Why Should I Invest in Rental Properties?

Andrew Carnegie stated that 90% of millionaires got their wealth by investing in real estate. Rental properties have been, and remain to this day, a proven way to build uncommon wealth because they have a unique combination of powerful wealth-building benefits that no other investment vehicle can match. 

In this article, I will go into detail on each of the top reasons to invest in rental properties. Let’s get started!

This post may contain affiliate links.  If you click on a link and complete a transaction, I may make a small commission at no extra cost to you. 

Table of Contents

Six Financial Benefits of Rental Property Investing

Rental Properties Are Semi-Passive Investments

I love investing in rental properties because, if done right, they can be a mostly-passive investment that you can do on the side and still make meaningful money over time.  If you hire a property manager to take care of your properties, they really become an almost fully passive investment. Because of this passive element, I think it is superior to most other forms of real estate investing.

Don’t get me wrong, flipping is a great strategy and can be really profitable, but you need to have a deep understanding of your real estate market. You have to be able to spot a deal worth flipping and jump on it. You also need repeatable methods of finding deeply discounted properties and a team of reliable contractors. 

Bottom line is that the learning curve is steep and you need to be actively involved in the business.  Plus, it can all come tumbling down if there is a meaningful downturn in the real estate market. 

Rental properties, by contrast, are far more passive and, in my view, less risky.  If your rental property goes down in value temporarily, so what?  You are still getting paid the rent each month.  You can ride it out.

Rental Properties Provide Cash Flow

The ability to generate positive cash flow each month is perhaps the best-known and most touted benefit of rental properties.  Cash flow is basically rent minus expenses.  It is how much of the rent money is left over for you to keep after you pay all the costs associated with your property.  

In my area, cash flow is often modest because the properties are expensive and, after paying the higher mortgage payments, taxes, insurance, and other costs, there is not much left. 

That being said, I never buy a property unless it cash flows at least a little bit (even if it is only $200 or so).   You do not want to be in a situation where you have to draw money away from your personal funds to support your rental properties.  

It is very hard to grow your real estate portfolio if each additional property is sucking money away from you.  But you don’t have that type of built-in barrier to growth if each of your properties has a positive cash flow and each property you add is increasing your total cash flow. 

In fact, you become highly motivated to find that next property that will add to your cash flow and wealth.  

Before you know it, you have built a solid portfolio of rentals and can simply live off the cash flow. This is not a pipe dream and it’s not rocket science.  Many people, including me, have used rental property investing to catapult them toward financial freedom.

Rental Properties Can Appreciate

In my area, appreciation is the primary driver of profits.  That’s probably true for most stable or growing large metropolitan areas, like NY, D.C., San Francisco, Los Angeles, etc.  

I know that many real estate investors view appreciation as the icing on top, but it is absolutely real (ask anyone who lives in the Bay Area) and can be immensely impactful to your bottom line.

If you are going to be investing in areas where appreciation does not play as large a role (usually less urban areas), you will likely fare better in terms of cash flow than I did.  That seems to be the trade-off.  

On a related note, because real estate tends to appreciate, it is a well-known hedge against inflation. Similarly, rents also tend to rise with inflation, so you are covered there as well.

Because my cash flow is pretty weak, but my appreciation is strong, my strategy for retirement will be to sell some of my most appreciated properties, so that I can pay off my remaining mortgages. 

That kills two birds with one stone. I will have fewer property management hassles intruding on my free time because I have fewer properties, but I will have way more cash each month to pay for expenses because my mortgage payments will be gone.

Mortgage Paydown By Tenants

If you buy with a mortgage, then each month you are paying that mortgage down (the paying down of your mortgage is referred to as a paydown of “principal”).  Each month, the amount by which you are paying it down is increasing.  

So in Year 1, you may only be paying down around $200 in principal per month, but by Year 10, you will be paying down much more than.  Toward the end of your mortgage, almost the entire amount of your mortgage payment is going to be applied to the principal. 

This means time is your friend when it comes to paying down the mortgage. 

The positive effect on your net worth due to steadily increasing principal payments is amazing.  Each quarter I calculate my net worth, and each quarter I see how much my properties are growing my net worth, just through paydown of principal.  

As you acquire more properties and as time passes, the debt paydown on your properties (and its resulting positive impact on your net worth) becomes bigger and bigger.  

You don’t really feel it when you have one property and you are in the early stages, but after you acquire some properties and hold them for several years, it starts to feel like a flood of principal reduction is happening each month.

Inflation works to your advantage here too. As the value of a dollar erodes over time due to inflation, you are still paying the same amount each month on your mortgage.  That means that the real hit to your wallet for your mortgage payment is decreasing over time.

A critical point that I want to highlight is that all of these benefits of principal paydown are made possible through the rents you receive.  

