Pros and cons of owning rental real estate

Beware of issues with apartment buildings

Friday, September 30, 2005

By Robert J. Bruss
Inman News

Years ago, when I was a novice realty investor, I read virtually every new real estate book (I still do) and took all the real estate courses offered at the local community college (I later taught four of those courses). One of my instructors really got my attention. He asked the students, "What is the best investment you've ever made?"

A wise guy in class responded, "My wife!" That's not what the instructor had in mind. But nobody could disagree with the student's sincere answer.

Purchase Bob Bruss reports online.

Two or three other students told us about their profitable stock market investments. Realizing the instructor had not yet heard the answer he wanted, I blurted out, "My home!"

Bingo! That was the answer he wanted. Then he quizzed me about my purchase price, my down payment, and how much the house was currently worth.

Actually, the property was a three-family triplex where I lived in the "main house" and received rental income from the two units to pay my mortgage payments and property taxes.

Although I had only owned that property a few years at the time, the instructor showed the class how I had more than doubled my cash down payment, thanks to market-value appreciation and the magic of "leverage." I never forgot that evening class, and I highly recommend community college real estate courses for "newbie" investors.

WHAT IS YOUR BEST INVESTMENT? For most of us, our house or condo has been our best investment. Especially those of us who didn't make a large cash down payment (or couldn't afford more), we have been especially fortunate in recent years.

For example, suppose a year ago you bought your house or condo for $200,000 with a $20,000 cash down payment and a $180,000 mortgage. According to the National Association of Realtors, during the last 12 months, your house or condo appreciated in market value about 15 percent. Some communities did better, some not so well.

If your $200,000 home is just average, your $20,000 equity grew by 15 percent to a home market value of about $230,000 with an equity of $50,000.

I realize the home appreciation market-value numbers have been fantastic during the last 10 years. Will they continue at that high rate? Probably not.

But most house and condo buyers can proudly point to their homes and say, "This is the best investment I ever made."

Of course, the negative thinkers will remind us "But don't forget those mortgage payments, property taxes and other expenses." My reply is, "That's true. But those expenses are roughly equivalent of what it would cost to rent comparable housing without any profit potential."

WHY NOT OWN SEVERAL HOMES? At this point, you are probably thinking, "If my primary residence has been such a profitable investment, why don't I own several houses (or condos)?"

You made a very smart observation.

For example, I own a second home, actually a vacation condominium, which has appreciated about 100 percent in market value during the last 10 years. Some years were better than others. Meanwhile, I enjoyed a sound investment.

Single-family houses usually do much better in market-value appreciation than condos, due to stronger demand. But condos are relatively trouble-free. I just turn the key in the door when I leave. Also, due to recent strong demand, condo appreciation rates have greatly increased in the last few years.

PROS AND CONS OF OWNING RENTAL HOUSES. If you think – like I do – that owning one or two homes for personal occupancy is a great investment, why not own more?

Even if you just buy one or two rental properties per year, after a few years you will own lots of profitable investments working for you building market-value equity.

Although there are many tax advantages of investing in single-family rental houses, there is a down side. They are called "tenants and toilets."

In addition to having to rent investment houses to tenants, who can be troublesome unless properly qualified and managed, there are periodic repair costs. Having earned substantial profits over the years with rental houses, I fully understand these negatives.

However, especially considering all the income-tax benefits, such as the non-cash depreciation deductions to shelter rental income from taxes, the obvious conclusion is the management negatives are far outweighed by the profit positives.

PROFESSIONAL PROPERTY MANAGERS CAN AVOID PROBLEMS. If you are not inclined to manage your rental houses, local professional property managers will be glad to manage your properties.

However, these firms charge around 10 percent of the gross rents, plus extras such as for renting vacancies and supervising repairs. But they insulate the property owner from the tenants. Although there are many superb professional property mangers, be sure to check references of current clients to be sure of making the right hiring decision.

WHY NOT INVEST IN APARTMENTS INSTEAD OF HOUSES? Although there are many super-successful apartment-building investors, most part-time real estate investors have difficulty managing apartments.

Personally, my experience has been (1) apartment buildings don't appreciate in market value nearly as fast as single-family houses, and (2) when you have an apartment building problem, it is usually a big problem.

For example, when I owned a San Francisco apartment building, one evening as I was enjoying dinner at my home, I received a phone call from a tenant who informed me there was no heat. Within the next hour, I received phone calls from most of the tenants. My so-called manager either was out for the evening or didn't answer his phone.

The next day I got the central heating repaired. But that experience shows how one problem can escalate into lots of complaint problems. By comparison, when I have a problem with a rental house, it only affects one tenant and is usually easy to solve.

After that incident affected my entire apartment building, I decided to switch to single-family houses, which are usually far more profitable and certainly much easier to manage.

Another drawback of apartment buildings and commercial properties is their market value depends on the "cap rate," which depends on the net operating income.

By contrast, the market value of single-family houses depends on recent sales prices of comparable nearby homes, rather than their rental income and expenses.

BONUS ADVANTAGE OF RENTAL HOUSES. A bonus advantage of owning rental houses is they can be exchanged, tax-free, for other investment properties of equal or greater cost without capital gains taxes.

Thanks to Internal Revenue Code 1031, a rental house or condo can be traded tax-deferred for other investment property of equal or greater cost without tax payment. IRC 1031 has been used by many real estate investors to pyramid their investments, tax-free, from a small property into investment property worth far more. Full details are available by consulting your tax adviser.