Anyone who has lived in, rented, or owned a home or apartment has some level of familiarity with real estate. Compared to other investments like stocks and bonds, this familiarity can make rental real estate investments seem like the most straightforward way to produce passive income.
It should be easy to buy real estate and produce a steady income stream, right
Not necessarily. In this Insight, we’ll explain why.
What do real estate investors need to know?
Generating rental income from a real estate investment may appear relatively simple: purchase a property at an attractive price, find a tenant, and start raking in the income. However, successful real estate investing requires intensive research, specialized knowledge, substantial upfront costs, and constant headaches.
Key Foundations for Effective Real Estate Investing
Just a few critical factors to consider include:
- Granular Knowledge of Geographic Location: real-estate pricing can vary systematically not only zip code by zip code, but block-by-block. A granular understanding of property locations and associated factors like safety, school districts, local taxes, and more is a critical foundation for assessing an attractive purchase price for a property.
- Financing: unless you plan to purchase a rental property outright, getting the most favorable mortgage possible will be critical to achieving a profitable real estate investment. Which lender can offer the most favorable terms? Should you go with a fixed- or floating-rate mortgage? These are just a few of the factors that an effective real estate investor will need to consider.
- Broker Expertise: a trusted broker who specializes in rental real estate is an indispensable resource for shepherding smooth transactions and ensuring that local regulatory requirements are fulfilled.
- Legal Expertise: it is vital to be familiar with applicable landlord and tenant laws, which can vary widely by state.
- Property Management: unless you plan on maintaining and managing a property yourself, finding a local property management team is another important first step for any real estate investment.
- Incorporation: setting up an LLC will help maximize the tax advantages of your real estate investment and limit potential liability.
- Upfront Capital Costs: even if you plan to take out a mortgage, upfront cash costs will include a down payment (typically 20% of the purchase price) plus costs for furnishing and initial maintenance work. Bringing a new rental property online may be an expensive proposition that takes years to begin generating profits.
We view the elements outlined above as the minimum requirements needed to establish a viable rental real estate investment. Individuals with a professional background in real estate will have experience, knowledge, and relationships that give them an immense leg up, and individuals with no specialized real estate background will face a much steeper uphill climb.
What are the pros and cons of investing in real estate?
While the requirements outlined above are a sobering reminder that real estate investing may not be as easy as it looks at first glance, there are still some critical advantages to consider:
- Owning an income-producing physical asset is appealing to many investors as a more tangible, less abstract source of income compared to financial instruments like stocks.
- A profitable rental property should offer the flexibility to sell at the right time for your personal financial plans.
- In addition to ongoing rent payments, property values tend to appreciate over time, driving further profits.
- Real estate investments can create opportunities for tax benefits such as depreciation, write-offs, and interest deductions.
These advantages should be weighed against the strategic disadvantages of real estate investing:
- Substantial costs like brokerage fees (5-6% on purchase and sales), property management fees (8-12% of collected rents), maintenance and upkeep (often estimated as 1% of property value per year), insurance, and real estate taxes (which can vary substantially by locality) can all eat into rental profits that may appear highly attractive at first glance.
- Real estate is an illiquid asset. If you have an unanticipated need for cash, selling a property will take significantly more time than selling stocks or bonds.
- Finding reliable tenants can be easier said than done, and property owners may be exposed to substantial risk if properties go vacant for long periods of time.
- Declines in local neighborhood appeal may cause local properties to depreciate relative to the broader real estate market.
Ultimately, historical evidence shows that real estate values typically grow at the same rate as inflation over the long run (excluding all maintenance and repair costs). The most common myth is that real estate never decreases in value. In fact, one simply doesn’t notice these decreases since the price doesn’t fluctuate on a daily basis, but only when similar properties are bought and sold. This fact demonstrates that while real estate investing may be an important part of an individual’s financial strategy, it is no panacea for exceptional returns or easy, stress-free income.
Is real estate the right choice for your personal financial plans?
Of course, a rental real estate business can be a huge success! If you manage to buy low, maintain quality tenants, control costs, and sell high, you can earn outstanding returns in real estate. But like any other kind of investment, educating yourself about the associated costs and risks is crucial.
We find that most individuals overestimate their ability to find ideal properties to generate high returns. For most individuals, owning a mixture of liquid stocks and bonds will generate higher long-term returns—with fewer headaches along the way.