In other words, your tenants are paying off massive loans for you.  So don’t be a slum lord – treat your tenants fairly and address their concerns promptly.

Rental Properties Give Tax Benefits

The government gives big tax breaks to real estate investors to encourage them to provide housing for people.  So in addition to being able to deduct out-of-pocket expenses, such as mortgage interest, property taxes, insurance, repairs, and other qualifying costs, you get to deduct a phantom expense known as “depreciation.”  

This is a tax concept that recognizes that when you buy something tangible it tends to break down over time, eventually becoming useless.  For rental properties, the IRS lets you count that depreciation as a loss on your taxes, even though you have not paid any out-of-pocket expense associated with the depreciation.  The truth of the matter is that houses tend to appreciate, not depreciate, but that is beside the point. 

The bottom line is that you could have positive cash flow on your property each year amounting to thousands of dollars, but after deducting all of your expenses, including depreciation, you actually show a paper loss.  

You just get to pocket that cash flow and likely pay little or no taxes on it.  This is a well-established benefit of real estate investing and has certainly been true for my properties.

Rental Properties Can Be Leveraged

I think I am burying the lead by listing leverage as the last benefit.  This is maybe one of the biggest reasons why real estate can be so profitable.  

What is leverage?  It’s using a mortgage to buy a property that is worth more than your available cash.  You are using debt as a lever to magnify the purchasing power of your money. 

In the stock market context, people use employ leverage if they have a margin account that allows them to purchase more stock than the available cash in their brokerage account.  

In a margin account, the brokerage firm is lending you money to buy securities.  If the stock value goes down significantly, the broker can make you deposit more money to cover that loss.  If you do not do that, they can force you to sell some of that stock to pay back part of the loan. 

But because of the perceived stability of real estate, banks are willing to lend far more on a loan secured by real estate (around 4X your down payment) than your brokerage firm is on your margin account. 

And, unlike a margin account, if the value of your real estate goes down, the bank cannot make you sell your property to cover that decline in value as long as you are making your monthly mortgage payments. 

People often criticize real estate investing by comparing it to the stock market.  They argue that the stock market has returned around 10% average annual returns while house prices have appreciated at a far lower rate.

They are not wrong, but their analysis is incomplete. 

According to my research, at the turn of the century, the average U.S. home value was $126,000 and in 2020 that figure is $259,000.

Source: visualcapitalist.com

Based on my calculations, that equals approximately 3.7% average annual growth in home values over the past twenty years.  

The critics of real estate seem to be right, but they ignore the power of leverage to amplify real estate’s returns.  When you factor in leverage, real estate can significantly outperform the stock market over the long term (and with far less volatility). 

Let’s take a simple example. 

Kevin has $100,000.  He invests all of it in the stock market and receives a 10% return per year (this has been the long term average return of the S&P 500).  At the end of 10 years, he has $259,374.  Not bad! 

Kelly also has $100,000, but she chooses to invest in five rental properties, each worth $100,000, and puts a 20% down payment ($20,000) on each of them.  Her combined mortgage amount is $400,000 and her properties are worth $500,000.  Let’s assume a mortgage rate of 3.5% (which is actually above market as of the time of this writing) and an appreciation rate of 3.7%, which is the rate of appreciation for average home values over the past 20 years.  

At the end of 10 years, her properties are worth $719,047.  Her combined mortgages equal $309,708.  If you subtract her mortgage from the value of her properties, she has $409,339.  Real estate wins and it’s not even close.  

And this does not take into account all of the cash flow that Kelly has been receiving on her rental properties for 10 years.  Imagine investing all of that cash into the stock market or into real estate again to further enhance your returns? 

I think you get the picture.

The Human Element

While this does not translate into dollars and cents, I find owning rental property to be immensely gratifying. There is something about owning real estate and being able to point to it and say that’s mine. I simply do not feel that with any other investment that I own. 

On top of that, you have the opportunity to provide quality housing to people who need it. Housing is an essential element of life. If you provide people a great place to live at a reasonable price, that’s a real service and you should be proud to offer it.

Conclusion

Rental property investing offers a powerful combination of benefits that can make you wealthy. Monthly cash flow, debt paydown, appreciation, tax shelters and leverage all work together to create a potent investment vehicle that is unlike anything else. 

Interested in learning more?  Check out the rest of the articles on real estate on our website to help you get started.

If you’d don’t have the funds yet to invest in rental properties directly or want to explore a more automated approach to real estate investment, consider online crowdfunding, which is a maintenance-free option that some consider to be a safer investment. DiversyFund, for example, lets you invest in a diversified basket of real estate investments with an initial investment of as low as $500.

This post may contain affiliate links.  If you click on a link and complete a transaction, I may make a small commission at no extra cost to you.

 

 

 

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