Ask Yourself These Key Questions Before Taking the Real Estate Plunge

Real estate is red hot right now. Unlike post-2008 when it was a buyer’s market (to put it mildly!), today it’s not uncommon for sellers in “hot” areas to get multiple offers on a property and end up getting as much as 20% over the offering price.

Prices are skyrocketing again and, even better (at least for the property owners), rental rates are on the upswing as well. For anyone with the assets to invest in rental property, the environment begs the question: is now the time to jump on the real estate bandwagon?

I received this email from my client Garnett last week:

Hi George.

Fred and I have been talking about purchasing a rental property using my recent inheritance from Mom as a down payment. Specifically, we are looking at houses under $200,000 in the Tacoma area where it is really a hot market right now. We’re thinking about building on these investment properties over time as a secondary income to support our retirement.

Any thoughts or ideas? I have been doing lots of research and have a great mentor who had been doing this for a long time. She has been so helpful.

First, full disclosure: I have a thing for real estate. 45 years ago, back in 1970, I bought my first rental property. For $14K, I was able to buy a duplex in an edgy neighborhood of Colorado Springs. To make it my own, I just had to write a check for $500 to assume a $13,500 VA loan, so it was pretty easy to take on even as a young man with a young family. Over the years I kept buying houses and condos, then a warehouse, and more recently some “scrape” teardown properties in Denver. In the last 5 years the stakes have gotten higher, but I’ve finally found a way to simplify my role of landlord using passive real estate where the tenant, instead of the owner, is responsible for the maintenance (whoopee!), property taxes, and insurance. So yes, I believe in the value of real estate in general, but that doesn’t mean it’s right for everyone, nor that every opportunity is a good one.

Here are four key questions to consider before deciding to take the plunge:

1. Is real estate a “better” (higher return) investment for your portfolio than stocks?

Real estate is so different from stocks that this is hard to answer. That said, real estate offers tax benefits through the use of depreciation that can be used to shelter part of the generated income. Plus, the use of leverage in real estate can sometimes turn a small down payment into a sizable return. For example, say Garnett puts down $40,000 (20%) on a $200K purchase price. If the house increases in value by 5% a year, with her leverage of 5 to 1, she has the potential to make a whopping 25% a year on her investment. (5% of $200K is $10,000, which is 25% of the cash down payment of $40,000). That certainly beats the recent stock market return numbers!

2. What are the disadvantages of real estate?

Lack of liquidity is always a concern—especially for older investors who may require access to liquid assets. In a “normal” market (which we’ve not seen for quite a while), it typically takes 4 or 5 months to sell and close on a property. In today’s market, that time can be much longer, which means your assets are tied up until the deal is complete.

Property maintenance and vacancies can create an “alligator” that eats away at cash flow. Maintenance is (or at least should be!) a given. Every homeowner knows how the costs of things like a new roof, plumbing problem, or landscaping and gardening can add up. Your tenants are likely to be much less willing to wait on repairs than you are on your own home, so unexpected costs can hit at the worst time. Also, vacancies (which happen in any market) are a reality, and whether you’re collecting rent that month or not, you have to be able to make payments on the mortgage.

Managing a property takes time—or money. To take care of your property and your tenants, you either have to be a landlord yourself or hire a management company at a cost of around 8% of the rent collected. If you choose to be the landlord, you have to expect and respond to calls at all hours. And if your tenant’s pipes burst while you’re on vacation, you’ll have to put your own plans on hold to deal with the situation. Be realistic about what you’re most willing to give up: time or money.

3. What pitfalls should I avoid?

When it comes to buying property, there are many potential pitfalls, but here are a few to consider:

Buying when your finances aren’t in great shape. Make sure your income is stable, your consumer debt is paid off monthly, and your emergency fund is intact. If you aren’t 100% certain you can make the payments on a new property, don’t consider it an option.

Buying with a partner, especially a family member. Managing a rental property is stressful enough alone; bringing in a second party can easily add to this stress and, in worst cases, be too much for even the best relationships to handle.

Overpaying. Just as when you’re investing in stocks, it’s best to buy low and sell high. Be sure you’re viewing a property from a rational—not an emotional—perspective to be sure you’re making a wise investment. As you look, ask yourself: Would I want to live here? And, would I be willing to pay the rent that I’m asking a tenant to pay?

Neglecting estate planning. The more property you have, the more important estate planning is. Take the right steps to be sure your heirs don’t inherit a real estate nightmare and large legal fees.

4. What’s the best way to fund the purchase?

Putting down 20% on a rental property is not only recommended, but it’s often required. This means a $200K home requires $40K down (plus closing costs of another $4-$5K), and the resulting loan would be $160K at about 4% interest. You shouldn’t have to pay any points at that rate, and you may be able to avoid paying a loan origination fee as well.

After exploring all of the above with Garnett, we agreed that diving into the world of rental property made sense for her, and she’s going ahead with a purchase in Tacoma. If you’re considering the leap yourself, proceed slowly, check the depth and temperature of the water before jumping, and if everything feels right, take the plunge.