Guest post courtesy of our partner, SparkRental – Automated Landlord Software
You get it: real estate, even your own home, can produce income.
Maybe you’re bringing in some extra money by renting out storage space in your garage or basement. You might even rent out the occasional room on Airbnb, or rent a room to a housemate, or some other form of house hacking through the sharing economy.
Ready to up your game by renting out an entire property?
Buying long-term rental properties comes with a slew of perks, along with a few risks as well. The good news is that you can mitigate each risk through good ol’ fashioned preparation.
When you build enough rental income to cover your living expenses, you reach financial independence, and your day job becomes optional.
Here’s what you need to know about building passive income from rental properties and how to make sure you always come out ahead.
7 Advantages to Rental Properties
Why should you buy a rental property? What makes it a good investment, as opposed to bonds or stocks or a mutual fund?
As you explore where to invest your money, consider these seven key benefits to long-term real estate investments.
1. Ongoing Passive Income
Rental properties generate income forever.
They never mature, never stop paying dividends, never declare bankruptcy. Sure, they can burn down, but insurance protects you against that possibility.
You start collecting income today, and in 50 years from now, you’ll be collecting even more income. All without having to lift a finger after the initial property purchase, if you choose to hire a property manager. If you don’t, there are ever more tools available to you to automate your property management.
2. Predictable Returns
When you buy a stock, you cross your fingers and hope for the best. Even bonds, which state their returns up front, fluctuate in resale value based on the day’s interest rate environment.
Rental properties, by contrast, offer returns that you can calculate in advance. You know the market rent, you know your purchase price, and you can forecast expenses with great accuracy.
Where so many new rental property investors mess up is in ignoring or underestimating the irregular, but inevitable, expenses. Instead, investors must take the long-term average of expenses like vacancy rate, maintenance, and major repairs. They don’t hit every month, but they do hit semi-regularly.
Fortunately, you can predict them accurately. For example, you can easily discover the vacancy rate for a given neighborhood by speaking with local property managers and landlords who operate there.
Use a free rental property calculator to run the numbers on any given property before buying and never make a bad investment again.
3. Tax Advantages
Rental properties come with a wealth of tax benefits.
The IRS lets you deduct every conceivable expense, plus some paper expenses like depreciation. You can deduct for most closing costs (and the others can be depreciated), property management costs, mortgage interest, property taxes, insurance, legal fees, maintenance costs, and more.
Best of all, you can take these deductions even if you take the standard deduction. No itemizing necessary!
4. Retirement Advantages
When your retirement portfolio consists of stocks and bonds, you’re faced with a singular problem: they often don’t produce enough ongoing income to live on.
This means that retirees have to gradually sell off their nest egg over the course of their retirement, and hope they don’t run out of money in their lifetime. They worry about problems like safe withdrawal rates and sequence of returns risk. It’s a terrible fear to live with and many retirees find themselves constantly checking their remaining portfolio balance.
In contrast, rental properties keep generating income forever with an average yield of 10-15%, which is almost double what stocks and bonds would give you. Not to mention you don’t have to sell your rental properties to generate that kind of income.
Quite the opposite: they only grow more valuable over time.
As a general rule, rental properties rise in value over time, because demand for housing rises over time. Meanwhile, housing supply grows ever more expensive to produce, given rapidly rising labor and material costs, and the finite supply of desirable land.
Values gradually go up, and your mortgage balance gradually goes down. So even as you earn money each month on rents, you also build equity. For example, property values across the United States rise between 3-5% each year in a good market.
6. Returns Adjust for Inflation
For most investments, you have to subtract out inflation to reach the real return. For example, if a five-year bond pays 4% interest, but during the five years you hold the bond, inflation runs at 2.5%, then your real return on investment is only 1.5%.
This is not the case with rental properties.
Rents not only rise alongside inflation, they’re one of the primary causes of inflation. Rents nearly always rise at inflation speeds or faster, so you’re inherently protected against the slow ebb of inflation draining your returns.
That effect compounds when you leverage other people’s money to buy your rental properties, too.
