Rental properties are some of the most frequently discussed investments on the internet. There are countless YouTube channels and blogs that promote their benefits and sell courses that teach you how to invest in them.
They are commonly advertised as It’s a way to gain financial independence, and their arguments are very persuasive.
The whole idea of buying a property with bank money and having the tenant pay off while waiting for the property to be appraised is very compelling. You can also earn positive cash flow while waiting and enjoy significant tax benefits.
It’s also inflation-proof, recession-proof, and everyone always needs a roof over their head…so the risk versus reward may seem unbeatable. Good places tend to appreciate over time.
Many people legally became wealthy by investing in rental properties, so it’s certainly possible.
But there’s a dark side to all of this…the untold truth.
It’s not all sun and rainbows, as every YouTuber who sells courses seems to be.
In fact, I would argue that the risk-to-reward of rental properties is actually very poor, and that in most cases there are much better options that offer better returns for less risk.
Coming from a family of real estate entrepreneurs, I studied real estate investing for years and ended up working in private equity real estate and bringing my own rental properties, so I think I understand the topic very well. .
Below, we highlight five key points to know before investing in a rental property. If I had known them, I probably wouldn’t have bothered:
Point #1: Real Earnings Are Much Lower Than You Think
A simple calculation that most rental property investors do is:
(monthly rent x 12) / purchase price
It is used to get a rough idea of the yield of the property.
They usually offer very attractive yields. As an example, I was recently looking for opportunities in Riga, the capital of Latvia, and came across this property:
A developer is selling a studio in a newly renovated historic building in the center of Riga for around €50,000. You can rent each for up to €400 per month and there is a lot of rental demand.
This gives a yield of close to 10%. Then, taking this calculation one step further, if his 70% of the purchase price was financed with a mortgage, his return on equity after deducting interest costs jumps to over 20% for him.
(400 x 12) – (35k x 0.04) / 15k = 22.6%
It is wonderful.
You can buy a package of five studios in a building for more efficient management and own it all decades after tenants pay off their mortgages, offering great cash flow and financial freedom.
Real estate is likely to appreciate over time, and there are many tax incentives, especially in Latvia, which ranks second in the OECD for tax competitiveness.
But here the calculation becomes ambiguous.
A property’s actual net operating income is far from gross rental income as there are many operating expenses that need to be considered. A rule of thumb commonly used by experienced rental investors is the “50% rule”. This means that the NOI will be approximately half of the rental income.
So in this case the NOI is really only €200 per month, even after deducting all costs and taking into account temporary vacancies etc.
So the return on equity is already halved, but it’s still very attractive at 11.3%.
Unfortunately, that’s not all.
We haven’t yet considered the value of your time. Buying and managing a rental property can be a daunting task, even if you delegate some of it. Each property takes time and energy to find, negotiate, finance, buy, offer, sell, rent, monitor, repair, release and ultimately sell.
Some weeks work less, some weeks more, but as a rule of thumb, it takes at least 3 hours a week on average, including all the time actually spent looking for a property. Complete your purchase.
If you value your time at €30 per hour, you could have earned this money in another job, so the overhead you have to account for is €90 for a week and €380 for a month. increase.
If you only own two studios, you know you’re not actually making any money from your assets. You just get paid for the work/time you put in. Even with five studios, the returns aren’t particularly attractive, so economies of scale aren’t as important as they’re worth.
Sure, you could use a property manager, but there’s still some work to be done, so you’re giving up most of your revenue, creating new conflicts of interest, worsening management, and increasing other costs. There is likely to be.
Bottom line, in my experience, most rental properties aren’t as attractive as they first seem. Properly accounting for the value of all costs and time, returns range from 5-10% depending on how much appreciation you receive.
Point #2: You’re Taking Too Much Risk Because of Liability Issues
So let’s assume that after deducting all costs and time value, we can get a 10% annual return.
Is it worth the risk and effort?
No, most of the time they don’t.
Rental properties are not listed and they think the value is stable, so they may give you a sense of security. Plus, rental income stays virtually unchanged during a recession, giving you control over your property.
But in reality, this is a private, illiquid, concentrated, management-intensive, highly indebted and highly leveraged investment.
