Do Rental Properties Make Good Investments?

On this episode of The Long View podcast, Ilyce Glink, author of a nationally syndicated column on real estate matters and of more than a dozen books on real estate and home buying, including the fourth edition of “100 Questions Every Home Buyer Should Ask,” sits down to discuss the real estate sector and tips for today’s market volatility.

Here are a few excerpts from Glink’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Rental Properties as an Investment

Ptak: You’ve long been an enthusiast about buying rental properties as investments. I think you often talk to investor groups about how to do this, and you’ve been a successful owner of rental properties yourself. What are the key positives, in your opinion, and what are some of the key risk factors that someone should keep in mind?

Glink: What do I like about it? Well, I like the income that it brings in. We’ve owned the property that we have now – we’ve had others, but we’ve had this property for, oh, my goodness, 23 years-ish. So, it’s gone up in value. Not a lot, not as much as I would have loved, but it’s almost all paid off. And we make good money on it every month. In retirement, that will be a really nice way to generate income. And there are a lot of people who are doing that now. They’re buying property to generate income, and if you have enough of it, you want to make it your primary business, more power to you. There is a lot that goes into it. Do you have the temperament to be a landlord or not? Are you okay with people calling you in the middle of the night to fix toilets or not? Are you able to manage the books and all of the other things that go into it, keep it straight, it’s what you like to do, you like to work with people, you like to find tenants? All of those things are pieces of it. And then remember, even once it’s paid off and you’ve got $20,000, $30,000 of revenue coming in, let’s say, a year, something might happen and you’re going to have to spend a chunk of money.

So, for example, we just in our property had to replace the HVAC system, and it was 9 grand. Well, 9 grand is a significant chunk of the revenue we’re getting in every year, but we should be good now for the next 10 to 15 years. So, you got to think about that. Single-family homes have different needs, but you may get better price appreciation than a condo. So, when you’re thinking about what it is you want to buy and how you want to leverage that, and are you going to buy a three flat, live in one, rent out the other two, or are you going to buy, let’s say, a vacation home, and that’s going to be the thing you rent out like a friend of mine did very successfully, you just have to think through all the things that go into it and then be ready to tackle whatever problems exist. And you may buy a lemon, in which case, you’re going to want to get rid of that thing as soon as possible.

Institutional Investors and Rental Properties

Benz: Wanted to ask about the emergence of large institutional investors as buyers of rental properties – BlackRock, for example. What does that mean for smaller investors dabbling in this space on their own? It seems like it could make it harder for them if there’s more competition for some of these properties.

Glink: So, that is a growing concern. I listened to a number of people talk about this at the Annual National Association of Real Estate Editors Conference back in December. Right now, the numbers are pretty low on a relative basis. There are tens of millions of homeowners in the country, and BlackRock and other companies, even if they’re buying 20,000 homes at a time, it’s a teeny tiny fraction. But every home they buy takes homes out of the marketplace. So, what happened 12 or 13 years ago is that there were thousands and thousands of these homes that homeowners basically went under, and they couldn’t afford to make the payments and there was a massive foreclosure crisis. So, the banks took those homes back and then they had to unload them. They can’t just hold on to them forever. And so, a lot of the people that had money even three, four, or five years later, were these big investment companies, and so, they started buying them.

And then, in many cases, they leased it back to the homeowners who originally had them. But that means that those homes are no longer available. It was expected that they might turn around and sell them. But what’s happened is that there’s been so much price appreciation and there’s been such a good return on investment because they bought them so low that they don’t want to sell them and pay capital gains. They’re just going to collect the rents. And so, those homes are now off the market. And depending on where you live, that has contributed to a certain extent to the shortage of homes and one of the big underlying causes of the price appreciation. We simply are about 5 million to 6 million home short in this country. So, it is a problem for investors, small investors, mom and pop investors, because you’re up against institutional buyers who come in with cash. And if you don’t have cash or make a cash-like offer, that can be a problem. Okay.

But there’s other problems as well, because you’re up against individual people who just want to buy a home to live in, and in many cases, this is driving up the competition. And I think that as interest rates are now higher, we’re going to see maybe a little bit less competition for these homes from everybody. Everybody is going to sit back and wait and see what is going to happen with interest rates. But that’s good. That’s an opportunity for home buyers to go in, buy these homes, and then as interest rates fall, as they inevitably will, to refinance down to something even more affordable.

The Housing Shortage

Ptak: Do you think rising interest rates and cooling off the housing market that that is going to be what it takes to basically solve the problem of there being a housing shortage? Or there are other things that you think need to happen for the housing shortage to become less acute?

