There can be something particularly gratifying about buying and owning real estate—about plowing your hard-earned money into your very own corner of the Earth. For investors who feel nervous about the stock market or who struggle with the abstract nature of stock investments, it may feel reassuring to own something tangible, that you feel confident will still be standing in a year (or 20).
That may partly explain why direct real estate investing has been having a renaissance. Becoming a landlord is often touted as a key strategy for building wealth and financial independence among financial influencers and the so-called "FIRE" community (which stands for financial independence, retire early). For millennials and other cohorts who still remember the volatility of the Great Recession, there may be an appeal to building a portfolio that's less affected by decisions made on Wall Street or in corporate boardrooms.
"Investing in rental properties is an opportunity to provide a good place for someone to live while building equity in a property over time," says Meredith Stoddard, a Fidelity life events experience lead who's been purchasing, selling, and renting out properties since her college years. "It may also provide a way to diversify your cash flow."
However, buying investment properties isn't for everyone. In addition to requiring a substantial up-front commitment of cash, it comes with a unique set of risks and rewards that prospective investors need to understand. Here are some of the factors to keep in mind.
Potential risk: Cost of ongoing time and effort
While rental income is sometimes referred to as "passive income," there's nothing passive about becoming a landlord. In addition to finding and vetting tenants, you have to manage ongoing relationships with those tenants, maintain and periodically upgrade your property, and make sure you're abiding by any applicable laws or regulations. If your portfolio expands to multiple properties, these management duties can become a full-time job in themselves.
You essentially have 2 options for handling management: You can commit time to doing it yourself or pay a management firm to do it for you. And even if you hire a firm to handle the day-to-day, you'll still have to make key decisions.
Short-term vacation rentals can add another layer of management complexity. Vacationers expect sheets, towels, soap, and other hotel-like items for the duration of their stay. And if you take bookings online, you may have to worry about cultivating a steady stream of 5-star reviews.
Potential reward: Unique tax advantages
While the rental income landlords collect is generally taxable as ordinary income, there are deductions for a wide range of items, which Stoddard notes can help reduce the tax bill.
Deductions for income from rental properties can include:*
- Mortgage interest
- Property taxes
- Depreciation (i.e., a property's gradual loss of value as it ages)
Costs for renovations aren't deductible the same way that maintenance costs are, but they can still provide tax benefits. "Money you put into improvements of the property can be added to your cost basis and factored into your depreciation," Stoddard says. "A higher cost basis can also reduce the taxes you owe if and when you sell."
It's important to note that if you do eventually sell investment property at a profit, you'll generally have to pay capital gains tax on the full amount of any appreciation over the adjusted cost basis. That's because you won't be eligible for the capital gains exclusion (which applies to sales of primary residences) for properties that you've exclusively used as rentals.
If you're getting serious about real estate investing, consider consulting with a tax professional to better understand the potential tax implications.
Potential risk: Lack of diversification and liquidity
Buying even just one investment property can often take a significant commitment of cash. Because properties are so high value in many high demand areas, it can be challenging even for wealthy investors to build a diversified portfolio of properties. That can mean you're heavily exposed to the risks of the individual properties you own, and a few strokes of bad luck—tenants who stop paying, or a 100-year flood—could put a real dent in your financial wellbeing if your investments aren’t broadly diversified.
That’s why it’s important to ensure that you not only have a financial safety net to handle repairs and ongoing maintenance, but it is also important to look at real estate as part of your overall financial strategy and in context of any other investments you have such as stocks, bonds, retirement or other assets.
Additionally, unlike traditional financial assets that are generally easy to sell, it takes time (plus effort and money) to sell a property if you ever need to raise cash or rework your portfolio. Your ability to sell quickly, and at a good price, may also heavily depend on the dynamics of your local area at a given point in time.
Potential reward: Inflation protection
Investment properties have the potential to hedge inflation in 2 ways: with rising rents and rising property values. Rental income can provide a particularly good inflation hedge if you have a fixed-rate mortgage on the property, says Stoddard. "Rents generally go up over time, but the payment on a fixed-rate mortgage stays the same, and your payments do go towards paying down the principal balance over time " she notes.
And although it's never guaranteed that a given property will increase in value over any specific period, real estate values on average tend to keep pace with inflation over the long term. (Of course, the significant ongoing expenses for owners—from taxes, to repairs, and improvements—also tend to rise with inflation over time.)
Pitfalls to avoid
Not keeping enough cash on hand
Plan for recurring costs, such as your mortgage payment, and also for irregular expenses like repairs. Make sure to create enough of a buffer in your cash flow so you can ride out periods of high expenses.
Not researching the local area
Stoddard says it's imperative to understand the dynamics in your local market, compare similar properties, and choose locations that appeal to prospective tenants. For instance, if you plan to rent to vacationers, is the property near the highway or public transit? Understanding their desires will help you select a property they'll find appealing.
Tenants are your customers. They can make or break your business, so it's essential to maintain healthy relationships with them. "It's never a good idea to nickel-and-dime your good tenants or create an adversarial dynamic," Stoddard says.
One of the best ways to ensure good relationships with tenants is to be selective about who you rent to in the first place. The more reliable and responsible your tenants are, the less friction there's likely to be. Being disciplined about checking credit and references can help prevent problems before they occur.
Make sure you research and understand your local landlord/tenant laws so that you can follow applicable regulations accordingly and not put your income or business at risk.
Is property your passion?
For investors who are comfortable with and financially equipped to handle the risks, investing in property has the potential to provide cash flow and growing equity over time.
That said, it may work best if there's a fit not only with your financial goals and situation, but also with your personality. For some investors, dealing with tenants, contractors, and neighbors may feel like an unwelcome headache. For others, it may feel like part of your investment in your asset and your community.
Remember also that buying properties outright isn't the only way to gain exposure to real estate or an inflation hedge. Real estate investment trusts (REITs) can offer exposure, plus the added possible benefits of diversification and professional management, with similar convenience and simplicity as traditional stock investments. Treasury Inflation-Protected Securities and exposure to commodities can also potentially help provide an inflation hedge. (Learn more about protecting your money from inflation.)