Part 2: Rental Real Estate
This article is the second in a series looking at the pros and cons of various income-producing vehicles to help you determine whether they belong in your portfolio mix. But before we dive in, we’ll begin with an important caveat: Here at Pure Financial Advisors, we believe that for most individuals, the income alternatives we’ll be discussing are best suited as compliments rather than substitutes for high-quality bonds.
With that warning out of the way, let’s start by looking at our second income alternative: rental real estate. Some of the world’s greatest fortunes have been built with real estate, and rental properties have been a key component of wealth creation for many people. With that in mind, should you get involved in the rental real estate market?
Well, first you need to determine what you are trying to accomplish with real estate. Are you trying to build wealth through price appreciation? Or are you looking for income to help fund your retirement? You’d be surprised at how often people confuse those two goals. For instance, an individual might want more cash flow from their assets, so they consider purchasing a property in an expensive coastal market where rental income is perceived to be high. However, while the value of that property may appreciate over time, in the short run, because of their higher purchase prices many coastal cities produce minimal cash flow at best.
The problem isn’t that the person bought a bad property, but rather that they are using the wrong tool for the job they are trying to accomplish. Rather than buying on the coast, this individual might have been better off looking for property further from the coast or in lower-priced markets such as Memphis, Kansas City, Dallas, and Atlanta. These markets have historically not provided the same level of price appreciation as some coastal cities, but they have tended to offer more opportunities for generating cash flow.
Note: Keep in mind that owning and managing out-of-state properties comes with additional challenges from being a long-distance landlord.
Real Estate Pros & Cons
Let’s look at some of the pros and cons of adding rental properties to your investment mix, starting with the benefits.
- Potential for income: rental properties can produce monthly cash flow that migth exceed what is available on other types of investments
- Potential for price appreciation: some markets have seen strong upward price movement over time, producing the potential for capital gains
- Leverage: capital gains (and losses) on real estate can be magnified using leverage in the form of mortgage loans when purchasing a property
- Diversification: although it is sensitive to the economic cycle, real estate does not move in perfect lockstep with stocks or bonds, which means it can provide some portfolio diversification
- Illiquidity: Unlike many other investments, liquidating real estate can be a slow and expensive process. In some cases, it can even be impossible to sell a property at an acceptable price
- Lack of transparency: When compared to publicly traded stocks and bonds, there is often less information available on a particular property and what it may be worth
- Labor intensive: Maintaining rental properties can be labor-intensive and time-consuming. The alternative is to outsource property maintenance, but doing so can eat into cash flow and profits
- Competition: As of this writing real estate supply and demand is such that it is a “sellers’ market” and buyers looking for attractively priced rental properties face stiff competition
That last bullet point deserves a bit closer look. You’re probably aware that real estate prices have skyrocketed in many markets, driven by a lack of supply. So, if you are looking to purchase, you’ll likely be competing with other buyers. That means it’s important to let the numbers guide you; remember, for you, this isn’t a home, it’s an investment, so purchasing at an attractive price is paramount.
Also, keep in mind that the single-family rental market has seen an influx of institutional investors over the last decade. That means that you’ll also potentially be competing with some of the largest money managers on earth; firms that own hundreds of thousands of homes. That scale gives them an informational advantage as well as economies of scale. All of this is not meant to dissuade you from purchasing real estate today but rather to make sure you start your journey with your eyes wide open and prepared to put in the legwork necessary to find the right investment for you.
So, How Should You Use Rental Real Estate?
As with any investment, what’s important with real estate is what percentage of your overall mix does it comprise? Opinions on this vary widely, but here at Pure, we are somewhere in the middle of that debate. If, and this is a big if, you can stomach the illiquidity and headaches that come from rental properties, it could make sense to own real estate. But because of the illiquid nature of the investment, for most individuals, we think rentals should be a relatively small slice of your overall assets if any slice at all.
Also, although it can provide income, we don’t think real estate is a substitute for high-quality bonds, because, in addition to income, the role of bonds in a portfolio is to provide ready access to funds in times of turmoil. Given its illiquid nature, real estate as an asset class generally cannot fill this need. In fact, we would view physical real estate as a stand-alone asset class, and a compliment to stocks, bonds, cash, and the like.
Thus far, we’ve been talking about the direct ownership of physical real estate as an investment, but of course, you can also get exposure to real estate through various pooled investment products as well. With that in mind, check back soon for the next installment in this series wherein we’ll look at the pros and cons of investing in real estate investment trusts (REITs.)