Glink: No, you have to build homes. You have to build houses. It’s not enough. I think people don’t really understand how many homes fall out of use every year. So, if you have 100 homes, at any point in time, there are homes that just have to be torn down and new homes have to go up. They are just 110 years old, or they no longer meet the needs of the neighborhood, or they’re in such a bad shape it literally gets torn down. So, we have to build replacement property as well as building new homes. And why is that? Because the number of people in this country every year goes up and up and up. We used to be at 275 million, and then we were at 300 million, and now, we’re at 325 million, maybe closing in now on 340 million people. So, all those people have to have somewhere to live. And we’re living longer, and so, more people are alive, and we need more places to house them.

So, just simply raising interest rates doesn’t solve that problem. What the Fed is trying to do is solve the problem of inflation. And I’m not really in an inflation expert. So, I won’t go there and really talk about that other than to say, the work that’s being done with interest rates will slow the number of people looking to buy homes right now, but it still means that those people have to live somewhere, and they’re going to need to live in a rental property, and there’s only a limited number of rental properties to go around as well, and that’s why rental property prices are going up.

Tax Benefits and Homeownership

Benz: You referenced the favorable tax treatment that homeowners receive. I want to delve into the exclusion on capital gains from home sales. Can you discuss how that works and also, what kind of documentation people should keep about the improvements that they’ve made?

Glink: So, right now, the tax law says that if you live in your home as a primary residence for two of the last five years, you can keep up to $250,000 in profits tax-free or up to $0.5 million if you’re married filing jointly. The two out of the last five years is important. If you move before that two years is up, then you might get a proportionate share of the profit. Like, for example, if you get divorced and you have to move, or if you move to take a job that’s more than 50 miles away, there’s a lot of different rules.

So, how do you calculate what profit looks like? That’s the second part of your question. And the way that in general this is calculated is the cost of purchase, plus the cost of sale, plus the cost of any capital improvements. So, if you add on a room, that’s a capital improvement. If you replace the roof, it’s a capital improvement. If you paint the whole butter yellow, that is not a capital improvement. So, cost of purchase, cost of sale, cost of capital improvements. Add that together, subtract it from the sales price. That is your net profit, and that is what the IRS is looking for.

Oh, and you asked about keeping paperwork. Good idea to always keep paperwork. So, we know that the cost of the capital improvement, the roof replacement, and this is how much it was, you should have a file with all of these costs. Keep it. Keep it even after you sell your house for seven years. And then, after that, you can shred it all.

To Pay or Not to Pay Off a Mortgage?

Ptak: One decision that many homeowners wrestle with is whether to pay off a mortgage early versus invest in the market. This comes up especially with people who are in their 50s and 60s and closing in on retirement. How would you advise people to decide their best use of funds? It certainly seems like a very polarizing topic.

Glink: I have friends who have interest-only mortgages at 2%, who when those are – they’re done paying with them and they sell their house, they’re hoping that the home price has gone up because they literally haven’t paid down any of it. And that’s fine for them. They’re high-net-worth people, and they like to play that game. For everybody else basically, I personally would advise, and I have done this myself to try and pre-pay these mortgages. Because if you’re living in your house for 20 years, it would be nice at the end of it to have that all paid off, especially if you’re about to go into retirement, because what that does is just free up cash flow. So, I’m nowhere near retirement age, I’m happy to say, but our house is paid off, and literally, now all we have to do is maintenance and taxes, and it’s become very cheap to live here. By the same token, though, if I want to go anywhere else, I’m going to spend more, probably get less house than I have, and have more expenses in it. So, the reason, or the raison d’être for me to sell has kind of gone down. There’s nothing compelling me to make that move right now. There would have to be some sort of a major lifestyle change to get me to leave my house.

But I think that for a lot of people the idea of making extra payments, they don’t understand the value of it, and I get it. If your interest rate is 2.5%, maybe right now you shouldn’t. Right now, don’t put in that extra money because you’ll do better in savings. But for the last 15 years, you wouldn’t do better in savings or investments. You might have done better in investments, but maybe not. So, the nice thing about prepaying your mortgage is that’s a guaranteed rate of return. And if you want to keep some of your money in cash, this is one way to kind of by building that equity while it’s relatively illiquid, you could still get access to it if you needed to, at least some of it, but it’s there, and you’re building it, you’re building that net worth, and you’re working towards the goal of having that mortgage paid off. And I think that’s a valuable thing for most people.