feel like there’s a steep learning curve. In fact, many people worry that it’s too complicated or might even feel like a second job.
But there are plenty of ways to take a “set it and forget it” approach to rental properties. Working with a property manager is a great way to ensure you never have to field a late-night flooded basement phone call.
Additionally, you can invest in real estate platforms like Arrived Homes that do all the research and homework for you. Rely on other experts who’ve analyzed the market and selected high-performing properties. You can eliminate a lot of the risk and a lot of the work–and still reap the benefits of rental properties in your portfolio!
For more insight into Arrived Homes and other investing platforms, check out our full review.
Rental Property Drawbacks
Investors who found success with rental property love to tell people about those wins. And they should! After all, real estate can really help you further your financial goals. However, it is important to be aware of some of the drawbacks that come with rental properties.
REAL ESTATE INVESTING IS NOT PASSIVE
Unless you're using a crowdfunding platform like Fundrise or Arrived Homes, traditional rental property investing is a lot of work. You are running a small business with real costs, real deadlines and real human factors.
Since this is not something to be taken lightly, you'll need to dedicate time to making sure you're doing it right financially, legally, and ethically.
If you're in a busy time in your life already, investing in rental properties may not be worth it.
Unpredictable Taxes and Insurance Costs
Most people who take out mortgages on rental properties have fixed mortgage costs. However, property taxes and homeowners insurance costs can swing, sometimes dramatically depending on the area.
If your rental income can’t absorb those rising costs, you may have to raise your rent at the end of the lease. This can mean turnover in tenants and other issues.
Sometimes, rental property owners find themselves in for a surprise when the neighborhood their property is in starts to change. It’s possible that an area can be hit with high unemployment if a big company goes bust.
Other times, the age of a neighborhood starts to shift. Young families move out if school boundaries change, and so on. A changing neighborhood can make it difficult to lease your property, and it can also change the type of tenants who want to live there.
Of course, one way to lower this risk is to stay involved in local news and politics to keep a pulse on the neighborhood.
Leverage Requires Increased Risk
One of the reasons why real estate investments can sometimes outperform index funds is that they are sometimes much riskier investments.
Scott Trench cautions, “This out-performance, this extra return that a real estate investor can generate only works if the portfolio is leveraged. [It has to be] leveraged for the entire duration of the hold period with regular re-leverage as notes are paid down or average annual long-term appreciation sets in and equity values increase.”
What does that mean? Well, it means that you need to really understand how your money is invested and how your properties are generating income.
That’s because Scott also says, “So if you're going to use leverage over a long period of time, that creates additional risk. An uneducated, undisciplined operator can and will likely lose a substantial amount of money or go bankrupt at some point in the hold period if they are not managing their properties and their portfolio correctly. Either that or they're going to seek to reduce risk by paying down their debt and owning the properties free and clear.”
Does this mean you shouldn’t invest in real estate? Not at all! It means that you should do your homework first, which is true for any investment. The key to protecting your money is to not invest in something you don’t understand.
Home Values Can Drop in Tough Times
Deacon Hayes from Well Kept Wallet currently owns one AirBnB. He’s also had experience in the homeownership and rental market for more than a decade.
He reminds us that home values don’t increase indefinitely. Deacon says that in 2006, “I decided to buy two properties in Arizona. The housing crisis happened, and those properties were cut in half in value. It took almost I think 11 years for them to get back to even. However, one of them was foreclosed on. The other one we sold for like a $50,000 loss.”
Much like the stock market, it’s difficult or even near impossible to predict how the real estate market will move. And just like the stock market, ups and downs are to be expected.
Unfortunately, it is often only the market-ups that are discussed. Making sure that you have a plan to weather market downturns–in real estate and in other investments–is key to managing this rental property con.
Final Thoughts on Rental Properties Pros and Cons
The truth about owning rental property is that your results can vary depending on many different factors. That’s why it’s important to understand rental property pros and cons before diving in.
If you’re looking for a straightforward way to invest in real estate, check out Arrived Homes to see if they might fit your goals.
What are your thoughts on rental properties? Can you think of any rental properties pros and cons that we missed?
Please let us know in the comments below.