7. Leverage & Ease of Financing
Real estate lets you leverage other people’s money to build your own portfolio of assets. A portfolio that pays you money each month to boot.
Thus, you can finance most of the purchase price with a rental property loan, earn a monthly profit, and then your tenants pay that loan off for you. Talk about a win-win!
You can even use your rental cash flow to pay down your mortgage faster if you prefer, and rid yourself of the monthly payment.
But before you do, consider that your mortgage payment stays the same each month, even as your rent rises. That means that your profit margin rises at a faster rate than your rents alone do.
Imagine your property rents for $1,000, the rental property loan costs $500 per month, and your non-mortgage expenses total $400. So, your monthly cash flow margin is $100.
Over the next year, rents in your market rise by a healthy 4%. The rent goes up to $1,040, but most of your expenses stay the same.
So, your monthly cash flow rose from $100 to $140: a 40% improvement in profits, even though the rent only rose by 4%!
That’s the beauty of leverage.
Be sure to compare rental property loans on interest rate, fees, down payments, and requirements before committing, as most loans last 15-30 years and refinancing is expensive.
Risks of Owning Properties
No investment is all upside and no risk. And while you can forecast returns with a rental property calculator, not everyone calculates it right.
Beyond miscalculations, here are the three largest risks facing rental property investors.
What happens if the tenants stop paying the rent?
It happens sometimes. But not very often fortunately, and you have several ways to prevent losses from rent defaults.
First, you can prevent losses by screening your tenants thoroughly. That starts with reports such as credit, criminal, and eviction reports, but screening doesn’t end there. You should also verify their income, employment, and rent payment history.
But nowadays you can also buy insurance against your tenants defaulting. It typically costs $300-400 per year, and if your tenant stops paying the rent, the insurance pays it while you file eviction and find replacement tenants.
Between aggressive tenant screening and rent default insurance, landlords can effectively eliminate the risk of losses due to rent defaults.
Another risk comes from tenants damaging your property. Because let’s face it: you’re handing them possession of an asset worth hundreds of thousands of dollars.
You can also mitigate this risk through tenant screening and insurance. Before approving an applicant that otherwise looks good, stop by their current home and see how they live. Do they treat it with respect? Is it clean?
However they treat that property, that’s how they’ll treat yours. Decide accordingly.
Insurance policies also provide some protection against damage caused by tenants. But be sure to read the fine print carefully though, and ask your agent what’s covered and what’s not.
But the traditional protection against tenant damage is a simple security deposit. If they damage your property, take the cost out of their deposit when they move out.
Finally, conduct semi-annual inspections to catch issues early, and either evict or non-renew tenants who don’t treat your rental property with the respect it deserves.
Vacancies are a reality of rental investing. No property has a 100% occupancy rate forever.
So many landlords worry: what if I can’t rent my property, and it sits vacant for a long time?
If you ran the numbers properly in a rental property calculator before buying, you should be budgeting for vacancy rate every month. For example, if your property’s neighborhood has a 5% vacancy rate, you should be setting aside 5% of every rent payment for future vacancies.
Keep in mind that good neighborhoods don’t have high vacancy rates. If you choose a neighborhood with reasonably strong demand, you should have no trouble re-renting your property.
Rental properties do come with risks, like any investment. But you can manage and mitigate those risks with basic preparation and foresight.
In return, you can earn ongoing income that rises even faster than inflation, and appreciates all the while. Income from assets that you can largely buy with other people’s money, even as you gain tax advantages and build equity.
With enough passive rental income, you can cover your monthly living expenses, and reach financial independence and retire early (FIRE).
If there’s a downside, beyond the risks outlined above, it’s that rental properties require some work and knowledge to buy. It’s a barrier to entry, which prevents the average person from investing.
But it’s that very barrier to entry that keeps the returns higher for those willing to take on that initial investment of knowledge and work. In other words, that barrier weeds out the indifferent, leaving only those who truly want it.
Have you ever considered buying rental properties for passive income? Why or why not?