Stocks are often thought to be extremely risky and highly volatile, but since they are not traded, there is a sense of security.
You’ll also be personally signing the loan, which exposes you to significant liability risks if things go wrong. Also, landlords are always sued by tenants. While using an LLC to get insurance can help, it does not remove all liability risks. This is why thousands of rental investors file for bankruptcy protection each year.
The risk of potentially having to go through a legal battle with tenants makes most rental investments unattractive. is not worth the
On top of that, after deducting legal fees, a 10% return suddenly turns into a negative 10% return…
Point #3: Tax benefits are overstated
Rental investors can usually defer tax by depreciating their assets.
That’s all great, but Uncle Sam doesn’t give gifts without getting in return. What rental investors seem to overlook is that when you depreciate a property, you’re stuck with it. .
Selling it will generate huge taxes due to the very low cost base.
Sure, you can use the 1031 exchange to reinvest in another property, but you’re still stuck in real estate. You can’t get out of real estate once the market is no longer attractive. This loss of flexibility can cost you a lot.
Furthermore, there is no guarantee that the 1031 rule will exist forever. Many politicians have been trying to close this “loophole” for years.
Point #4: Your time, energy and geographic freedom are worth it
Your main earning power comes from your career, so this should be your number one focus for increasing your income and wealth.
But once you start investing in rentals, this quickly becomes a major distraction for your career. It is a second career because it requires a lot of time and energy.
This means that your primary career will suffer from it, reducing your chances of getting that promotion and increasing your primary income stream.
I am also stuck in one place. Even if you get a great job offer on the other side of the country, you may be hesitant to accept it simply because it makes managing the property more difficult.
The loss of time, energy, and geographic flexibility has a major impact on careers, which are the primary source of income. Most of the time, the earnings aren’t attractive enough to be worth it.
Point 5: Get better returns with less risk, no effort and total freedom by just buying a REIT instead
Last but not least, you can also buy a listed real estate investment trust (“REIT”) to gain exposure to real estate. That way, you have the potential to earn the same or better returns with less risk and effort.
Several studies have shown that REITs are actually worth more than private real estate investments when all costs are deducted.
Here are 10 reasons why this makes sense. This topic is covered in detail in another article. click herebut in short:
- 1) REITs spread investments faster to compound interest
- 2) REITs can enter real estate-related businesses and increase returns
- 3) REITs can develop their own properties
- 4) REITs can sell and leaseback
- 5) REITs enjoy large economies of scale
- 6) REITs have strong bargaining power with tenants
- 7) REITs hire the best talent in the real estate industry
- 8) REITs have a total return approach
- 9) Most REIT managers are well aligned with shareholders
- 10) REIT investors don’t pay transaction costs
Especially since REITs are actually much cheaper today, it doesn’t make sense to invest in rental properties.
Their valuations are historically low, and many REITs are priced at a significant discount to the fair value of their assets after deduction of debt.
To name a few:
AvalonBay Community (AVB) owns Class A apartment communities in some of the nation’s best markets, has an A-rated balance sheet, and has an impressive track record of generating above-market returns, but has a 20% relative to net worth. % discount rate. Value (“NAV”).
STAG Industrial (male only) owns a warehouse dedicated to e-commerce, and its largest tenant is none other than Amazon (AMZN). Rents are up more than 15% at the moment due to high demand for warehouse space, while the market is pricing him at an estimated 25% discount to NAV.
REITs and other listed real estate securities also enable foreign investment. Vonovia (OTCPK: Bonoi/ OTCPK: VNNVF), Germany’s leading apartment landlord, is temporarily priced at just 50% of NAV as the market overreacted to the war in Ukraine and the energy crisis it sparked. It will negatively affect the company in the short term, but the long-term outlook remains the same: you can get a property for 50 cents a dollar, but the euro is also cheaper – double discount. A dividend yield of 6.3% will be paid while waiting for
Simply put, you get the benefits of a rental property with the added benefits of liquidity, decentralization, limited liability, and cost-effective professional management by a REIT, all of which are significantly less than fair value. discounted to
Higher returns with less risk and less hassle. Again, why buy a rental property?
At High Yield Landlord, investing in historically undervalued REITs has yielded around 15% annual returns, but rental properties have failed to do so.